Is Stress Testing more effective than VaR?

UCITS Risk Management conference, May 2011

Aristides Protopapadakis
Managing Director

Stress Testing vs. VaR

Old concept but renewed interest. Why?

Senior managers have lost confidence in modeling? Regulatory stress testing exercises

Factors in favor of stress testing

Post-crisis skepticism about VaR model assumptions

Fat Tails? Correlation structures?...

Stress results easier accepted by senior management Stress scenarios based on insight of experienced managers Can cover risk types poorly managed in VaR models Particularly relevant to managing the risks on hedge fund strategies

Are VaR models suitable to Hedge Fund strategies?

Static Strategies
Hedge fund strategies may reflect expectations about future occurrence of historically rare events The VaR methodology will be likely based on the same data used to formulate the strategies => Not independent view!

Dynamic Strategies
Buy/ Sell accross time upon specific events

Long term cumulative risks typically ignored by VaR models!

Unlike VaR, stress scenarios must be strategy specific

Risk Manager must identify strategies expressed in the portfolio Implement scenario sets that stress the particular strategies
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Examples

Strategy #1 (Static)
Long-short CDS on paired names/ diff. tenors/ CDS vs. Bond basis/ index tranches at various attachment points Stress Scenarios: Idiosyncratic movement of spreads, spreads term structure, Bond vs. CDS liquidity premium, base correlation curve across index or between indexes

Strategy #2 (Dynamic)
G7 ccy strategy: Borrow GBP and sell against USD when spot rate + interest differential <> equilibrium view Stress scenarios: Dynamic paths of FX and interest rates, and then simulate the buy and sell decisions across each path

ESMA Guidelines: Risk management process

Applies to Investment Co (self-managed UCITS) or ManCo Should comprise procedures enabling the ManCo to assess the UCITS risk exposure (risk measures, limits) All material risks must be addressed:
Market risks
Liquidity risks Counterparty & Issuer Concentration risks Operational risks

Assessment at least on a daily basis

Stress Testing in ESMA Risk Guidelines

Program in line with UCITS risk profile (freedom) Must capture all risk factors, in particular those not captured by VaR model. Run at least monthly

Execution of the program must be documented and traceable

Which statement appeals more to you? A. VaR models where developed for Banks and are not well suited to funds risk management

B. Stress tests are a meaningless regulatory requirement: Too subjective to be taken under account seriously

C. Stress testing is a valuable risk assessment tool, in addition to traditional VaR analysis.

Stress Testing in practice

I. Market Risk

Gaussian vs. Fat tails

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Gaussian vs. Real world dependence structure

Source: Acharaya (2008)

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Dependence in the real world

Source: Jon Gregory (2008)

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Tool: Use of PCA for stress testing interest rates

Traditional analysis: Multiple, correlated risk factors

NPVbonds = f( 1m, 3m, 6m, 9m, 1y, 2y, 3y, 5y, 7y, 10y, 15y, )

PCA analysis
NPVbonds = f( trend, tilt, curvature )

Easy to stress a six sigma change in trend, tilt, or curvature

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Stress Testing + VaR: Stressed VaR!

Bank Supervisors will be more proactive in using stress testing as a determinant of a Banks capital requirements. Stressed VaR is a move in this direction
c max VaRt 1, mc VaRavg max sVaRt 1, mc sVaRavg

This at least doubles capital for market risks

Model inputs must be calibrated to historical data from a continuous 12-month period of significant financial stress relevant to the banks portfolio. Respected authors call this approach ridiculous!
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Stress Testing in practice

II. Specific (idiosyncratic) Risk

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ESMA Guidelines: Choice of VaR model

Historical, Monte Carlo simulation, or Parametric

At least six tenors for interest rates Include non-linearity (gamma) Include vega risk

VaR model must also account for idiosyncratic risk:

Credit Spread risk Equity residual risk Premium/ discount (between cash and futures)

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Idiosyncratic or Specific Risk assessment

Three components for idiosyncratic risk

Credit spread volatility Migration Risk Default Risk

Typically (a) can be taken under account in VaR model

(b) and (c) require a different approach:
Simulate a new rating for each bond at times Ti (stressed path) If matured: replace by similar bond constant level of risk assumption If defaulted: Reinvest recovery amount in new bond with orig. rating

If migrated: Sell and absorb P&L, reinvest in new bond as original

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Stress Testing in practice

III. Liquidity Risk

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Incorporating market liquidity in a VaR model

Exogenous liquidity refers to the transaction cost (bid/ offer spread) for trades of average size Endogenous liquidity: Is related to the cost of unwinding portfolios large enough that the bid-ask spread cannot be taken as given, but is affected by the trades themselves.

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Exogenous vs. Endogenous liquidity

Approach for exogenous liquidity: Integrate the variability of the bid/ offer spread for average transactions as a risk factor

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Endogenous liquidity

Particularly relevant in under stress conditions

Margin requirements may cause different price movements on assets with identical payoffs Delta hedging activities (buying an asset when price goes up). Especially when many banks have same kind of positions against investors who do not dynamically hedge.

Approaches: Liquidity-adjusted returns, weighted bid/ as spreads based on volume.

Preferred approach: Varying time horizon.

Parameter required for each position: Fraction of daily volume that can be liquidated without significant impact to the market.

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Stress Testing in practice

IV. Counterparty Risk

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Stress testing Counterparty Risk

Essentially, similar to market risk stress testing Instead of looking for large losses, we look for large profits from specific counterparties and/ or margin postings Example: a six-sigma steepening, combined with a flattening of the euro yield curve could result in:
OTC profit, Counterparty A : 2mln OTC loss, Counterparty B (hedge): -2mln

Margin posting, Counterparty C: 0.9 mln

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Building a Stress Testing Framework

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But: Stress tests are subjective!

Euromoney 31/3/11 (criticizing the latest EU stress test)

Sure the economic scenario seems mostly fairly severe [but] the . Equity prices are assumed to fall by 15%; the DAX has just fallen 12.5% in three weeks. Valuation haircuts on sovereign bonds are very small, especially at the front end where banks hold much of their exposure. Private tests would allow for much sterner stress scenarios to be examined, perhaps involving multiple sovereign government defaults. That would at least allow banks and regulators to and overall balance sheets in such a calamity. It wouldnt necessarily matter if most banks failed such private tests, because regulators might in turn attach an .

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The problem with stress testing is

In traditional stress testing we dont know the likelihood of the scenario happening. There is no probability attached to it. However, scope can be too vague: Framework required:
what do I need to stress? combinations?
by how much?

Limited research guidelines compared to pricing, VaR etc.

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Stress framework: Additional considerations

Different scenarios (idiosyncratic, market wide) Multiple severity levels in each scenario Time dimension (Dynamic vs. Static) Different changes to different asset classes

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Stress scenario construction

Historical changes (absolute/ relative)

Missing instruments: Beta model Missing Risk Factors: Behavior model

Predictive:
set a few RF changes => behavior model for the rest

User-defined
Dependency structure assumptions??

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Reverse Stress Testing

Algorithmic search for scenarios leading to intolerable loss Tool to facilitate brainstorming by stress testing committee The scenario is not fixed in advance. However Likelihood of occurrence to such a scenario can still only be judgmentally assessed! Scenarios need to respect correlation assumptions.

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Conclusions

Stress testing is a diagnostic tool to better understand your institutions risk profile It incorporates the insight of experienced managers It contains forward-looking elements

It should trigger debates within your organization as to the possibility of an unwanted situation and the acceptance of its consequences Risk Management is by no means a mechanical exercise!

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Thank you!

Contact me any time

aripro@systemic-rm.com

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