Scenario Analysis and

Stress Testing
Chapter 22

Risk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015

Stress Testing
Key

Questions

How do we generate the scenarios?

How do we evaluate the scenarios?
What do we do with the results?

Risk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015

Generating the scenarios

Stress

individual variables
Choose particularly days when there were
big market movements and stress all
variables by the amount they moved on
those days
Form a stress testing committee of senior
management and ask it to generate the
scenarios
Risk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015

Core vs Peripheral Variables

If

scenario generated involves only a few

core variables, regress other peripheral
variables on the core variables to determine
their movements. (Kupiec, 1999)
Ideally the relationship between peripheral
and core variables should be estimated for
stressed market conditions (Kim and
Finger, 2000)
Risk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015

Making Scenarios Complete

Often

an adverse scenario has an

immediate effect on the value of a portfolio
and a knock on effect
Examples
Credit crisis of 2007
LTCM

Risk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015

Reverse Stress Testing

Use

an algorithm to search for scenarios

where large losses occur
Can be a useful input to the stress testing
committee.

Risk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015

What are the Incentives of a

Financial Institution?
If

the stress testing committee comes

up with extreme scenarios more
regulatory capital is likely to be required
The stress testing committee may
therefore has an incentive to water
down the scenarios they consider

Risk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015

Scenarios Chosen by Regulators

A part of US, UK, and EU regulation

CCAR for largest US banks considers recession
scenarios similar to 1973-75, 1981-81, and 2007-2009
and banks must submit capital management plan
DFAST for medium sized banks involves similar
scenarios but no capital management plans are
required
If banks fail the tests they have to raise more capital
Regulators have to make sure banks do not game the
system (See Business Snapshot 22.2)

Risk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015

What to do with the Results?

Should

managers place more reliance on

stress testing results or VaR results
One idea is to ask the stress testing
committee to assign probabilities to
scenarios (e.g. 0.05% or 0.2% or 0.5%)
The stress scenarios can then be
integrated with the historical simulation
scenarios to produce a composite VaR
Risk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015

Example from Chapter 13

Scenario

Loss ($000s)

Probability

Cumul. Probability

s5

850.000

0.00050

0.00050

s4

750.000

0.00050

0.00100

v494

477.814

0.00198

0.00298

s3

450.000

0.00200

0.00498

v339

345.435

0.00198

0.00696

s2

300.000

0.00200

0.00896

v349

282,204

0.00198

0.01094

v329

277.041

0.00198

0.01292

v487

253.385

0.00198

0.01490

s1

235.000

0.00500

0.01990

v227

217.974

0.00198

0.02188

v131

205.256

0.00198

0.02386

v238

201.389

0.00198

0.02584

Risk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015

10

Subjective vs Objective
Probabilities
Objective probabilities are calculated from data
Subjective probabilities is based on a individuals
judgment.
Objective probabilities are inevitably backward
looking
The procedure just described is a way of
combining subjective and objective probabilities.

Risk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015

11