Risk Management; Stress Testing

1. Introduction
With advent of globalization and rapid enlargements in the business environment, companies are
required to formulate strategies to deal with unanticipated risks in the distant future. Companies
should search for appropriate alternatives to deal with economic, financial, technological, social
and environmental risks. This article discusses about stress testing as an effective tool to manage
and mitigate the impact of risk. This tool helps the management in analyzing the possible and
acceptable worst case scenarios and its impact on firms income. The article argued that in order
to predict and avoid future losses, it is essential for the firm to identify various possible reasons
behind previous losses. The companies need to analyze that whether it is applying and involving
a suitable risk management process in every day decision making process. The companies need
to keep a check that whether it is reviewing and regularly updating the risk management process
as per the situation or as and when the need arises. Sound risk management techniques will help
firm to deal with changing business rules and practices, rising credit balance, emerging and
developing economies, rise of inflation, changing demands, new entrants, changing consumer
attitudes and preferences for energy efficient products, social responsibility. Therefore, this
article declares that an efficient risk management technique helps in maintaining the tradeoff
between risk and return by fully utilizing the available investment opportunity in the market
(Stulz, 1996).

Risk Management in Emerging Markets

Effective risk management technique helps the firm in gaining an insight into capital market and
handling the tradeoff between risk and return to effectively implement the strategic plan and
achieve the objectives formulated by the managerial department.Companies engage themselves
into risk management processes to overcome the problem of underinvestment. Managing risks
effectively will help the firm to deal with falloffsin the available potential opportunities of the
market.The only problem that a company face is that it fails to prioritize the risk or it fails to
identify the risk company is exposed to (Nocco& Stulz, 2006). There is an emerging need for
companies to prioritize risks on the basis of its impact and ability to halt the overall growth of the
firm. Organizations needs to integrate the risk management process into the overall strategic plan

of the organization to minimize the impact of unpredictable or uncertainties in future

events.Managing risk effectively directly impacts the value of the firm, the profit it generates or
its investment decisions. The type of risk an organization is exposed to depends upon its
credibility, political situation and nature of organization or the economic situation of the country
in which it exists. Prior to 1940s buying insurances was the only source to diminish the impact of
losses that the company bears. But currently, corporations engage themselves into a complete
formal process of identifying, assessing, evaluating measures to nullify the impact of risk
(Hampton, 2009).With advancements in technological innovations, increasing flow of capital
within countries, and turbulence in the financial systems, regulators needs to develop mechanism
to manage risks. Modern technique of risk management compute the value that diversified
portfolio of a particular business generates and determines trading limits. Risk managers are
mainly responsible for computing the change in value of a firm as a result of diversified portfolio
(Bangia et al, 2002). However, risk management in developing countries is different from risk
management in developed countries. Because of unstable political environment and economic
situation of a developing country, it is difficult to predict the uncertainties in the prices, which
further complicates the process of anticipating future risks. Also in a developing economy neither
any foreign exchange takes place nor do equity options are traded, to measure the skepticism in
future prices (Ramos, 2000).

2 Literature Review
Credit risk is the most common traditional source of risk which organizations frequently face.
Modern finance theory relies on two fundamental concepts which include diversification and
efficient markets. Markets are considered to be efficient only when it offers risks in the form of
new potential opportunities to the firm. Firm is expected to gain some profit only when it is
exposed to some kind of risk. Organizations use various risk management models to anticipate or
forecast various future financial outcomes that various financial investments are likely to
generate. These risk management models when implemented wisely helps in safeguarding future
loses by diagnosing all possible future events and their financial outcomes.

Definition of Stress Testing

Stress Testing is a risk management tool used by the managerial department to evaluate the
impact and financial outcome that diversified portfolio of any a particular business unit is likely

to generate. By diagnosing the outcomes of anticipated events in the distant future, companies
can insight into expected losses the diversified portfolio of the business might generate over a
given period of time. This test is frequently used in systemizing the market risks especially the
diversified portfolio of the trading market. These portfolios include foreign exchange rate,
interest rate, commodity instruments and equity because of the amendments in their market
prices in a very short interval of time on regular basis (Lopez, 2005). This test acts as an efficient
communication tool between the senior management of the organization and its associated
business line. The tool relates the potential future losses to specific set of events. That is stress
test takes into account various unrelated risk factors that are likely to affect the portfolio of
business unit like depreciation in the currency to a certain percent and so on.
Guo (2008) defined stress testing as a method to assess the effect of certain unpredictable events
on balance sheet of the company. It is used determine the profitability of the business portfolio
even at the times of financial downturns. It helps in taking operational, financial and strategic
decisions.

Purpose of Stress Testing

Stress Testing should be incorporated into the organizational decision making process. The
integration of the same will help the managerial department to take into consideration the
plausible events at the times of financial crisis. It should help in discovering unknown risks and
its concentration which indirectly has a direct impact on the viability of the organization. The test
can also be used to determine the concussion on customer behavior as a result of changes
incorporated in product line. The tool is used to evaluate factors responsible for changing
marking conditions. Stress testing should be a central tool in identifying, measuring and
controlling funding liquidity risks. Stress test should be efficient enough to determine the overall
picture of institution wide risk (Berkowitz, 1999).
Therefore, Stress testing is an appealing risk-management tool because it provides risk managers
with additional information on possible portfolio losses arising from extreme, although plausible,
scenarios. A stress test is a projection of the financial condition of a firm or economy under a
specific set of severely adverse conditions that may be the result of several risk factors over
several time periods with severe consequences that can extend over months or years.

http://www.actuaries.org/CTTEES_SOLV/Documents/StressTestingPaper.pdf
http://archive.nyu.edu/fda/bitstream/2451/27078/2/wpa98080.pdf

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letter/2005/june/stress-tests-useful-complements-to-financial-risk-models/ >. [Accessed on 6th

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