Stress Testing for Market Risk

Sanjay Basu, NIBM,

October 2012.
 Outline
• Purpose.
• Problems and Solutions: Expected Shortfall.
• Stress VaR and Expected Shortfall in Variance-
covariance and Simple Historical Simulation.
• Stress VaR and Expected Shortfall with Volatility-
weighted (Hull-White) Historical Simulation.
• Stress VaR and Expected Shortfall with Age-
weighted (BRW) Historical Simulation.
• Comparison and Summary.
BSE Sensex - January 2008
 Large Losses in BSE Sensex
Date Absolute Loss % Loss over Remarks
over previous day previous day

18.1.2008 687 points 3.5% 8.7% lost over a week

21.1.2008 1408.35 points 7.1% Biggest-ever absolute

loss; first-ever four
digit loss at close
22.1.2008 875 points 4.97% Biggest intra-day loss
of 2,273 points
 Purpose of Stress Testing
• Stress tests are used to estimate extreme economic
losses.
• While Value-at-Risk (VaR) measures potential risks
under normal market conditions, stress tests are
designed to capture the risks (of bankruptcy or
insolvency) in highly volatile or abnormal markets.
• The Basel Committee has recently included Stress
VaR in Pillar I Capital Charges for IMA.
• RBI has conducted a series of stress tests for bank
portfolios, in its Financial Stability Reports.
 Key Questions
• Top Down/Senior management: How much could the
bank lose if a stress scenario occurs?
• Bottom Up: What events (s) would cause me to lose
more than the VaR threshold?
 Posed at the book or business level after relevant scenarios
have been collected at the different desks.
 Search for position-specific risk factors which would be
affected during a stressed scenario.
 Benefits of Stress Testing
• Stress tests are conducted for the remote tail, where
VaR is unlikely to be of help in taking decisions.
 Some scenarios might be unprecedented.
 Historical data on volatility and correlations might be
unreliable and misleading.
• In order to reveal the full impact of a shock, stress
tests can be conducted for longer holding periods.
• The liquidity risk related to large market crashes,
and the interactions with interest rate or credit risk,
can be captured better by specific stress tests.
 Scenario Generation
• Using relevant shocks which preferably capture
regime shifts, involve all risk factors, consider risk
interactions and market illiquidity.
• Shocking volatilities and correlations: Sensitivity
tests which affect instrument and portfolio VaR.
• Portfolio revaluation and summary: Computation of
MTM losses, for each scenario and business line as
well as aggregation to arrive at the portfolio impact.
 Problems with stress testing
• No probabilities or correlations:
1. If the likelihood of extreme events is unknown, risk
managers cannot choose necessary action or communicate
results to the board. Large shocks will be regarded as
irrelevant by top management.
2. Difficult to integrate stress test results with the level of risk
capital, i.e. VaR.
3. Correlations are either held constant or assumed to be

perfectly positive.
 Solution
• A composite distribution: Assign a weight π to
stress events and (1- π) to historical returns.
• Stressed losses could still remain well beyond VaR.
 VaR methods should capture fat tails and volatility clusters,
i. e. respond to large market shocks.
 Parameter uncertainty in complex models leads to high
uncertainty in VaR estimates.
 Need for risk measures which consider losses beyond VaR.
 Need for risk measures like EVT which consider only tail
observations.
 Expected Shortfall (ES)
• It is the average (or expected) value of all losses
larger than VaR.
• For a normal distribution, ES for a given c.l. can be
calculated as the arithmetic mean of all tail VaRs
above that c.l.
• For historical simulation (HS), ES for a given c.l. is
the mean of all losses beyond VaR for that c.l.
 Unlike VaR, ES responds to large market shocks and all
returns can be assigned user-defined probability weights for
stress testing in a HS framework.
 Scenario analysis with HS becomes easier when we use ES
rather than VaR.

•
 Stress testing: VCVaR vs simple HS
• Stress scenarios affect both SDs and correlations in
the Variance-covariance method.
 As two assets become more volatile together, the chance of
simultaneous large losses (in the portfolio) also goes up.
 VaR and ES for individual assets, as well as the portfolio,
will increase.
• In simple HS, extreme losses (under stress) might
lie way outside even 99% VaR.
 VaR might not rise much, under stress, but since ES
measures losses beyond VaR, it will shoot up.
Volatility-Weighted (Hull-White) VaR
• In Hull and White’s VWHS model, all past returns
are scaled by a volatility-adjustment factor.
• This tells us how much current volatility has changed
relative to the past.
• Since volatility-adjusted returns are assumed to be
repeated in the future, latest volatility will be
reflected in risk estimates as well.
• Since VWHS combines latest volatility estimates
with historical returns, fat tails and skewed shocks are
automatically captured.
Volatility-Weighted (Hull-White) VaR
(1) Measure market value of the currencies, as well as
the portfolio, in rupees (as on 22/04/2008).
(2) Calculate returns for the past 1500 days, i.e.
convert past rate data into return data.
(3) Calculate standard deviation of each return set, as a
measure of volatility.
(4) Apply the stress shocks and recalculate the sample
SDs.
(5) Compute the ratio of return volatilities after and
before the shock to find out the volatility-
adjustment factor.
Volatility-Weighted (Hull-White) VaR
(6) Multiply all returns by the volatility-adjustment
factor to arrive at volatility-adjusted returns.
(7) Multiply all volatility-adjusted returns by current
market value, i.e. (1)  (5) and add resultant losses or
profits across all currencies.
(8) Rank in ascending order from worst losses to highest
profits.
(9) Mark off currency-wise and portfolio VaR as the
99% worst sample loss.
Stress testing: Volatility-Weighted HS
• As volatility goes up with the stress scenarios, all
past returns are scaled upwards.
 In more volatile markets, larger gains and losses are possible
in future.
 Unlike in simple HS, individual and portfolio VaRs will also
rise sharply.
• The ES might rise less than in simple HS.
 Volatility-weighted HS captures stress indirectly in terms of
higher SDs, while simple HS directly estimates stressed
losses.
 Stress testing: BRW HS
• Temporary recent shocks can distort VaR since
large negative shocks get high weights as well.
 VaR might rise sharply, stay at a high level for some time
and then drop off.
• The stressed loss becomes the VaR for several
confidence levels.
 The largest loss is also the most recent one and gets the
highest weight.
 There is an abrupt breakdown in diversification benefits.
• The ES is not defined.
 Summary
• If the goal is to estimate the (VaR-based) stress
capital, volatility-weighted HS is the best method.
 VaR increases smoothly with volatility; it is almost
unaffected in simple HS and jumps abruptly for BRW HS.
 No diversification benefits, at high c.l.s, under BRW HS.
• If the purpose is to estimate the expected amount of
bailout or insurance for losses beyond VaR, under
stress, simple HS might also be used.