ScenarioAnalysisandStress TestingChapter 19RiskManagementandFinanciallnstitutions3e,Chapter19,CopyrightJohnC.Hull2012
Risk Management and Financial Institutions 3e, Chapter 19, Copyright © John C. Hull 2012 Scenario Analysis and Stress Testing Chapter 19 1
Stress TestingKeyQuestionsHow do we generate the scenarios?How do we evaluate the scenarios?What do we do with the results?2RiskManagementandFinancialInstitutions3e,Chapter19,CopyrightJohnC.Hull2012
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 3e, Chapter 19, Copyright © John C. Hull 2012 2
Generating the scenarios Stress individual variables Choose particularly days when there werebig market movements and stress allvariables by the amount they moved onthose daysForm a stress testing committee of seniormanagement and ask it to generate thescenariosRiskManagementandFinancialInstitutions3e,Chapter19,CopyrightJohnC.Hull20123
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 3e, Chapter 19, Copyright © John C. Hull 2012 3
Core vs Peripheral VariablesIf scenariogenerated involves only a few“"core"variables, regress other“peripheral'variables on the core variables todetermine their movements. (Kupiec, 1999)ldeally the relationship between peripheraland core variables should be estimated forstressed market conditions (Kim andFinger,2000)RiskManagementandFinancialInstitutions3e,Chapter19,CopyrightJohnC.Hull20124
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 3e, Chapter 19, Copyright © John C. Hull 2012 4
Making Scenarios Complete Often an adverse scenario has animmediate effect on the value of a portfolioand a“knock on" effectExamples Credit crisis of 2007LTCM5RiskManagementandFinancialInstitutions3e,Chapter19,CopyrightJohnC.Hull2012
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 3e, Chapter 19, Copyright © John C. Hull 2012 5