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
Reverse Stress Testing Use an algorithm to search for scenarioswherelargelosses occur Can be a useful input to the stress testingcommittee.6RiskManagementandFinancialInstitutions3e,Chapter19,CopyrightJohnC.Hull2012
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 3e, Chapter 19, Copyright © John C. Hull 2012 6
What arethe Incentives ofaFinancial Institution? If the stress testing committee comesup with extreme scenarios moreregulatory capital is likely to be requiredThe stress testing committee maytherefore has an incentive to“waterdown" the scenarios they consider7RiskManagementandFinancialInstitutions3e,Chapter19,CopyrightJohnC.Hull2012
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 3e, Chapter 19, Copyright © John C. Hull 2012 7
Scenarios Proposed by Regulators?Will regulators provide their own scenarios tobe used by all banks?Part of the Basel Committee's consultativedocument suggests that it is thinking aboutthis as a possibilityThere is a danger that, if the scenarios areannounced in advance, financial institutionswill hedge only against the scenarios (SeeBusiness Snapshot 19.2; traffic light options)RiskManagementandFinancialInstitutions3e,Chapter19,CopyrightJohnC.Hull20128
Scenarios Proposed by Regulators? ⚫ Will regulators provide their own scenarios to be used by all banks? ⚫ Part of the Basel Committee’s consultative document suggests that it is thinking about this as a possibility ⚫ There is a danger that, if the scenarios are announced in advance, financial institutions will hedge only against the scenarios (See Business Snapshot 19.2; traffic light options) Risk Management and Financial Institutions 3e, Chapter 19, Copyright © John C. Hull 2012 8
What to do with the Results? Should managers place more reliance onstress testing results or VaR results One idea is to ask the stress testingcommittee to assign probabilities toscenarios (e.g. 0.05% or 0.2% or 0.5%)The stress scenarios can then beintegrated with the historical simulationscenarios to produce a composite VaRRiskManagementandFinancialInstitutions3e,Chapter19,CopyrightJohnC.Hull20129
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 3e, Chapter 19, Copyright © John C. Hull 2012 9
Examplee from Chapter 14ScenarioLoss ($o00s)ProbabilityCumul.Probabilitys5850.0000.000500.00050s4750.0000.000500.00100v494477.8140.001980.00298$3450.0000.002000.004980.00198v339345.4350.00696s2300.0000.008960.002000.00198v349282,2040.010940.00198v329277.0410.012920.00198v487253.3850.01490s1235.0000.005000.019900.00198V227217.9740.021880.00198v131205.2560.02386v238201.3890.001980.02584a"..**....10RiskManagementandFinanciallnstitutions3e,Chapter19,CopyrightJohnC.Hull2012
Example from Chapter 14 Risk Management and Financial Institutions 3e, Chapter 19, Copyright © John C. Hull 2012 10 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 . . . . . . .