Scenario Analysis and

Stress Testing
Chapter 19

Risk Management and Financial Institutions 3e, Chapter 19, Copyright John 1C. Hull 2012
 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.
2 Hull 2012
 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.
3 Hull 2012
 Core vs Peripheral Variables
Ifscenario 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.
4 Hull 2012
 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.
5 Hull 2012
 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.
6 Hull 2012
 What are the Incentives of a
Financial Institution?
Ifthe 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.
7 Hull 2012
 Scenarios Proposed by
Regulators?
Will regulators provide their own scenarios to
be used by all banks?
Part of the Basel Committees 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.
8 Hull 2012
 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.
9 Hull 2012
 Example from Chapter 14
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 3e, Chapter 19, Copyright John C.
10Hull 2012
 Subjective vs Objective
Probabilities
Objective probabilities are calculated from data
Subjective probabilities is base don 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 3e, Chapter 19, Copyright John C.
11Hull 2012