READING 68: STRESS TESTING AND OTHER RISK MANAGEMENT TOOLS

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https://www.melonsblog.cn/2020/02/reading-68-stress-testing-and-other.html#more

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Stress tests tend to use ordinal rank arrangements, while EC methods use cardinal probabilities. Stress tests tend to focus on longer periods of time (e.g., several years) compared to EC methods (e.g., point in time). Stress tests tend to focus on conditional scenarios, while EC methods tend to focus on unconditional scenarios. Stress tests tend to compute losses from an accounting perspective while EC methods tend to compute them from a market perspective.

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Both stress tests and VaR methods attempt to transform a scenario into a loss estimate. Cardinal probabilities are a key feature of VaR methods, not stress testing. Stress tests often focus on a few scenarios (while VaR methods often focus on many scenarios). For regulatory stress tests, generating hypothetical scenarios uses the current period, not past history, as a departure point.

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Assigning probabilities to outcomes often allows the results of stress tests to be generated. The use of stressed inputs has been especially notable in the area of market risk, not credit risk. Financial institutions usually use a Merton model, not a binomial model, to simulate defaults and credit quality. The same percentile loss on the VaR loss distribution would be taken in the EC model as a proxy for the stressed loss resulting from market risk.

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A key advantage of using stressed risk metrics is that they are conservative. In examining capital adequacy for unexpected losses and considering stressed metrics, the amount of capital is likely to be more than sufficient. In other words, a risk metric that is stressed is likely to be more conservative. A more conservative risk metric does not necessarily mean it is more realistic. One of the disadvantages of using stressed inputs is that the risk metric becomes unresponsive to current market conditions and is more dependent on the investments within the portfolio.