Stress Testing And Other Risk Measures
Stress tests and value at risk (VaR) and economic capital (EC) measures attempt to transform scenarios into loss estimates. The loss estimates’ distributions provide the basis to compute VaR at a very high confidence level. Stress tests tend to look at far fewer scenarios compared to VaR measures. Additionally, stress tests usually develop scenarios that are conditional, while VaR/EC measures tend to develop unconditional scenarios.
Complementing Stress Tests with VaR Models
VaR/EC models compute expected losses using the following general formula:
expected loss = PD × LGD × EAD
In an attempt to assign a probability to a hypothetical or historical stress scenario, one could determine where the stress test losses fall within the VaR/EC loss distribution. By assigning probabilities to outcomes, the calculated probability from the loss distribution facilitates the implementation of stress test results.
Stressed Inputs and Stressed VaR
Stressed inputs have been used in analyzing market risk and for both supervisory and internal purposes within financial institutions. There is a mandated use of stressed inputs, stress tests, and stressed parameters by the Basel Accords. Stressed VaR can be used to analyze the potential losses for an investment portfolio. In addition, it can be used to compute the capital charge for credit valuation adjustments (CVAs).
Stressed Risk Metrics Advantages and Disadvantages
A key advantage of using stressed risk metrics is that they are conservative. A key disadvantage is that risk metrics will not necessarily respond to current market conditions.
