Modelling Stress Scenarios

Sanjay Basu, NIBM,

November 2012.
 Outline
• Hybrid HS.
• Monte Carlo Simulation.
• Normal scenarios
• Stress scenarios.
 Problems with equally weighted HS
• Periods of high and low volatility are bunched.
 Equal weighing overestimates risk during low-volatility phases
and underestimates it during high-volatility phases.
• Event risk might not be captured.
 A one-time currency market crash might not be captured even
at 99% VaR.
• Ghost effects might occur if a few extreme events,
from the past, are in the dataset.
 The VaR might be unduly high.
 It will fall drastically once such losses move out of the sample.
 Hybrid HS
• Older returns get lesser weights (01) than more
recent ones (w1+w2+w3+….wn=1).
1. Give least weight to the oldest return and increase
weights for nearer ones.
2. Sort returns in ascending order and multiply by
current portfolio value to obtain simulated P/L.
3. The simulated loss corresponding to a cumulative
weight of x% is the (100- x)% VaR. Linear
interpolation might be used to find this number.
 Merits: Hybrid HS
• Generalization of equally–weighted VaR (1).
• By suitable choice of , large losses can be given
higher weights, especially the more recent ones.
• Clusters of large, but unlikely, past losses receive
lower and lower weights and do not distort VaR.
 Sudden jumps in VaR do not occur as these losses fall out of
sample.
 The sample size can be increased, to include more recent and
probable losses.
 Monte Carlo Simulation (MCS)
(1) Fit distributions and estimate parameters for
historical returns.
(2) Insert historical correlations.
(3) Generate many (e.g. 50000) random numbers, to get
simulated returns, from the distributions.
(4) Revalue current portfolio with the random numbers.
(5) Find portfolio P/L and sort, to get VaR and ES.
(6) Add a stress shock and repeat steps 1-5.
 Factor Push Methods
• Break down the current market price of an asset
into PVs of its underlying cash flows.
• Identify the risk factors affecting each cash flow.
• Compute the historical shocks to such risk factors.
• Assign special weights to the sharper shocks.
• Identify the parameters of the weighted historical
distributions of shocks and simulate.
• Perturb all PVs of cash flows with the simulated
shocks and compute returns, to estimate the effect
of the stress scenarios on the price of the asset.
 Normal scenarios
• Use Nelson-Siegel parameters (from CCIL), to
generate spot rates for each TTC for the past 250 or
500 trading days.
• Calculate the daily returns from model prices, to
create a historical distribution of returns under
normal conditions.
• Estimate the parameters and conduct MCS.
• Use the simulated returns, from the chosen c.l., to
estimate the fall in the bond price.
 Stress scenarios
• On the basis of experience, give proper weights to
sharper historical or hypothetical rate shocks.
 Some sharp shocks might have a higher probability of future
occurrence.
• Estimate the parameters of the new distribution and
conduct Monte Carlo simulation.
• The difference between the MV impact of the new
shocks and the original shocks captures the effect of
stress scenarios on the bond price.
 More extreme shocks will lead to larger losses.
 Problems with Factor Push Methods
• Factor push methods assume that an asset incurs
higher losses, with larger shocks to underlying risk
factors.
 This is appropriate only when there is a linear relationship
between asset payoffs and movements in risk factors.
• For products with nonlinear payoffs, factor push
methods might produce misleading results.
 The buyer of an interest rate collar incurs the highest loss,
i.e. loses both the premiums on the cap and the floor, when
interest rates do not fluctuate much.