Chapter 22

Scenario Analysis and

Stress Testing

©2015 by Scott Warlow 1

 Stress Testing
• Key Questions
– How do we generate the scenarios?
– How do we evaluate the scenarios?
– What do we do with the results?

©2015 by Scott Warlow 2

 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
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 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) (i.e. represent the peripheral
variables as linear functions of the core variables)
• Ideally the relationship between peripheral and
core variables should be estimated for stressed
market conditions (Kim and Finger, 2000) (the
regression weights may be different when the
market is stressed)
©2015 by Scott Warlow 4
 Making Scenarios Complete

• Often an adverse scenario has an immediate

effect on the value of a portfolio as well as
a “knock on” effect
• Examples
– Credit crisis of 2007
– Long Term Capital Management (LTCM)

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 Reverse Stress Testing

• Use an algorithm to search for scenarios

where large losses occur (try to identify the
core variables and what happened to them,
that led to the large losses)
• Can be a useful input to the stress testing
committee.

©2015 by Scott Warlow 6

 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 (impacts
ROE)
• The stress testing committee may therefore
have an incentive to “water down” the
scenarios they consider

©2015 by Scott Warlow 7

 Scenarios Chosen by Regulators
• A part of US, UK, and EU regulation
• CCAR for largest US banks considers recession scenarios
similar to 1973-75, 1981-81, and 2007-2009 and banks
must submit capital management plan
• DFAST for medium sized banks involves similar scenarios
but no capital management plans are required
• If banks fail the tests they have to raise more capital
• Regulators have to make sure banks do not game the
system (See Business Snapshot 22.2)

©2015 by Scott Warlow 8

 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
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 Example from Chapter 13
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

…. …. …. ….
…. …. …. ….

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 Subjective vs. Objective
Probabilities
• Objective probabilities are calculated from data
• Subjective probabilities are based on the
judgement of individuals
• Objective probabilities are inevitably backward
looking
• The procedure just described is a way of
combining subjective and objective probabilities

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