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Stress Test Your Way to Success

A very popular way to test the limits of a potential employee is to make this person endure stress. People fear extended silence or stair, unexpected tasks or strange behavior of the interviewer. This helps revealing and assessing something that was not prepared and rehearsed in advance: how a newly hired will probably act in when faced with a problem.

Similar to people that you hire, you need to test your portfolio for resilience in a crisis situation. Stress testing as a risk management technique is widely implemented to measure the response of the subject position, instrument, asset class, or portfolio to extreme changes of a particular factor or to an impact of a specific crisis scenario. Stress testing is crucial to risk management, despite the fact that statistically such scenarios or significant factor changes are unlikely and usually when they do occur, are different from the ones that happened in the past. As it is often compared, the probability of fire completely destroying your house is low, yet you buy insurance to protect your savings and well being. Similarly, the probability of severe financial crisis at any given day is low, but stress testing allows you to estimate the potential behavior of your portfolio value and be prepared for it.

Stress testing is essentially an attempt to model and measure the effect of changes in the relevant market factors on the performance of an instrument, portfolio, entity, or the entire economy. If only one factor is changed, we care about sensitivity analysis. If the factors are interconnected in a scenario, whether existent in the past or hypothetical, the procedure is called “Stress Test Scenario Analysis”.  To perform a stress test, you must:
– Identify the scope of the test, whether you want to test the portfolio or a particular slice
– Determine the factors relevant to the portfolio performance and strategy
– Estimate the co-influence of the factors on each other and model their effect on the portfolio value
– Shock the factors separately and together to measure their effect on the portfolio

Naturally, the process involves trials and errors, follow-ups and corrections. However, the clear advantages make it a necessary part of risk management.

Stress testing:

– Measures the loss from extreme but plausible events not captured by VaR
– Identifies the relevant factors and the effect of their changes
– Assesses the resilience of the portfolio in the situation of crisis
– Allows for the development of any “what if” scenario according to expert opinion

Stress testing is not free of the disadvantages and risk manager needs to be cautious as the flaws include:
– Estimates are only as good as the model itself: simplification may result in significant approximations
-The relationships between the unique factors effecting the portfolio are hard to estimate
-Even estimated initially, the correlations between factors do not stay constant
-Crisis never repeats precisely, so old scenarios may not be valid and new ones are hard to construct and hypothetical

The cost of handling these disadvantages can be significantly cut by using the third party risk data provider like RiskMetrics, Measurisk, Investor Analytics, etc and even more so by allowing the specialized risk management vendors to develop, run and manage the risk of your portfolio.

When you test people, your most valuable asset, at a job interview there is no guarantee that the candidate, who knows how to spot counterfeited coins amongst 10 sacks of money, is the one who will actually perform best under pressure. Similarly, stress testing is not designed to give the precise answers but without it, portfolio managers are left blinded with regards to factors affecting the portfolio and hence unprepared for crisis.

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