Financial Risk Management: A Practitioner's Guide to Managing Market and Credit Risk, 2nd Edition

CHAPTER 7

VaR and Stress Testing

In the statement of requirements for robust risk management in Section 6.1.1, the estimation of losses that could result from liquidation of positions figured very prominently. This showed up under the headings “The need for simulation” and “The need to consider periods of reduced liquidity.” The need for simulation, which closely corresponds to the G-30 Recommendation 5, “Measuring Market Risk,” is discussed in detail in this chapter as value at risk (VaR). The need to consider periods of reduced liquidity, which closely corresponds to the G-30 Recommendation 6, “Stress Simulations,” is discussed in this chapter as stress testing.

These two methods for measuring the total risk exposure of a portfolio still need to be supplemented by more detailed nonstatistical risk measures, such as the value of the basis point, delta, or vega, for reasons given in Section 6.2. But measures of total portfolio risk do offer advantages that detailed nonstatistical risk measures do not:

• Nonstatistical measures do not allow senior managers to form conclusions as to which are the largest risks currently facing the firm. It is not possible to meaningfully compare the value of a basis point in two different currencies, since this comparison does not reflect the relative size of potential interest rate moves in the two currencies. Both VaR and stress testing give a measure that combines the size of position and size of potential market move into a potential impact on ...