Handbook of Market Risk

Chapter Twelve

Stress Testing and Back Testing

Stress testing is especially important after long periods of benign economic and financial conditions, when fading memory of negative conditions can lead to complacency and the underpricing of risk. It is also a key risk management tool during periods of expansion, when innovation leads to new products that grow rapidly and for which limited or no loss data is available.

—Basel Committee, May 2009

All models seen previously adopt the assumption of normal conditions of market and assign a low probability of extreme events. If we want to know what the potential loss would be under extreme scenarios, then VaR is not always a reliable method, and as such it needs to be complemented with appropriate stress tests and reliable back testing.

While VaR has acquired a strong following in the risk management community, there is reason to be skeptical of both its accuracy as a risk management tool and its use in decision making. There are many dimensions on which researchers have criticized VaR, and we will categorize these issues into those dimensions. Following the financial crisis raised by the subprimes, some newspapers were clearly writing about the failure of VaR.

The technique of stress testing is a technique that is used to estimate the potential loss by submitting the model to extreme variations in the parameters, corresponding to a financial disaster scenario: stock market crash, collapse of the exchange rate, sudden increase in interest ...