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Market Risk Analysis Volume IV: Value-at-Risk Models by Carol Alexander

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IV.7

Scenario Analysis and Stress Testing

IV.7.1 INTRODUCTION

Previous chapters have focused on VaR estimates that are based on historical asset or risk factor returns. Believing these data capture the market circumstances that are assumed to prevail over the risk horizon, we then obtain a distribution of the returns (or P&L) on a portfolio and estimate the VaR and ETL at the required confidence level over the risk horizon. Whilst such a belief may seem fairly tenuous over risk horizons that are longer than a few months, experience proves that in the absence of a shock, such as the terrorist attacks on the US in 2001, market behaviour and characteristics are unlikely to alter completely over a risk horizon of a few days or weeks. It is therefore reasonable to base short-term VaR and ETL estimation on historical data, provided it is adjusted to reflect current market conditions, but as the risk horizon increases the case for using other beliefs than ‘history will repeat itself’ becomes stronger.

A main focus of this chapter is to describe the application of a particular type of belief, which is called a stress scenario, to risk models. Stress testing is a risk management tool for quantifying the size of potential losses under stress events, and for quantifying the scenarios under which such losses might occur. A traditional definition of a stress event is an exceptional but credible event in the market to which the portfolio is exposed. Then, in a stress test one subjects the risk ...

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