Stress testing and scenario analysis offer a way for firms to look at the potential downside of their portfolios and businesses by thinking through the impact either of a very particular stress or of some more generalized downturn scenario.

A big advantage of the approach is that the firm is free to imagine any potentially damaging situation; it is not bound to consider only past or expected events or to limit the extent of its pessimism in other ways. It can use its imagination and business intuition. The outcome can then be analyzed at the level of product, portfolio, or enterprise.

The balance between art and science in stress testing is equally flexible, regulatory expectations aside. A stress test ...

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