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Practical Applications - December 2008
Dec 15, 2008
Composite Stress Test
Recently released to RiskManager is a new way of aggregating generalized and user defined stress tests components into a composite stress test. The generalized stress test is broken into two parts: a risk factor stress test (risk factors with historical time series); and a model parameter stress test (risk factors created by RiskServer on the fly). The risk factor stress allows either a parallel shift to all a general risk type or the application of a user defined predictive stress test to the general risk type. The model parameter stress test allows a parallel shift to a general risk type for which there is no historical time series. The composite stress test then aggregates these components by starting with a market stress definition (a user defined predictive stress test to be applied to the whole portfolio) and then uses the risk factor, model parameter and a single name stress test (created by a user defined simple stress test) to override parts of the market stress definition.
The example in the report shows two stress test PV delta statistics one with a 9/11 user defined predictive stress test applied and the other with a composite stress test applied. The composite stress test starts with the same 9/11 stress test as the market stress definition and then uses the risk factor stress test to override the effect on commodities by applying a parallel downward shock of 10% and the effect on equities by applying a Black Monday predictive stress test. Next a user defined simple stress test is used to override individual time series, in this case shocking the AUD down 5 US cents. Finally we override the effect on volatility by applying a parallel upward shock of 50%.
- For the FX forward (long AUD, short USD) we can see that the 9/11 stress test strengthens the AUD and our forward makes money. But the composite stress test forces the AUD to weaken and our forward loses money.
- For the fixed rate Ford bond there is no difference as the composite stress test applies the 9/11 stress test and does not specify any overrides to interest rate or CDS time series.
- Our IBM equity call option loses more money under the composite stress test as the increase in volatility is offset by an even larger decrease in equities specified by the Black Monday stress test in the risk factor stress test.
- The natural gas call option loses more money under the composite stress test as the increase in volatility is offset by an even larger decrease in commodity prices as specified by the risk factor stress test.