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    Stress Testing: and Scenario Analysis

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    Stress testing is used to determine if a financial institution can withstand an economic crisis. It involves assessing the institution's credit risk under extreme hypothetical economic scenarios, such as high interest rates or a decrease in borrower recovery rates. Common scenarios are based on historical crises, expert opinions, or regulatory guidance. Stress testing tools like Monte Carlo simulations are used to model how risk measures like probability of default would change under the scenarios. This allows the institution to ensure it has sufficient capital to cover potential losses in a crisis situation.

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    Stress Testing: and Scenario Analysis

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    carlosito_laura
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    Stress testing is used to determine if a financial institution can withstand an economic crisis. It involves assessing the institution's credit risk under extreme hypothetical economic scenarios, such as high interest rates or a decrease in borrower recovery rates. Common scenarios are based on historical crises, expert opinions, or regulatory guidance. Stress testing tools like Monte Carlo simulations are used to model how risk measures like probability of default would change under the scenarios. This allows the institution to ensure it has sufficient capital to cover potential losses in a crisis situation.

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    Week7 Stress

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    Stress testing is used to determine if a financial institution can withstand an economic crisis. It involves assessing the institution's credit risk under extreme hypothetical economic scenarios, such as high interest rates or a decrease in borrower recovery rates. Common scenarios are based on historical crises, expert opinions, or regulatory guidance. Stress testing tools like Monte Carlo simulations are used to model how risk measures like probability of default would change under the scenarios. This allows the institution to ensure it has sufficient capital to cover potential losses in a crisis situation.

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    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    35 views15 pages

    Stress Testing: and Scenario Analysis

    Uploaded by

    carlosito_laura
    Stress testing is used to determine if a financial institution can withstand an economic crisis. It involves assessing the institution's credit risk under extreme hypothetical economic scenarios, such as high interest rates or a decrease in borrower recovery rates. Common scenarios are based on historical crises, expert opinions, or regulatory guidance. Stress testing tools like Monte Carlo simulations are used to model how risk measures like probability of default would change under the scenarios. This allows the institution to ensure it has sufficient capital to cover potential losses in a crisis situation.

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    of 15

    Week 7

    Lesson 2
    TW3421x - An Introduction to Credit Risk Management
    Stress Testing
    and Scenario Analysis

    Dr. Pasquale Cirillo
    Introduction
    !
    A stress test is an procedure meant to determine the ability of a given nancial
    institution to cope with an economic crisis.
    !
    The idea is to verify if a bank, or another nancial institution, is able to deal
    with credit risk in case of very bad economic conditions.
    Questions
    !
    Typical questions a bank has to answer when performing stress testing are for
    example:
    "
    What happens if interest rates increase by at least x%?
    "
    What happens if recovery rates on a given type of loans decrease by y%?
    "
    What happens if the correlation among defaults increases?
    "
    What happens if systemic risk increases, thus increasing the PD of all
    counterparties?
    Use
    !
    Stress testing has become increasingly important.
    !
    Under Basel III, stress testing is a regulatory requirement for large international
    institutions, which must prove to have adequate capital allocation levels to
    cover potential losses due to extreme - yet plausible - events.
    !
    Stress testing is based on the so-called scenarios.
    Scenarios
    !
    A scenario is simply a given conguration of parameters and variables,
    according to the model we are using to assess (credit) risk.
    !
    A scenario typically includes unusual values for macroeconomic quantities such
    as interest rates, ination rates, unemployment rates, volatility, etc.
    Tools
    !
    Stress testing is performed using computational and statistical tools, such as
    Monte Carlo simulations, sensitivity analysis and extreme value theory.
    Example
    !
    Assume that for estimating the PD of a counterparty (and hence capital
    requirements under the F-IRB approach) we use Mertons model (Week 5), so
    that the 1-year probability of default of our counterparty is


    P(V
    1
    B) =

    log(V
    0
    ) log(B) +

    r
    2
    V
    /2

    V
    !
    Example
    !
    Assume today r=0.02, V
    0
    =22, B=16, !
    V
    =0.2. Then



    !
    A simple scenario is to assume that !
    V
    increases to 0.5, or 0.8, or even 1.0.
    P(V
    1
    < 16) =

    log(22) log(16) + (0.02 0.2


    2
    /2)
    0.2

    = 0.0557
    Example
    !
    According to these values of !
    V
    , the PD changes to


    !
    A bank then decides if it is ready to cope with such extreme cases, by
    computing the capital requirements under these scenarios.
    !
    The regulator typically decides which scenarios need to be taken into
    consideration, when determining capital allocations.
    PD

    V
    =0.5
    = 0.3347
    PD

    V
    =0.8
    = 0.4908
    PD

    V
    =1
    = 0.5642
    More complex scenarios
    !
    Naturally we can also think of more complex scenarios, in which more
    parameters change.
    !
    This is typically what banks do, using complex computer programs.
    !
    But the intuition is exactly the same.
    How are scenarios
    produced?
    !
    Scenarios may be produced on the basis of:
    "
    Historical evidence.
    "
    Expert judgments.
    "
    Decisions of the regulator.
    Stressed Measures
    !
    Another way of performing stress testing is to use the so-called stressed
    measures of risk.
    !
    These are the same measures of risk we have seen together, but we use them in
    more extreme situations.
    !
    A simple example is the Stressed VaR.
    Stressed VaR
    !
    Developed for Market Risk, Stressed VaR (S-VaR) is now increasingly used in
    Credit Risk as well.
    !
    The computation of S-VaR follows the rules of VaR (Week 3), but we only
    consider the worst losses, the worst scenarios.
    Stressed VaR
    !
    Typically we consider the worst 50% losses (the largest ones), and then we
    compute a VaR at level ".
    !
    Lets consider a simple example in R.
    Thank You

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