HullRMFI4eCh22

Risk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015Scenario Analysis and Stress TestingChapter 22 *

Risk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015

Stress TestingKey QuestionsHow do we generate the scenarios?How do we evaluate the scenarios?What do we do with the results?Risk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015*

Risk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015

Generating the scenariosStress individual variablesChoose particularly days when there were big market movements and stress all variables by the amount they moved on those daysForm a stress testing committee of senior management and ask it to generate the scenarios Risk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015*

Risk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015

Core vs Peripheral VariablesIf scenario generated involves only a few core variables, regress other peripheral variables on the core variables to determine their movements. (Kupiec, 1999)Ideally the relationship between peripheral and core variables should be estimated for stressed market conditions (Kim and Finger, 2000)Risk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015*

Risk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015

Making Scenarios CompleteOften an adverse scenario has an immediate effect on the value of a portfolio and a knock on effectExamplesCredit crisis of 2007LTCMRisk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015*

Risk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015

Reverse Stress TestingUse an algorithm to search for scenarios where large losses occurCan be a useful input to the stress testing committee.

Risk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015*

Risk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015

What are the Incentives of a Financial Institution?If the stress testing committee comes up with extreme scenarios more regulatory capital is likely to be requiredThe stress testing committee may therefore has an incentive to water down the scenarios they considerRisk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015*

Risk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015

Scenarios Chosen by RegulatorsA part of US, UK, and EU regulationCCAR for largest US banks considers recession scenarios similar to 1973-75, 1981-81, and 2007-2009 and banks must submit capital management planDFAST for medium sized banks involves similar scenarios but no capital management plans are requiredIf banks fail the tests they have to raise more capitalRegulators have to make sure banks do not game the system (See Business Snapshot 22.2)

Risk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015*

Risk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015

What to do with the Results?Should managers place more reliance on stress testing results or VaR resultsOne idea is to ask the stress testing committee to assign probabilities to scenarios (e.g. 0.05% or 0.2% or 0.5%)The stress scenarios can then be integrated with the historical simulation scenarios to produce a composite VaR

Risk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015*

Risk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015

Example from Chapter 13Risk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015*

ScenarioLoss ($000s)ProbabilityCumul. Probabilitys5850.0000.000500.00050s4750.0000.000500.00100v494477.8140.001980.00298s3450.0000.002000.00498v339345.4350.001980.00696s2300.0000.002000.00896v349282,2040.001980.01094v329277.0410.001980.01292v487253.3850.001980.01490s1235.0000.005000.01990v227217.9740.001980.02188v131205.2560.001980.02386v238201.3890.001980.02584........

Risk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015

Subjective vs Objective ProbabilitiesObjective probabilities are calculated from dataSubjective probabilities is based on a individuals judgment. Objective probabilities are inevitably backward lookingThe procedure just described is a way of combining subjective and objective probabilities.Risk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015*

Risk Management and Financial Institutions 4e, Chapter 22, Copyright John C. Hull 2015

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