Msci.com ©2011. All rights reserved. msci.com Reverse Stress Testing Ron Papanek.

msci.com©2011. All rights reserved. msci.com

Reverse Stress TestingRon Papanek

msci.com©2011. All rights reserved.

Agenda

What is Reverse Stress Testing? Why is it important? Practitioner Examples

Single-Factor Multi-Factor Historical Monte Carlo

Related Stress Tests Historical Unwind Liquidity

Hedging


Reverse Stress Testing – What is it?

Portfolio Specific Incorporating information specific to the fund company, or portfolio.

Create an Explanatory Narrative Traditional Stress tests quantify loss from a real or potential event

Reverse Stress tests tell a story from the numbers.

Definitions

Traditional Stress Test Reverse Stress Test

Shock P&L P&L Shocks


Reverse Stress Testing – Why is it Important?

Engages Management The methodology leads to a better understanding of firm risk through the process of identifying

thresholds and the exploration of macro scenarios

Connects the portfolio risk to the business risk

Provides a different perspective than traditional stress tests Provides a more thorough examination of tail risk

Can yield more efficient hedging strategies

Tells a story

Advocated by Regulators FSA, BIS, FED, CRMPG have all voiced support for reverse stress testing

“The emphasis of a ‘reverse-stress test’ would be on identifying the high impact stress events which would cause the firm to fail and considering the appropriate action, if any, to protect against such failure.” FSA 12/2008 (2.27)

Identify systemic risk and trigger points for contagion


Reverse Stress Testing

Sensitivity Analysis

One Factor - Simple, Predictive, Multiple correlated factors

Multifactor – two or more independent risk factors

Scenario Analysis

Historical – Date Range

Monte Carlo – Loss simulations

Reverse Stress Test Methodologies


Reverse Stress Testing - One Factor

Traditional stress test

is a function

not necessarily monotonic.

Reverse stress test

is not a function

Different shocks can produce the same P&L


Two Factor Reverse Stress TestOne

P&L

Equity Shift


Sensitivity Analysis

One Factor – One Dimension

Two Factors – Two Dimensions

Locking two factors together allows us to introduce a third factor

Multi-Factor


Two Factor Reverse Stress Test


Multi-Factor Sensitivity Grid

20 % 3 0 %

40 % 50 %


Reverse Stress Testing - Historical

Run a traditional Historical stress test and sort by threshold violation.

Run same Historical stress test, but widen period from days to rolling periods, widening

periods until loss threshold is triggered.

The output of the Reverse Historical Stress Test is a series of dates and date ranges.

Steps



HistoricalDaily

2 Day

Weekly

Monthly

DailyDaily

2 Day

http://www.nytimes.com/


Reverse Historical Stress Test

Match date scenario with events to explains the portfolio loss

Single Date Date Range

September 20, 2008 March 2003


Reverse Stress Testing – Scenario Generation

How do we simulate a 100 year flood?

Run 100 years worth of Monte Carlo simulated returns

Run Monte Carlo simulated returns using correlation periods from different market

regimes.

Monte Carlo


Reverse Stress Testing - Scenario

Run long term Historical Simulation

Sort sims by loss threshold and use dates to create a period for correlation calculation

Run Monte Carlo simulated returns report using new “extreme correlation period”

Sort sims by loss threshold and aggregate risk factor scenarios

Historical / Monte Carlo Hybrid


Reverse Stress Testing - Simulations

Historical / Monte Carlo HybridHistorical

Monte Carlo


Worst to Best

Monte Carlo Visualization


Reverse Stress Testing - SimulationMonte Carlo by Position


Reverse Stress Testing - Simulation


Monte Carlo Visualization

Reverse Stress Testing - Simulation

Visualization allows the inspection of hundreds or thousands of scenarios

Observe the distribution of individual scenarios (not just the average)

Visually identify hedge positions and hedge effectiveness


Agenda



Related Tools Historical Unwind Liquidity

Hedging


Benefits Provides insight into Bubbles

Reverse Stress Testing – Related Tools

Historical Unwind

Historical Stress Test Historical Unwind

Replays History Replays History in Reverse

Separates buy and hold from arbitrage strategies

Identifies increasing leverage

Can highlight trend following

Separates idiosyncratic trends within an asset class



Historical Unwind

1 2 3 4

month month month month



Historical Unwind



LiquidityPortfolio specific Risk

Risk - based on position not security

Test liquidation assumptions with acquisition history

Compare Lock-up to liquidity horizon


Agenda



Related Tools Historical Unwind Liquidity

Hedging


Reverse Stress Testing - Hedging

Focus on hedging the tail

Identify and aggregate the most commonly occurring risk factor scenarios

Finding the cheapest and most efficient hedge

Strategies Costless Collar

Correlated Asset Put Spread

Macro Scenario overlay

Hedge the Business not the Portfolio


Reverse Stress Testing - Conclusions

Engage management as much as the risk department The information flow between CEO and risk department is two way

There is a significant amount of firm specific data that should be incorporated into stress

testing and risk management.

Connect a story to the risk The event has more meaning than the date or the scenario # or the P&L

Firm risk is not portfolio risk – Hedge Appropriately P&L is linear Risk is not

Reverse Stress Testing helps to identify the conditions for failure allowing for early warning

as wells as prevention.

Msci.com ©2011. All rights reserved. msci.com Reverse Stress Testing Ron Papanek.

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