Systemic - Stress Testing Ucits

8/6/2019 Systemic - Stress Testing Ucits

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Is Stress Testing more effective than VaR?

UCITS Risk Management conference, May 2011

Aristides ProtopapadakisManaging Director


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Stress Testing vs. VaR

Old concept but renewed interest. Why?

Senior managers have lost confidence in modeling? Regulatory stress testing exercises


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Factors in favor of stress testing

Post-crisis skepticism about VaR model assumptions Fat Tails? Correlation structures?...

Stress results easier accepted by senior management

Stress scenarios based on insight of experienced managers

Can cover risk types poorly managed in VaR models

Particularly relevant to managing the risks on hedge fundstrategies


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Are VaR models suitable to Hedge Fund strategies?

Static Strategies Hedge fund strategies may reflect expectations about future

occurrence of historically rare events

The VaR methodology will be likely based on the same data used toformulate the strategies => Not independent view!

Dynamic Strategies Buy/ Sell accross time upon specific events

Long term cumulative risks typically ignored by VaR models!

Unlike VaR, stress scenarios must be strategy specific Risk Manager must identify strategies expressed in the portfolio

Implement scenario sets that stress the particular strategies


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Examples

Strategy #1 (Static) Long-short CDS on paired names/ diff. tenors/ CDS vs. Bond basis/

index tranches at various attachment points

Stress Scenarios: Idiosyncratic movement of spreads, spreads termstructure, Bond vs. CDS liquidity premium, base correlation curve

across index or between indexes Strategy #2 (Dynamic)

G7 ccy strategy: Borrow GBP and sell against USD when spot rate +interest differential equilibrium view

Stress scenarios: Dynamic paths of FX and interest rates, and thensimulate the buy and sell decisions across each path


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ESMA Guidelines: Risk management process

Applies to Investment Co (self-managed UCITS) or ManCo

Should comprise procedures enabling the ManCo to assessthe UCITS risk exposure (risk measures, limits)

All material risks must be addressed:

Market risks Liquidity risks

Counterparty & Issuer Concentration risks

Operational risks

Assessment at least on a daily basis


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Stress Testing in ESMA Risk Guidelines

Program in line with UCITS risk profile (freedom)

Must capture all risk factors, in particular those not capturedby VaR model.

Run at least monthly

Execution of the program must be documented andtraceable


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Which statement appeals more to you?

A. VaR models where developed for Banks and are not wellsuited to funds risk management

B. Stress tests are a meaningless regulatory requirement:

Too subjective to be taken under account seriously

C. Stress testing is a valuable risk assessment tool, inaddition to traditional VaR analysis.


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Stress Testing in practice

I. Market Risk


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Gaussian vs. Fat tails


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Gaussian vs. Real world dependence structure

Source:Acharaya (2008)


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Dependence in the real world

Source:Jon Gregory (2008)


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Tool: Use of PCA for stress testing interest rates

Traditional analysis: Multiple, correlated risk factors NPVbonds = f( 1m, 3m, 6m, 9m, 1y, 2y, 3y, 5y, 7y, 10y, 15y, )

PCA analysis NPVbonds =

f( trend, tilt, curvature )

Easy to stress a six sigma change in trend, tilt, or curvature


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Stress Testing + VaR: Stressed VaR!

Bank Supervisors will be more proactive in using stresstesting as a determinant of a Banks capital requirements.

Stressed VaR is a move in this direction

This at least doubles capital for market risks

Model inputs must be calibrated to historical data from a

continuous 12-month period of significant financial stressrelevant to the banks portfolio.

Respected authors call this approach ridiculous!

avgct avgct sVaRmsVaRVaRmVaRc ,max,max 11


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II. Specific (idiosyncratic) Risk


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ESMA Guidelines: Choice of VaR model

Historical, Monte Carlo simulation, or Parametric At least six tenors for interest rates

Include non-linearity (gamma)

Include vega risk

VaR model must also account for idiosyncratic risk: Credit Spread risk

Equity residual risk

Premium/ discount (between cash and futures)


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Idiosyncratic or Specific Risk assessment

Three components for idiosyncratic risk Credit spread volatility

Migration Risk

Default Risk

Typically (a) can be taken under account in VaR model (b) and (c) require a different approach:

Simulate a new rating for each bond at times Ti (stressed path)

If matured: replace by similar bond constant level of risk assumption

If defaulted: Reinvest recovery amount in new bond with orig. rating

If migrated: Sell and absorb P&L, reinvest in new bond as original


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III. Liquidity Risk


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Incorporating market liquidity in a VaR model

Exogenous liquidity refers to the transaction cost (bid/ offer

spread) for trades of average size Endogenous liquidity: Is related to the cost of unwinding

portfolios large enough that the bid-ask spread cannot betaken as given, but is affected by the trades themselves.


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Exogenous vs. Endogenous liquidity

Approach forexogenous liquidity:Integrate the variabilityof the bid/ offer spread

for averagetransactions as a riskfactor


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Endogenous liquidity

Particularly relevant in under stress conditions Margin requirements may cause different price movements on

assets with identical payoffs

Delta hedging activities (buying an asset when price goes up).Especially when many banks have same kind of positions against

investors who do not dynamically hedge. Approaches: Liquidity-adjusted returns, weighted bid/ as

spreads based on volume.

Preferred approach: Varying time horizon. Parameter required for each position: Fraction of daily volume that

can be liquidated without significant impact to the market.


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IV. Counterparty Risk


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Stress testing Counterparty Risk

Essentially, similar to market risk stress testing

Instead of looking for large losses, we look for large profitsfrom specific counterparties and/ or margin postings

Example: a six -sigma steepening, combined with a

flattening of the euro yield curve could result in: OTC profit, Counterparty A : 2mln

OTC loss, Counterparty B (hedge): -2mln

Margin posting, Counterparty C: 0.9 mln


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Building a Stress Testing Framework


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But: Stress tests are subjective!

Euromoney 31/3/11 (criticizing the latest EU stress test) Sure the economic scenario seems mostly fairly severe [but] the

. Equity prices are assumed to fall by 15%; the DAX has just fallen 12.5% in three weeks. Valuation haircuts on sovereign bonds are very small,especially at the front end where banks hold much of their exposure.

Private tests would allow for much sterner stress scenarios to be examined, perhaps involving multiple sovereign government defaults. That would at least allow banks and regulators to

and overall balance sheets in such a calamity. It wouldnt necessarily matter if most banks failed such private tests, because regulators might in turn attach an .


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The problem with stress testing is

In traditional stress testing we dont know the likelihood of

the scenario happening. There is no probability attached toit.

However, scope can be too vague: Framework required: what do I need to stress? combinations?

by how much?

Limited research guidelines compared to pricing, VaR etc.


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Stress framework: Additional considerations

Different scenarios (idiosyncratic, market wide)

Multiple severity levels in each scenario

Time dimension (Dynamic vs. Static)

Different changes to different asset classes


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Stress scenario construction

Historical changes (absolute/ relative) Missing instruments: Beta model

Missing Risk Factors: Behavior model

Predictive:

set a few RF changes => behavior model for the rest

User-defined Dependency structure assumptions??


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Reverse Stress Testing

Algorithmic search for scenarios leading to intolerable loss

Tool to facilitate brainstorming by stress testing committee

The scenario is not fixed in advance. However Likelihood ofoccurrence to such a scenario can still only be judgmentally

assessed! Scenarios need to respect correlation assumptions.


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Conclusions

Stress testing is a diagnostic tool to better understand your

institutions risk profile It incorporates the insight of experienced managers

It contains forward-looking elements

It should trigger debates within your organization as to thepossibility of an unwanted situation and the acceptance ofits consequences

Risk Management is by no means a mechanical exercise!

Th k !


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Thank you!

Contact me any time [email protected]

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Systemic - Stress Testing Ucits

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