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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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Stress Testing in practice
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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Stress Testing in practice
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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Stress Testing in practice
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!
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