Value at Risk (VaR) is a way for companies to assess their risk exposure by quantifying the maximum possible financial loss over a particular time frame. stress testing supplements this valuable risk-assessment tool by identifying the consequences of extreme market events. Generally speaking, the financial industry does not have a standard stress testing method for 澳洲幸运5官方开奖结果体彩网:value at risk measures.

Ways to Stress Test

There are different VaR methods, such as 澳洲幸运5官方开奖结果体彩网:Monte Carlo simulations, historical simulations, and parametric VaR, that one can stress test in different ways. Most VaR models assume away extremely high levels of volatility. This makes VaR particularly poorly adapted, yet well-suited, for stress testing.

Stress testing involves running simulations under crises for which a model was not inherently designed to adjust. The purpose of it is to identify hidden vulnerabilities, especially those based off of methodological assumptions, and to answer the "what if" questions that VaR doesn't address.

The literature about business strategy and corporate governance identifies several approaches to stress testing. Among the most popular are historical scenarios, hypotheticals, and stylized scenarios.

Historical Scenarios

In a historical scenario, for instance, the business, asset class, portfolio, or individual investment is run through a simulation based on a previous crisis. Examples of historical crises include the 澳洲幸运5官方开奖结果体彩网:stock market crash of October 1987, the 澳洲幸运5官方开奖结果体彩网:Asian financial crisis of 1997, and the 澳洲幸运5官方开奖结果体彩网:tech bubble bursting in 1999-2000.

Hypotheticals

A hypothetical stress test is normally more firm-specific. For example, a firm in California might stress test against a hypothetical earthquake, while an oil company might stress test against the outbreak of a war in the Middle East.

Stylized Scenarios

Stylized scenarios are a little more scientific in the sense that only one or a few test variables are adjusted at once. For example, the stress test might involve the 澳洲幸运5官方开奖结果体彩网:Dow Jones index losing 10% of its value in a week. Or it might involve a rise in the 澳洲幸运5官方开奖结果体彩网:federal funds rate of 25 澳洲幸运5官方开奖结果体彩网:basis points.

VaR Calculations and Monte Carlo Simulations

A company's management 澳洲幸运5官方开奖结果体彩网:calculates VaR to assess the level of 澳洲幸运5官方开奖结果体彩网:financial risk to thꦗe firm; an investor does the same for an investment portfolio. Typically, they compare VaR to 🍬some predetermined risk threshold. The concept is to not take risks beyond the acceptable threshold.

Standard VaR equations have three variables:

1. Probability of loss
2. Amount of potential loss
3. Time frame that encompasses the probable loss

A 澳洲幸运5官方开奖结果体彩网:parametric VaR model employs 澳洲幸运5官方开奖结果体彩网:confidence intervals to estimate the probability of loss, profit, and maximum acceptable loss. Monte Carlo simulations are similar, except they involve thousands of tests and probabilities.

One of the variable parameters in the VaR system is 澳洲幸运5官方开奖结果体彩网:volatility. The more volatile a simulation, the greater the chance for loss beyond the ma🐲ximum acceptable level. The purpos♔e of a stress test is to increase the volatility variable to an extent consistent with a crisis. If the probability of extreme loss is too high, the risk might not be worth assuming.

Some financial industry experts consider stress testing and VaR as competing concepts. They also view stress testing, which uses fixed horizons and 澳洲幸运5官方开奖结果体彩网:specific risk factors, as incompatible with true Monte Carlo simulations that use random scenarios.

The Bottom Line

Stress testing helps a firm or investor determine the impact of a particular risk factor (or multiple risk factors). It's often used as a supplement to value-at-risk modeling because it captures the effect of extreme market moves without necessitating a statistical likeliness of such moves. Stress testing gives a firm or investor valuable information which can be used to effectively manage risk.