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11 · Stress tests

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Portfolio and Risk, lesson 11

Stress tests

What happens on the worst days, and planning for them.

VaR and expected shortfall from Measuring risk, and how correlation drives a portfolio's risk from Diversification.

Part 1. Change the inputs

A simulated $130m book of stocks, bonds, credit and commodities. Its VaR uses calm volatilities and correlations. Change them.

Stress the bookLive

Doubling volatility doubled VaR. Pushing correlations up added nearly as much again, because the bonds stopped offsetting the stocks. One hypothetical day where everything fell together cost more than any VaR figure, and the way to fit the limit was to cut what loses most in that scenario for each dollar it earns.

Stress test and scenario

A stress test asks what a portfolio would lose in a specific bad situation, a scenario, rather than on a typical bad day. A historical scenario replays the moves of a past crisis on today's positions. A hypothetical scenario is designed, such as "stocks −20%, bonds −6%".

Your turn

A book holds stocks and bonds that have hedged each other, with a correlation of −0.2. In a stress where both fall together, which VaR input changed most?

The hedge depended on the correlation. Push it from −0.2 towards +0.8 and the bonds stop cancelling the stocks, so the book's risk moves towards the sum of the separate risks.

Part 2. A worked problem

Keep going with Pro

You've done the first part. Pro opens the rest of this lesson, and every other one.

Still to come
  1. A worked problem
  2. Kinds of scenario
  3. The same thing, for real
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