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Risk Management and Financial Institutions, + Web Site, 3rd Edition by John C. Hull

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CHAPTER 19

Scenario Analysis and Stress Testing

Stress testing involves evaluating the impact of extreme, but plausible, scenarios that are not considered by VaR models. If there is one lesson to be learned from the market turmoil that started in the summer of 2007, it is that more emphasis should be placed on stress testing and less emphasis should be placed on the mechanistic application of VaR models. VaR models are useful, but they are inevitably backward looking. Risk management is concerned with what might happen in the future.

This chapter considers the different approaches that can be used to generate scenarios for stress testing and how the results should be used. It explains that the financial crisis of 2007 and 2008 has caused bank supervisors to require banks to conduct more stress testing. Indeed, supervisors themselves have sometimes developed stress tests for financial institutions to determine the ability of the financial sector as a whole to withstand shocks.

19.1 GENERATING THE SCENARIOS

The most popular approach for calculating VaR is the historical simulation approach covered in Chapter 13. This approach assumes that data from the last few years is a good guide to what will happen over the next 1 to 10 days. But if an event has not occurred during the period covered by the data, it will not affect the VaR results when the basic VaR methodology in Section 14.1 is used.

We have discussed a number of ways VaR calculations can be modified so that they reflect more ...

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