APPLICATION: STRESS TESTING

In risk management, stress testing assesses the likely impact of an extreme, but plausible, scenario on a portfolio. There is no universally accepted method for performing stress tests. One popular approach, which we consider here, is closely related to factor analysis.

The first step in stress testing is defining a scenario. Scenarios can be either ad hoc or based on a historical episode. An ad hoc scenario might assume that equity markets decline 20% or that interest rates jump 5%, for example. A historical scenario might examine the Russian Debt Crisis of 1998 or the Asian Currency Crisis of 1997. Black Monday, the equity market crash of 1987, is probably one of the most popular scenarios for historical stress tests. For both the ad hoc and the historical approaches, we want to quantify our scenario by specifying the returns of a few key instruments, or factors. For the 5% jump in interest rates, we might specify that 10-year U.S. Treasury rates increase by 5%, BBB credit spreads increase 2%, and the S....