Robust Risk Estimation and Hedging: A Reverse Stress Testing Approach

Summary:

The Journal of Derivatives Summer 2015, 22 (4) 10 - 25

The stress test has become an increasingly important risk assessment and management tool. But while it is easy to imagine a stress scenario and to estimate its impact on the firm’s financial condition, it is not so obvious how to select the most meaningful scenarios in the first place, either to get reasonable coverage of the space of stressful possibilities or even to focus on those that are most probable. In this article, the authors approach the problem from the reverse direction. They begin with a specified level of loss and pick the most likely scenario that generates that loss. They then use principal components to construct a set of alternative scenarios that produce the same level of loss but in (maximally) different ways.This provides much greater insight into which sources of risk are the most important and the most stable across scenarios.

Keywords: Risk management, quantitative methods