Stressed VaR and Stressed ES
We will cover following topics
Introduction
In this chapter, we will delve into the concepts of stressed Value at Risk (VaR) and stressed Expected Shortfall (ES) as crucial components of stress testing. We will explore their significance in assessing extreme market scenarios and compare the process of determining stressed VaR and stressed ES to that of traditional VaR and ES. Understanding these measures is essential for effective risk management and ensuring institutions are prepared for adverse market conditions.
Stressed VaR and Stressed ES
Stressed VaR and stressed ES are risk measures designed to capture potential losses in extreme market conditions, which are beyond the scope of regular market movements. Stressed VaR represents the maximum potential loss at a specified confidence level, given a particular stress scenario. Stressed ES, on the other hand, goes beyond VaR by considering the expected magnitude of losses in the tail of the distribution beyond VaR.
Comparison with Traditional VaR and ES
While traditional VaR and ES provide insight into regular market movements, stressed VaR and stressed ES are tailored to extreme scenarios that might occur during times of market stress or crisis. The key distinction lies in the severity of the scenario considered. Traditional VaR and ES focus on the “normal” distribution of returns, while stressed VaR and stressed ES consider the tails of the distribution where rare and severe events may occur.
Determining Stressed VaR and Stressed ES
The process of determining stressed VaR and stressed ES involves selecting an appropriate stress scenario and assessing the impact on the portfolio’s value. This requires identifying extreme market conditions that are relevant to the portfolio’s risk factors. For example, in a stressed scenario, interest rates might spike, leading to a significant impact on fixed-income portfolios.
Example: Let’s consider a bank’s portfolio of mortgage-backed securities. In a stressed scenario involving a severe housing market crash, stressed VaR would estimate the maximum potential loss the bank might face due to the sudden decline in property values. Stressed ES would further estimate the expected magnitude of losses beyond the VaR threshold.
Conclusion
Stressed VaR and stressed ES serve as valuable tools in stress testing by evaluating extreme market conditions and potential losses beyond regular risk assessments. By comparing these measures to traditional VaR and ES, institutions can gain insights into the impact of severe scenarios on their portfolios. Understanding the process of determining stressed VaR and stressed ES enhances risk management practices, enabling institutions to be better prepared for adverse market events.