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Stress testing originated to ensure that financial institutions had adequate capital levels to deal with possible extreme events such as the 2007/8 credit crunch, 9/11 terrorist attacks or the Asian economic crisis. Nowadays, the Stress Test Report is becoming increasingly important for portfolio and risk managers since it not only measures portfolio risk under unusual conditions, but also is mandatory for sophisticated UCITS III funds.

Traditional VaR, on its own, is not sufficient for portfolio risk analysis. Stress tests allow users to model the effect of extreme events that are out of the historical range suggested by a VaR analysis. For example, LTCM faced huge losses in 1998 because it underestimated the risk of the market under unusual conditions (Kurtosis risk).

Worst case scenarios

While Value-at-Risk (VaR) shows the probability of loss on the assumption that the market behaves as it has done within a recent time period (e.g. 100 days), Stress Testing is a simulation technique used to determine how the portfolio would be expected to react to extreme scenarios such as a stock market crash, extreme changes in exchange rates or extreme changes in yield curves.

Detailed stress analysis

By applying our Statistical Factor Model to determine market moves for all of the assets in your portfolio, Excerpt provides users with a robust Stress Testing solution that meets UCITS III requirements. As well as calculating the effect each hypothesis has on overall portfolio weight, Excerpt produces a detailed asset-level breakdown of such changes. Excerpt’s Stress Testing report also details the expected change in each security’s value following the chosen scenario.

Standard and user defined Stress Scenarios

Excerpt is pre-installed with a set of 8 default stress scenarios, representing a sample of some of the most common historical stresses that managers are often interested in running. These are:

  • 1973-74 oil shock
  • 1987 stock market crash
  • Sterling exit from the ERM in 1992
  • 1994 bond market crash
  • 1994 Mexican peso devaluation
  • 1997 Asian financial crisis
  • 1998 Russian bond default
  • 9/11 terrorist attacks, 2001

In addition, users can create other stress scenarios based on historical events or forecasts.

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