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Stress Testing
A Capgemini White Paper
www.capgemini.com/financialservices
Abstract
Stress testing encompasses tools and techniques that are used to identify vulnerability of portfolios in extreme yet plausible events. Stress testing is used in conjunction with portfolio risk measurement tools like VaR and
EC. An EC measure makes a statement like “We are 99.96% percent
certain that we will not lose more than $L in the next say one year”.
Setting a target EC of 99.96% means that the institution is able to
withstand all but 4 in 10,000 events that could occur over the span of the
year. Stress testing on the other hand involves estimating how the
portfolio would have performed under some of the extreme market
moves.
A good stress-testing program should be able to isolate such incidences or
events and also indicate how probable they are. If the event in question
seems plausible, then the institution should be motivated to hedge itself
against that event. In addition to knowing about events where the
portfolio is vulnerable, this analysis can also provide an idea about what
kind of events the portfolio can withstand and still meet the desired
capital ratios while limiting losses.
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