Stress Testing

Overview

A stress test is a forecast based on a pre-defined economic scenario, usually chosen to be one of many possible worst case scenarios. A stress test will specify various economic measurements. The stress will tehn attempt to forecast the effect that the hypothesized scenario will have on the company or other entity that is being tested. A stress test is only as valuable as the forecast, therefore, care must be taken to use best practices in forecasting.

Comparison to Value at Risk

The value at risk measure is similar to a stress test, in that value at risk seeks to understand what happens to the firm in a worst case scenario. However, value at risk does not specify the details of the scenario being tested. Rather, it tries to construct a distribution of outcomes and associated probabilities, and then seeks to calculate the value in the tail of the distribution.

Stress Testing offers an alternative way to measure the tail of the distribution by examining various specific scenarios that exist in that tail and what their likely outcome would be.

Constructing a Stress Test

Constructing a Stress Test - is a resource intensive process but ulitmately beneficial if the bank can afford it.