Stress Testing for Market Risk

Dilip K Patro, Akhtar Siddique and Xian Sun

Stress testing has received increased attention from both financial institutions and regulators since the 2007–09 financial crisis. What constitutes reliable and relevant stress tests, however, still stirs a lot of debate among practitioners, stakeholders and researchers. The development and evolving practices of stress testing in the area of market risk management are reviewed in this chapter. In addition, the ways in which stress-testing methodology can be improved for risk management is presented.

Generally speaking, market risk refers to changes in a financial institution’s portfolio values due to unanticipated changes in market risk factors, such as the prices and volatilities of equities, interest rates and credit spreads, and the prices of commodities and foreign exchange rates. Stress testing for market risk has been an important component of stress tests, both in the internal stress tests run by banking organisations and in those run by financial regulators. During the financial crisis, the largest losses were often in portfolios sensitive to market risk. Traditionally, stress tests for market risk have been conducted for portfolios in banks’ trading books by using