Stress Testing

Alexander Denev

Applications

Once we have a way to build forward-looking distributions through PGMs, we have myriad potential applications to explore. The second part of this book focuses on some of them without precluding the fantasy of the reader finding another use for the methods described here. The applications we investigate in what follows are stress testing, asset allocation, credit portfolio risk and hedging. We shall also show how to build scenarios from scratch in two detailed case studies.

We shall examine issues that concern banks, insurance companies, pension funds and asset managers. The universe of practical uses of PGMs is vast, as is the universe of entities that can make use of them. The regulations, policies and practices behind each entity can also be quite diverse. Due to limitations of space, it is impossible to examine all the possible aspects and subtleties. Nevertheless, we aim to convey the broadest message possible and present a set of analyses that will give direction for any further exploration.

Stress testing… can be loosely defined as the examination of the potential effects on a firm’s financial condition of a set of specified changes in risk factors