Reverse Stress Testing
Ron Papanek
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Agenda
 What is Reverse Stress Testing?
 Why is it important?
 Practitioner Examples
 Single-Factor
 Multi-Factor
 Historical
 Monte Carlo
 Related Stress Tests
 Historical Unwind
 Liquidity
 Hedging
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Reverse Stress Testing – What is it?
Definitions

Traditional Stress Test
Reverse Stress Test
Shock  P&L
P&L  Shocks
 Portfolio Specific
 Incorporating information specific to the fund company, or portfolio.
 Create an Explanatory Narrative
 Traditional Stress tests quantify loss from a real or potential event
 Reverse Stress tests tell a story from the numbers.
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Reverse Stress Testing – Why is it Important?
 Engages Management
 The methodology leads to a better understanding of firm risk through the process of identifying
thresholds and the exploration of macro scenarios
 Connects the portfolio risk to the business risk
 Provides a different perspective than traditional stress tests
 Provides a more thorough examination of tail risk
 Can yield more efficient hedging strategies
 Tells a story
 Advocated by Regulators
 FSA, BIS, FED, CRMPG have all voiced support for reverse stress testing
 “The emphasis of a ‘reverse-stress test’ would be on identifying the high impact stress events
which would cause the firm to fail and considering the appropriate action, if any, to protect against
such failure.” FSA 12/2008 (2.27)
 Identify systemic risk and trigger points for contagion
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Reverse Stress Testing
Reverse Stress Test Methodologies
Sensitivity Analysis
 One Factor - Simple, Predictive, Multiple correlated factors
 Multifactor – two or more independent risk factors
Scenario Analysis
 Historical – Date Range
 Monte Carlo – Loss simulations
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Reverse Stress Testing - One Factor
Traditional stress test
 is a function
 not necessarily monotonic.
Reverse stress test
 is not a function
 Different shocks can produce the same P&L
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One
Two Factor Reverse Stress Test
Equity Shift
P&L
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Sensitivity Analysis
Multi-Factor
 One Factor – One Dimension
 Two Factors – Two Dimensions
 Locking two factors together allows us to introduce a third factor
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Two Factor Reverse Stress Test
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Multi-Factor Sensitivity Grid
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20 %
3 0
40 %
50 %
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Reverse Stress Testing - Historical
Steps
 Run a traditional Historical stress test and sort by threshold violation.
 Run same Historical stress test, but widen period from days to rolling periods, widening
periods until loss threshold is triggered.
 The output of the Reverse Historical Stress Test is a series of dates and date ranges.
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Reverse Stress Testing
Historical
Daily
Daily
Day
22 Day
Weekly
Monthly
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Reverse Historical Stress Test
Match date scenario with events to explains the portfolio loss
Single Date
September 20, 2008
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Date Range
March 2003
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Reverse Stress Testing – Scenario Generation
Monte Carlo
How do we simulate a 100 year flood?
 Run 100 years worth of Monte Carlo simulated returns
 Run Monte Carlo simulated returns using correlation periods from different market
regimes.
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Reverse Stress Testing - Scenario
Historical / Monte Carlo Hybrid
 Run long term Historical Simulation
 Sort sims by loss threshold and use dates to create a period for correlation calculation
 Run Monte Carlo simulated returns report using new “extreme correlation period”
 Sort sims by loss threshold and aggregate risk factor scenarios
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Reverse Stress Testing - Simulations
Historical / Monte Carlo Hybrid
Historical
Monte Carlo
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Monte Carlo Visualization
Worst
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to
Best
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Reverse Stress Testing - Simulation
Monte Carlo by Position
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Reverse Stress Testing - Simulation
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Reverse Stress Testing - Simulation
Monte Carlo Visualization
 Visualization allows the inspection of hundreds or thousands of scenarios
 Observe the distribution of individual scenarios (not just the average)
 Visually identify hedge positions and hedge effectiveness
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Agenda
 What is Reverse Stress Testing?
 Why is it important?
 Practitioner Examples
 Single-Factor
 Multi-Factor
 Historical
 Monte Carlo
 Related Tools
 Historical Unwind
 Liquidity
 Hedging
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Reverse Stress Testing – Related Tools
Historical Unwind
Historical Stress Test
Replays History
Historical Unwind
Replays History in Reverse
Benefits
 Provides insight into Bubbles
 Separates buy and hold from arbitrage strategies
 Identifies increasing leverage
 Can highlight trend following
 Separates idiosyncratic trends within an asset class
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Reverse Stress Testing
Historical Unwind
1
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2
3
4
month month month
month
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Reverse Stress Testing
Historical Unwind
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Reverse Stress Testing
Liquidity
Portfolio specific Risk
 Risk - based on position not security
 Test liquidation assumptions with acquisition history
 Compare Lock-up to liquidity horizon
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Agenda
 What is Reverse Stress Testing?
 Why is it important?
 Practitioner Examples
 Single-Factor
 Multi-Factor
 Historical
 Monte Carlo
 Related Tools
 Historical Unwind
 Liquidity
 Hedging
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Reverse Stress Testing - Hedging
Hedge the Business not the Portfolio
 Focus on hedging the tail
 Identify and aggregate the most commonly occurring risk factor scenarios
 Finding the cheapest and most efficient hedge
 Strategies
 Costless Collar
 Correlated Asset Put Spread
 Macro Scenario overlay
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Reverse Stress Testing - Conclusions
 Engage management as much as the risk department
 The information flow between CEO and risk department is two way
 There is a significant amount of firm specific data that should be incorporated into stress
testing and risk management.
 Connect a story to the risk
 The event has more meaning than the date or the scenario # or the P&L
 Firm risk is not portfolio risk – Hedge Appropriately
 P&L is linear Risk is not
 Reverse Stress Testing helps to identify the conditions for failure allowing for early warning
as wells as prevention.
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http://www.riskmetrics.com/events/risk2009
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