Stress Testing
TK5413 ISLAMIC RISK MANAGEMENT
Muhammad Saifullah Bin Mohamed Azmi (1100314)
Content
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Introduction to Stress Testing
Stress Test & Bank Regulation
Roles of Stress Testing
Scenario & Sensitivity Analyses
Stress Testing in Islamic Financial Institutions‘.
Conducting Stress Test
Limitation of Stress Test
References
Stress Testing
Definition
“A range of techniques used to access the vulnerability of portfolio to major
changes in the macroenomic environment or to exceptional but plausible
event.”
The objective of stress test is to make risk more transparent by
estimating the potential losses on a portfolio in abnormal market.
It is often used to complement the internal model and management
systems used by the financial institution for capital allocation decision.
Stress Test & Bank Regulations
Stress
testing techniques began to be applied widely by internationally active bank in
the early 1990’s and now most of large financial institutions.
Banking
supervisors and regulators have sanctioned the use of stress test as an
important component of internal-model approach to market-risk monitoring.
The
Basel Committee on Banking Supervision (BCBS) highlighted the need of stress
testing in they published the “Amendment to the Capital Accord Incorporate Market Risk”
in January 1996.
National
bank supervisor and regulators (including Bank Negara) have issued their
own guideline on stress testing in accordance with the principle laid down by BCBS.
According to Bank Negara guideline for Stress Testing (see page 5), it also applicable
for Islamic banks, Takaful and Retakaful operator.
Role of Stress Test
Standard Risk Management tool for licensed institutions to understand
the nature of their risk profile.
Help to identify the possible future unfavorable event that would affect
on institution.
Help to identify exceptional but plausible event that can affect the
institution if it really happened in the future.
To complement statistical model such as VaR by providing the assess
the effect of tail event beyond the level of confidence assumed in the
statistical model.
To be used in portfolio that lack of historical data which basically hard
to build a statistical model due to insufficient data.
Categories of Stress Test
Stress Test
Scenario
Analysis
Sensitivity
Analysis
Scenario Analysis
The historical scenario involves the
reconstruction of historical events and involves
less judgment as it reflects actual stress market
condition.
Scenario
Analysis
Hypothetical scenario means simulating shocks
to events that have not yet happened or have no
historical precedent.
Example of Scenarios
Common Stress Test Scenarios
Category
Equities
Historical
Asian
financial crisis 1997
 Terrorist
attacks 2001
Hypothetical
Hypothetical
crashes
Terrorist
Interest Rate Products
 Asian
financial crisis 1997
 Terrorist
attacks 2001
interest rate
increase and decrease

 When
price of oil per barrel
hiked, the price of raw rubber
also increased.
attack
US tightening
 Increase
in inflation
expectations.
 Historical
Commodities
stock market
 Japanese

monetary outlook
Commodity crisis
 Middle
 Oil
east unrest
Shortage
Sensitivity Analysis
Sensitivity
Analysis
Study on how the variation (uncertainty)
in the output of a statistical model can
be attributed to different variations in
the inputs of the model.
Technique for systematically
changing variables in a model to
determine the effects of such changes.
Scenario & Sensitivity Analysis
It is somewhat unavoidable to
distinguish between Scenario
based analysis and sensitivity
test
In the sense that some scenario
based analysis implicitly assume
some scenario for sensitivity
correlation estimators.
Conducting Stress Test
Type of Risk Model
Market Risk
Credit Risk
Other
Type of Stress Test
Sensitivity
Scenario
Other
Type of Shock
Individual market
variables
Underlying
volatilities
Underlying
correlation
Type of Scenario
Historical
Hypothetical
Monte Carlo Simulation
Stress Test in Islamic Financial
Institutions
Islamic Financial Institutions' exposed to market risk through 4 type
of risk namely:1.
Rate of return risk
2.
Commodity Price Risk (Murabaha, Istisna’, Salam)
3.
FX rate risk
4.
Equity price risk (Musharakah, Murabahah)
Commodity Price Risk
(Murabaha, Istisna’, Salam)

The behavior of commodities in Islamic Finance are driven both by
direct & indirect by many different risk factor.
Risk Exposed
Price Risk
Cost Risk
Market Influence Risk
FX Rate Risk
Quantity Risk
Future Delivery Risk
Inverse Price Risk
Equity Price Risk
(Musharakah, Mudaraba)


This type of risk can arise from the contract due to “profit & loss”
sharing that is driven by the share in the investment equity.
Can result in equity price risk
Therefore:The more the complex the contract, the more risk exposure.
Because even simple portfolio carry more than one market risk
factor.
Limitation of Stress Testing
1.
It is based on projected scenarios and not real event, thus it is
hard to choose the “right” event to be tested.
2.
The cost incurred maybe expensive.
3.
Wrong input will lead to wrong output. Thus wrong
interpretation.
4.
Only calculate “what would happen if” scenarios not the
probability that such event would happen.
5.
Limited to only portfolio which closely related to the market
risk.
References
1.
Guideline for Stress Testing, Bank Negara Malaysia.
2.
Stress Testing; Challenge yourself before being Challenged, Ernst & Young
(2009).
3.
Stress Testing of Financial Systems; An Overview of Issues, Methodologies' &
FSAP Experiences, IMF Working Paper (2001)
The End