Working Paper

A coherent framework for stress-testing

Abstract: In recent months and years both practitioners and regulators have embraced the ideal of supplementing VaR estimates with \"stress-testing\". Risk managers are beginning to place an emphasis and expend resources on developing more and better stress-tests. In the present paper, we hold the standard approach to stress-testing up to a critical light. The current practice is to stress-test outside the basic risk model. Such an approach yields two sets of forecasts -- one from the stress-tests and one from the basic model. The stress scenarios, conducted outside the model, are never explicitly assigned probabilities. As such, there is no guidance as to the importance or revelance of the results of stress-tests. Moreover, how to combine the two forecasts into a usable risk metric is not known. Instead, we suggest folding the stress-tests into the risk model, thereby requiring all scenarios to be assigned probabilities.

Keywords: Risk management; Risk assessment;

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 1999

Number: 1999-29