Stress Testing & Scenario Analysis

"Models work beautifully... until they don't."

VaR and ES rely on history. But what if something happens that has never happened before? (e.g., Covid-19, 2008 Crisis). This is where Stress Testing comes in.

Stress Testing vs VaR

• VaR: "What happens on a normal bad day?"
• Stress Testing: "What happens if the world falls apart?"

Types of Stress Tests

1. Historical Scenarios

Re-running your current portfolio through past crises.

• Question: "How much would my current portfolio lose if the 2008 Global Financial Crisis happened tomorrow?"
• Question: "What if the Covid-19 2020 crash repeats?"

2. Hypothetical Scenarios

Inventing new disasters based on economic logic.

• Scenario: "What if Oil hits $200/barrel AND the Rupee depreciates by 20%?"
• Scenario: "What if there is a cyber-attack on the banking system?"

Reverse Stress Testing

Instead of asking "What if X happens?", we ask: "What would it take to bankrupt us?" We work backward to find the breaking point of the institution.