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A Coherent Framework for Stress-Testing

by Jeremy Berkowitz of the Federal Reserve Board

July 14, 1999

Abstract: In recent months and years the idea of supplementing VaR estimates with "stress-testing" has been met with lavish praise and has worked its way into all sorts of regulatory documents.  The call for more and better stress-testing has become a mantra for risk-managers and regulators. 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 relevance 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, stress-test.

Published in: Journal of Risk, Vol. 2, No. 2, (Winter 1999/2000), pp. 1-11.

This paper is republished as Ch.11 in...

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