Stress Testing Definition
Stress testing refers to a computerized process of testing the ability of investment portfolios or corporations to maintain a level of efficiency in unfavorable future financial situations. Corporations carry out stress testing so as to know how strong they will be and how reliable their investment portfolios will be during extreme financial conditions.
Basically, stress testing helps to determine the reliably of stability of assets and investment portfolios during austere periods. The risks of assets, their efficiency and performs can be evaluated through the stress testing process.
A Little More on What is Risk Management
Stress testing is an important aspect of risk management for businesses. It entails the use of software of computer simulation to measure the risk of an investment portfolio, especially in future financial conditions. Stress testing does not only help to test the risk of a portfolio, it also helps to devise ways and strategies to mitigate risks and hedge against likely losses.
Portfolio managers conduct stress testing on investment portfolios periodically. This will help them gauge the risks of the portfolio and assess its volatility. Volatility in investment portfolio that are hidden are detected through stress testing.
Regulatory Stress Testing
The 2010 Dodd-Frank Act strengthened the need for stress testing. This was after the 2008 financial crisis that affected the economy, including the financial industry.
In the United States, new regulations tailored towards evaluating risks and ability of institutions to maintain a level of efficiency during financial crisis emerged. This includes the submission of Comprehensive Capital Analysis and Review (CCAR) by banks. This is to ensure that stress testing is done when necessary by banks and the develop strategies to manage their capital.
Globally, there is provision for an international regulation that ensures stress testing by institutions. The BASEL III has been effected and must be carried out by banks across the globally.
Types of Stress Testing
There are three major types of stress testing, that are;
- Stylized scenarios stress testing,
- Hypotheticals stress testing, and
- Historical scenario stress-testing.
In a Stylized scenario stress testing, scientific measures are deployed to check vulnerability in companies as well as ways to maintain efficiency during unfavorable situations.
In a hypothetical stress testing is based on testing on institutions with peculiar crisis manage them. This is more specific, it measures how a firm hedges a crisis.
In a historical scenario stress testing, individual investments and assets are tested using a computer simulation technique based on historical crisis of past events of crisis. Historical crises such as Asian crisis of 1997, the tech bubble of 199-2000 and the 1987 stock market crash can be used.
Aside from the three types of stress testing listed above, there are other stress test methodologies. One of the renowned methodologies is the simulation technique decided by Monte Carlo. This stress testing methodology is used in evaluating the probabilities of many outcomes of a particular variable. Moody’s analytics is another stress testing technique for determining risk in asset portfolios.