A Coherent Framework for Stress-Testing

14 Pages Posted: 4 Jan 2000

See all articles by Jeremy Berkowitz

Jeremy Berkowitz

University of Houston - Department of Finance

Date Written: June 22, 1999

Abstract

In recent months and years practitioners and regulators have embraced the idea 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 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.

JEL Classification: G21

Suggested Citation

Berkowitz, Jeremy, A Coherent Framework for Stress-Testing (June 22, 1999). FEDS Working Paper No. 99-29. Available at SSRN: https://ssrn.com/abstract=181931 or http://dx.doi.org/10.2139/ssrn.181931

Jeremy Berkowitz (Contact Author)

University of Houston - Department of Finance ( email )

Houston, TX 77204
United States

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