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  • Stress testing

    Chapter 3 - Cotton marketing - Risk management – A cotton supply chain manager’s perspective

     
     

    Stress testing is:

    • Examination of low probability events that could result in extraordinary losses or gains;
    • Examination of key sensitivities that might emerge in a trading book.

    Stress testing is an attempt to gauge the vulnerability of the portfolio when subjected to hypothetical events. It is done because of the need to find the non-linearity of the portfolio under conditions of duress. Stress testing incorporates external events (such as SARS and its impact on suppliers to the bird feed industry). It is a natural complement to VaR – stress testing is able to quantity the magnitude of low probability tail events that VaR cannot quantify.

    Stylized scenarios are simulated movements in the major risk factors. These movements can range from relatively moderate to extreme, and can be expressed in terms of absolute changes, percentage changes or standard deviation units. For example, one can simulate a scenario by assuming a 10 cent per pound change in cotton prices, or 30% change in cotton realizations. Similarly one can also consider an extreme 5 or 10 standard deviation change in the cotton prices.

    Scenarios can be constructed from actual extreme events (such as the stock market crash of October 1987 or the bond price falls of 1994). The best way to do this is to select scenarios of the same order of magnitude as the worst-case historical events.

    Another methodology for stress testing is known as factor push analysis. In this methodology the prices of each risk factor are pushed in the most disadvantageous direction, and the combined effect of all such changes in the value of the portfolio is calculated. At first a confidence level, say α, is specified. Subsequently each risk factor is considered on its own and pushed by α. times its standard deviation. Then the price movement up or down that has the worst effect on the value of the portfolio is selected (for example, for long positions push the prices down and for short positions push the prices up). 

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