The Impact of Stress Scenarios on VaR and Expected Shortfall Sanjay Basu, NIBM.

December 2006
Do not quote without permission

Abstract In the wake of Basel II, stress tests are recommended by most central banks, for their supervisory review process. However, most of these tests fail to consider the probability of occurrence of the shocks. Using data on USD-INR and GBP-INR between January 2000 and February 2001, we couch stress testing in a probabilistic, Value-at-Risk (VaR), framework. This allows us to estimate the impact of stress scenarios on VaR and Expected Shortfall under Variance-Covariance and Historical Simulation. Our analysis also tells us how sensitive VaR and Expected Shortfall are to these shocks.

JEL Classification: G21, G32

Keywords: Extreme Losses; Volatility; Correlation; Normality; Simulation.

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Electronic copy available at: http://ssrn.com/abstract=1091462

Introduction

The recent emphasis on stress testing of bank portfolios has been triggered by the advent of Basel II. While allowing the more sophisticated banks to use their internal models for risk measurement and management, Pillar 2 stipulates that these models should be stress tested regularly, to see how well they predict abnormal losses. It is clear that banks would certainly prefer those models and techniques which are more sensitive to extreme losses. If a risk measure is unable to capture a large shock, then a bank which uses it to compute stress capital might be undercapitalized when the market becomes more volatile.

Again, a risk measure should not only be able to predict the size of abnormal losses, but also indicate the probability with which they occur. If the measure forecasts a large loss, without specifying whether it is likely or not, the result is useless. A risk manger does not know whether to maintain extra capital, buy insurance, take a line of credit or dismiss the prediction out of hand. This is the problem with most what if scenarios. For instance, if we know that the modified duration of a bond is 6 years, then we can say that a 100 bps rise in YTM will lead to a 6% decline in the bonds price. But, how probable is an instantaneous rate shock of 100 bps? Duration analysis tells us nothing.

Our paper addresses these two issues. Specifically, we show that Expected Shortfall (ES) is more responsive to stress tests than Value-at-Risk (VaR). We also find that Variancecovariance VaR (VCVaR) changes more than Historical Simulation VaR (HSVaR). Thirdly, following Aragones et.al. (2001) and Dowd (2005), we embed stress scenarios in a VaR framework. This means that, unlike ad-hoc scenario analysis, we are able to indicate the probability with which large losses occur, upon abnormal shocks.

The intuition for our first result is simple. Traditional VaR methods give equal weights to all profits and losses, including extreme ones. Because a large loss is just one of many possible scenarios, it does not affect the VaR number much. In contrast, for a given confidence level, ES is the average of all losses beyond VaR. Therefore, it gives more weights to extreme observations and is more sensitive, than VaR, to very large losses. In

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Electronic copy available at: http://ssrn.com/abstract=1091462

particular, an abnormal shock might generate such a huge loss which lies well outside the 99% confidence level. In this case, 99% HSVaR might not be affected by the shock.

The foregoing analysis also explains our second result. In VCVaR, a large shock affects the parameters of the model the standard deviations of the individual positions, the correlations between the positions and the portfolio standard deviation. Not only do the individual positions become more volatile, but large shocks occur together across all positions. This increases position-specific and portfolio VCVaR at the 99% confidence level. In contrast, as already noted, the extreme losses caused by the same shocks lie way outside the 99% confidence level and does not increase HSVaR by much.

The benefit of our second result is that changes in parameter values are endogenous. Very often, stress tests perturb the parameters of return distributions in an arbitrary manner. The most common flaw is that volatilities are given a shock, but correlations are kept constant. The obvious problem with such methods is that if two or more positions are assumed to become more volatile simultaneously, then the chance of large losses being bunched also goes up. In other words, both volatilities and correlations increase at the same time. In sum, changes in parameters should not be exogenous. They should be derived from the distribution which has been distorted by large shocks.

Our paper is inspired by the recent Draft Guidelines on Stress Testing by the Reserve Bank of India (RBI 2006). This document presents several stress scenarios for different risk categories. None of these scenarios come with probability numbers. In other words, it is not clear how likely these shocks are. As a result, banks will not be able to decide what to do with the resultant losses. To solve this problem, we incorporate the scenarios in a VaR-ES framework. This not only gives us the likelihood of the extreme losses, but also tells us how different VaR methods perform under large shocks. We are able to compare the sensitivities of Expected Shortfall, HSVaR and VCVaR.

Among all the categories for which RBI has suggested stress scenarios, we choose forex risk. This is because forex markets are deep and liquid and daily quotes are available for

USD-INR, GBP-INR and Euro-INR rates. In particular, we enquire what happens to a portfolio of USD100 and GBP 100, when INR appreciates by a large amount. We borrow the hypothetical shocks from the RBI document and compute the losses in the forex market. Therefore, apart from the comparison of VaR methods and estimation of probabilities, our analysis also contributes to the current debate on the consequences of an appreciating rupee. It shows us how to calculate losses on forex open positions.

The structure of the paper is as follows. In section 1, we present a brief review of the existing literature. In section 2, we provide the data and the methodology. In section 3, we discuss and analyze the results. We conclude in section 4, with directions for future research.

Section 1: Literature Review

For risk management, a bank needs to measure the impact of three kinds of losses: (a) Expected Losses, which are long-run average losses borne in course of day-to-day business and have to be priced out (b) Unexpected Losses, which refer to unpredictable, but calculable, short-run deviations from average losses. These have to be absorbed under normal business conditions with economic capital (c) Extreme Losses, which refer to highly rare, though not improbable, losses under abnormal/distressed market conditions which a bank must overcome, in order to survive and remain solvent (Bessis 2002).

Stress tests study extreme losses. They are designed to illustrate and measure, in a consistent framework, how remote tail events can affect financial institutions in particular and the financial system in general. They are structured to identify the breaking points of an institution those scenarios (loss severity and frequency) which would force it into insolvency. Standard sensitivity measures tend to overlook such events (Dowd 2005).

There are a number of reasons for conducting Stress Tests. These are:

1.

Some scenarios offer such a sharp break with history that no analysis of past

experience can offer guidance. For instance, when firms were worried about the impact of Y2K, or about the collapse of Euro, the likely problems had no historical precedent. 2. Historical data on volatility and correlations can be unreliable and misleading. For

instance, VAR based on a pegged currency has traditionally underestimated exchange rate risk. Correlations between prices (e.g. bonds) have often broken down during market crashes. 3. The liquidity risk related to large market crashes, and the interactions with

interest rate or credit risk, are subtle and cannot be captured easily by VaR. Specific stress tests can focus more explicitly on them.

Stress tests are classified into (i) Scenario analysis and (ii) Sensitivity analysis. Scenarios can be historical or hypothetical events. They capture the effect of a relevant event on a number of risk factors. The stressed loss is a combined effect of simultaneous movement in a number of risk factors. Sensitivity tests isolate the portfolio impact of movement in a single risk factor. The stressed loss is the marginal contribution of a single risk factor. Even when several risk factors are shocked, the loss can be decomposed as the sum of marginal losses from various factors (BIS 2005).

BIS (2005) published results of a survey of stress tests among 64 banks and securities firms from 16 countries. It revealed that more than 80% of stress tests were conducted on trading portfolios. This is probably because market values, which have to be subjected to shocks, are most readily available for the trading book. Most of the tests are based on interest rate movements. The number of tests on Credit, FX and equity portfolios was much lesser. Sensitivity tests were most common, followed by hypothetical and historical scenarios. Hypothetical scenarios were more than historical ones for tests conducted at longer (3m -1 yr) intervals.

Another survey on Stress Testing was conducted by the Financial Services Authority (FSA 2005). The survey revealed that, even for the most sophisticated risk management operation, methods for stress testing aggregated risks are rudimentary. Where aggregation

does take place, firms often assume that certain correlations remain constant over time. There was little evidence to suggest that senior management reviews these correlations on an on-going basis. A key issue was the magnitude of correlations during a period of stress. It was widely felt that data on correlations in normal periods may not turn out to be a good guide in stress scenarios.

The two surveys mentioned above suffer from a common, glaring, omission the use of VaR. Indeed, VaR has become the global standard for measuring unexpected losses, for all risk categories (Jorion 2001). However, instead of using VaR, the survey participants had used sensitivity or scenario analyses to project their extreme losses. Moreover, as already mentioned, the correlations that they assumed across positions and risk categories were also kept constant. There is a very simple answer to both the problems. VaR is considered to be unsuitable for stress testing because it is a quantile measure of risk. It projects the maximum loss at a particular confidence level, but does not tell us how large actual losses can be when they exceed the VaR number.

VaR analysis also takes into account the interdependence among various risks primarily in terms of correlations. But, since it is silent about losses beyond VaR, we do not know how large or small correlations are for extreme losses. There is, in fact, a lot of evidence in support of correlation breakdown under abnormal market conditions. For instance, Jorion (2000) and Shirreff (2005) showed how LTCM lost heavily in August 1998, from Relative Value Trading, with a sharp decline in correlations between its long and short positions, as global financial markets became highly illiquid. Ang & Chen (2002) also showed that downside correlations (falling together) between US stocks and the market index are much higher than upside correlations (rising together). On the 3rd of July 2006, RBI came out with its draft guidelines on Stress Testing (RBI 2006). This brief document covers most risk categories: funding liquidity risk, earningsat-risk, economic value risk, credit risk and forex risk. However, the same old problem occurs here as well. None of the stress scenarios, in any of the risk categories, are accompanied by probabilities. As a result, a risk manager does not know how to treat the

resultant large losses. If they are highly unlikely, his top management might dismiss them as irrelevant. The guidelines do not tell us how to relate the day-to-day loss forecasts with these numbers.

From the foregoing discussion, it is clear that standard stress tests are very arbitrary. In particular, they indicate neither the chances of large shocks nor changes in dependence structures. This is because these scenarios are unrelated to return distributions in normal markets. So, on the one hand, we have VaR for unexpected losses in normal markets. On the other, we have stress scenarios for abnormal losses, but we do not know how likely these shocks are. As a result, we cannot combine the losses under normal and abnormal conditions. We cannot estimate the structural breaks or jumps in the return distributions, after the large shocks. This is because we do not know how the parameters of the original distribution are affected by the stress scenarios.

The first step to a composite VaR analysis was taken by Berkowitz (1999). He suggested that probabilities should be assigned to various stress scenarios, indicating their relative weights in the aggregate distribution. The choice of the probabilities is left to the analyst. Since the new distribution is some probability-weighted combination of the original one and the stress scenarios, we know how the original parameters have been changed by the shocks. Once we have a new distribution, it is easy to mark off VaR from the desired quantile. This allows us to compare VaR before and after the shocks.

The next step was suggested by Aragones et.al. (2001) and Dowd (2005). They understood that stressed losses might be so large that even 99% VaR might not change much. Therefore, VaR has to be complemented with ES, which puts more weight on losses beyond VaR. They also suggested how ES should be calculated for the purpose. For historical simulation, the 99% ES is the simple average of all losses beyond 99% VaR. For a distribution, e.g. normal, the 99% ES is the average of all possible tail VaRs beyond 99% VCVaR. So, for distributional ES, the tail has to be sliced into as many VaRs, beyond a given quantile, as is possible. The greater is the number of slices, the better is the result.

In view of the discussions above, our agenda is very clear. In the next section, we present the data source and our methodology for VCVaR, HSVaR and ES. In section 3, we present and compare the VaR results with the ES output. We conclude, in section 4, by pointing out the limitations of our work and the scope for future research.

Section 2: Data and Methodology

The questions that we ask are as follows:

(a)

How much capital should an investor set aside, on an open position of USD100

and GBP 100, so that he can cover 99% of his losses over the next day? (b) In case actual losses exceed the amount computed in (a), what is the average loss

likely to be?

The answer to the first question gives us the 99% VaR. The answer to the second gives us the 99% ES. We have deliberately posed the questions in terms of risk capital, to focus on the most popular use of VaR. The first reason why we want to predict unexpected losses is that we want to hedge it. Our interpretation of risk capital differs somewhat from the definition in the Internal Models Approach to Market Risk Capital Charges, prescribed by Basel-II, which also considers regulatory adjustments like the square root rule, the multiplicative factor and an average of VaR over the past sixty days (BIS 2006).

We assume that the investor is interested in rupee revenues. He is estimating VaR at the close of business on the 28th of February 2001. Therefore, our reference or settlement date is 28/02/2001. We are trying to project his unexpected losses as on 01/03/2001. In order to do this, we use a historical dataset on USD-INR and GBP-INR, from 3rd January 2000 onwards, consisting of 300 observations. We obtain these rates from the RBI website (www.rbi.org.in). We follow two methods, Variance-Covariance and Historical Simulation, for each currency.

2.1: Variance-Covariance

VaR

It assumes that all risk factors and asset returns are normally distributed. As the portfolio return is a linear combination of normal variables, it is also normally distributed. Our goal is to predict the change in current market value, if returns are normally distributed. The steps are as follows:

(1) Measure market value of the currencies, as well as the portfolio, in rupees (as on 28/02/2001). (2) Calculate returns for the past 300 days, i.e. convert past rate data into return data. (3) Calculate standard deviation of each return set, as a measure of volatility. (4) Express chosen confidence level as multiple of SD (NORMSINV in Excel). This gives us the size of shock, underlying a 99% loss, when returns are normally distributed. (5) Multiply each market value by SD multiple to get daily VaR. (6) Calculate correlations between returns to estimate portfolio variance and portfolio VaR.

The basic assumption here is that past volatility and interdependence, measured in terms of Standard Deviation and Correlation, persist in the future as well.

Expected Shortfall in Variance-Covariance

The 99% ES is the average of all losses beyond 99% VaR. In order to generate the losses beyond 99% VCVaR, we compute 99.25% VaR, 99.5% VaR and 99.75% VaR. Of course, we could have computed many more VaRs beyond 99%. The 99% ES is the average of all VaRs beyond 99% VCVaR (Dowd 2005).

Stress Scenarios

We use the same shocks suggested by the RBI guidelines on stresstesting (RBI 2006), but while RBI assumes that the rupee has depreciated, we assume that it has appreciated. This is because our investor has FX assets and will lose only when the rupee appreciates. We assume that (i) the rupee appreciates by 5% or 10% or 15%, against USD and GBP (ii) shocks of equal magnitude occur together, e.g. the rupee appreciates by 15% against both USD and GBP (iii) these shocks are also normally distributed. The second assumption is a simplifying one. We can, of course, pair a 5% appreciation against USD with a 15% appreciation against GBP. It will only affect portfolio correlation.

2.2. Historical Simulation

Historical Simulation (HS) tries to predict changes in current market value, from actual distributions for past returns, rather than assumed or estimated ones. The question we ask is that if future returns are the same as they were in the past, how will the current market values of the individual currencies, as well as the portfolio, be affected? The steps are as follows:

(1) Measure current market value in rupees. (2) Measure returns for the past 300 trading days. (3) Multiply all past returns by current market value, i.e. (1) (2) and add resultant losses or profits across all currencies. (4) Rank in ascending order from worst losses to highest profits. (5) Mark off currency-wise and portfolio VaR as the 99% worst sample loss.

In HS, each return is a distinct scenario for a potential change in price. With 300 observations, we have 299 possible ways in which current market value can fluctuate. Moreover, the association between two sets of returns will change from day to day. In contrast, for VCVaR, the standard deviation serves as the single measure of shock and the

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correlation as the single measure of dependence. But, these are average measures over 299 sample points. By using SD and correlation in VCVaR, we suppress day-to-day changes in the past.

The 99% ES is the average of all past losses beyond 99% VaR. All assumptions about stress scenarios also remain the same as in VCVaR, except that they are not supposed to be normally distributed.

Section 3: Results

We begin with VCVaR. First of all, we calculate the standard deviations and correlation to compute base-case VaR for USD, GBP and the portfolio. Then, we slice off the tail, beyond 99% VaR, to calculate 99% ES. Finally, we incorporate the three stress scenarios. The effects of the shocks on SDs and correlation are summarized in Table 1.

Table 1: SD and Correlation Base-case SDUSD SDGBP Correlation SD Portfolio 0.001514 0.005701 0.046652 0.003453 5% shock 0.003266 0.006375 0.418555 0.004493 10% shock 0.005972 0.008093 0.696072 0.006715 15% shock 0.00879 0.010342 0.826937 0.009307

The greater is the rupee appreciation, the higher are the SDs and correlation. However, the SDs are much less than the shocks. For instance, when the rupee appreciates by 5%, the SDs are not 5%. This is because the stress shock is a single extreme observation, in a set of many ordinary shocks. The weight of the ordinary deviations, in the dataset, pulls down the values of the SDs much below the size of the stress shocks.

Similarly, though shocks of equal size are given to both rates, the correlations are not equal to unity. For instance, even when both USD and GBP depreciate by 15% against the rupee, the correlation is only 0.826937. This is because the other ordinary shocks are

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much less correlated. Only one large shock is the same for both currencies, the others are not. Therefore, average dependence is less than perfect. However, as we pair ever larger shocks, the value of correlation approaches unity. The larger is the single joint deviation, the greater is its weight in the entire set of shocks and the higher its impact on correlation.

It is clear that the increase in SDs and correlation will affect not only currency-specific, but also portfolio-level, VaR and ES. To confirm this intuition, we present the following tables. Table 2: VaR and ES for USD 99% VaR 99% ES Base-case 16.40811 18.37406 5% shock 35.39625 39.63727 10% shock 64.71935 72.47374 15% shock 95.26515 106.6794

Table 3: VaR and ES for GBP 99% VaR 99% ES Base-case 89.2418 99.93436 5% shock 99.78825 111.7444 10% shock 126.6826 141.8612 15% shock 161.8949 181.2924

Table 4: Portfolio VaR and ES 99% VaR 99% ES Base-case 91.48743 102.4491 5% shock 119.0268 133.288 10% shock 177.9073 199.2234 15% shock 246.5624 276.1044

There are three observations. First, both VaR and ES are positively related to the size of the shocks. This follows from the fact that volatilities and correlation go up, as we apply stronger shocks. Secondly, the portfolio VaR (and ES) is less than the sum of individual VaRs (and ES). This is because the correlations are not perfect, even though they increase with the shocks. Despite one large loss occurring together, there is some diversification because other losses are not bunched. Thirdly, as we consider stronger shocks, ES rises more than VaR.

The third result is due to the fact that a change in 99% ES captures changes in tail VaRs, beyond the 99% confidence level. As we move to more extreme quantiles in a normal distribution, the SD multiplier increases at an increasing rate. This means that more

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extreme losses go up at an ever higher rate as well. The change in ES captures this disproportionate rise in losses. In contrast, the change in 99% VaR simply captures the change in SDs and Correlation, the multiplier staying put at 2.326. That is why 99% ES changes more than 99% VaR, both for the currencies as well as the portfolio.

We now move on to HSVaR. First, we compute VaR and ES for the currencies and the portfolio. Next, we apply each of the shocks and estimate the VaR and ES once again. The results are summarized in the following tables.

Table 5: HSVaR and ES for USD 99% VaR 99% ES Base-case 17.3037 21.5229 5% shock 19.7295 92.5922 10% shock 19.7295 170.238 15% shock 19.7295 247.884

Table 6: HSVaR and ES for GBP 99% VaR 99% ES Base-case 97.3118 114.411 5% shock 105.219 191.49 10% shock 105.219 303.642 15% shock 105.219 415.794

Table 7: HSVaR and ES for Portfolio 99% VaR 99% ES Base-case 101.616 112.418 5% shock 108.426 266.074 10% shock 108.426 455.871 15% shock 108.426 645.669

Again, there are three observations. First, even without using an explicit correlation, we find that portfolio VaR (ES) is less than the sum of the individual VaRs (ES) there is diversification effect. This is why advocates of HSVaR suggest that there is no need to compute and use an average measure of dependence like correlation the association is implicit in the market data. The returns are such that losses of the same degree are not clustered anyway.

The second point is that VaRs are not very responsive to shocks. In fact, they change only once, when the 5% shock is applied, and remain the same thereafter. This is because the losses are so large that they lie way outside the 99% confidence level and do not affect

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HSVaRs. In contrast, since the SDs and correlation are affected by the shocks, losses change much more and push up the 99% VCVaR as well.

Our third result is that while VaRs are more responsive to shocks in VCV, the ES is much more responsive in HS. This is because, for VCV, the ES is affected through changes in SDs. The SD puts a low weight on the extreme loss (in our example 1/300 or roughly 0.33%). In contrast, for HS, the weight is much higher (in our example 1/3 or 33%) in the computation of ES, which considers only those losses beyond 99% VaR. Therefore, ES changes more in HS than in VCV. This is why ES is a better risk measure than VaR, for capturing the impact of stress scenarios in HS.

Conclusion

The assumption of normality in VaR is only a simplification, to introduce the issues of confidence levels, volatility and correlation. But, our VCV analysis clearly shows how large shocks affect VaR and ES, through their impact on instrument and portfolio-level parameters. Similarly, our HS analysis shows that VaR is very sticky, while ES is highly responsive to large shocks. Our next step will be to get the best of both the worlds through Monte Carlo Simulation (MCS). Since we have to fit distributions for MCS, we will be able to affect the parameters of the distributions with large shocks. This will make the VaR responsive to shocks. Since this is also a simulation exercise, losses beyond VaR will get as much weight as in HS. This will make ES responsive to stress scenarios.

Stress testing is a complicated exercise, which requires collective wisdom, instinct and acumen. In this paper, we couch the stress scenarios in a probabilistic framework. This not only gives us confidence levels with which we can predict the stressed losses, but also informs us of the relative merits of VCVaR, HSVaR and ES. Our technique is simple, very general and applicable to any traded instrument. It is extremely relevant for Indian financial markets, which are subject to multiple stress factors like high interest rate volatility, recurrent liquidity shortages and increasing capital account liberalization. It might be good to hope for the best, but we should know how to prepare for the worst.

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References

1. Ang, A. and J. Chen, (2002): Asymmetric correlations of equity portfolios, Journal of Financial Economics, 63, 443494. 2. Aragones, J.R, C. Blanco and K. Dowd (2001): Incorporating Stress Tests into Market Risk Modelling, Derivatives Quarterly, Spring, 44-49. 3. Berkowitz, J. (1999): A Coherent Framework for Stress-Testing, Board of Governors of the Federal Reserve, July. 4. Bessis, J. (2002): Risk Management in Banking, 2nd Edition, John Wiley and Sons, Chichester, England. 5. BIS (2005): Stress testing at major financial institutions: survey results and practice, Committee on the Global Financial System, Bank for International Settlements. 6. BIS (2006): International Convergence of Capital Measurement and Capital Standards: A Revised Framework, Comprehensive Version, June, Bank for International Settlements. 7. Dowd, K. (2005): Measuring Market Risk, 2nd Edition, John Wiley and Sons, Chichester, England. 8. FSA (2005): Stress Testing, Discussion Paper 05/2, Financial Services Authority. 9. Jorion, P. (2000): Risk Management Lessons from Long-Term Capital Management, European Financial Management, 6, 277-300. 10. Jorion, P. (2001): Value-at-Risk: The New Benchmark for Managing Financial Risk, McGraw-Hill, USA. 11. RBI (2006): Annual Policy Statement 2006-07: Draft Guidelines on Stress Testing, DBOD. No. BP. 1 / 21.04.103/ 2006-07, Reserve Bank of India. 12. Shirreff, D (2005): Lessons from the Collapse of Long-Term Capital Management in Dealing with Financial Risk, The Economist in Association with Profile Books Ltd, Replika Press, Kundli.

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