What Is a Stress Test?
At its simplest, a stress test is a way of revaluing a portfolio using a different set of assumptions. The results of a stress test show the sensitivity of the portfolio to a particular shock. Stress tests can be useful because for most asset markets, the history of returns does not provide sufficient information about the behavior of markets under extreme events. Stress tests complement traditional models with estimates of how the value of a portfolio changes in response to exceptional but plausible changes in the underlying risk factors. IMF
A long time ago in a galaxy far, far away (it sometimes seems to me) I used to work in one of the big banks now undergoing stress tests. As an FX Options trader I had access to some fairly advanced (for the time) software that allowed me to examine the changes to my portfolio under a variety of different conditions. I very quickly learned that unimaginable scenarios were not just more plausible than I thought, they were actually happening.
When I started trading I would run a few simple "ladders"- calculations that would tell me my spot, forward, theta, and vega positions over a sequence of spot, interest rate, volatility and time changes. As time went on and my sense of the possible changed- hard lessons indeed- I learned the value of knowing how my book would change under a much wider set of assumptions than was normal practice at the bank. Informing me of how my book could change over the course of a few days was the goal of this process.
Before I left the bank I felt reasonably assured that my "doomsday" assumptions would cover all but the most dire of possibilities. Before I list them here's a few words on the US Treasury Department's assumptions in the current stress tests: According to the new Treasury Department guidelines, the banks would have to assume that the economy contracts by 3.3 percent this year and remains almost flat in 2010. They would also have to assume that housing prices fall another 22 percent this year and that unemployment would shoot to 8.9 percent this year and hit 10.3 percent in 2010.
My assumptions, and the experiences on which they were based, were:
1) short term interest rate changes of 5% (as I traded currency pairs, this covered both countries raising rates by 5% or one country raising by 5% while the other lowered 5%): Britain raised rates by 5% during the ERM crisis of 92
2) spot FX changes of 10%: The GBP fell 10% over a few days in 1992 (as did the A$ a few years earlier)
3) implied volatility changes of 10% in the front months and 3% in the back end: The A$'s volatility curve exploded in Feb '89, as did that of the GBP in '92. When the GBP entered the ERM the volatility curve for GBP/DEM collapsed
Armed with the information I then calculated the trades I would need to do to negate my risk as quickly as possible. As time went on and the book got bigger- 20 years ago when such things were many orders of magnitude smaller than currently- I found that the trades I would need to do couldn't be done in a short period of time, under normal market conditions. In other words my book grew big enough such that I had to be right, for I couldn't change things quickly enough if I wasn't.
This problem today is orders of magnitude larger.
If I was in Geithner's shoes, I would want to know how the big bank's positions would change if:
1) China didn't show up at a Treasury Auction and bond rates jumped 3-5%
2) China started dumping US$s on the open market and our exchange rate dropped 10%
3) The Fed, under such conditions, had to raise the Fed Funds rate by 5% quickly
4) An act of war or natural disaster struck one of the big coastal cities, putting it entirely out of commission thus pushing GDP down 6-10% quickly
Now that would be a stress test.
Admittedly, the Treasury is more interested in a longer view than I was, although given the highly leveraged derivatives positions, they might be well served to also inquire about substantial, discontinuous price changes.
I'm troubled that they don't test for what the past suggests is possible.
What if Unemployment goes to 30% as it did in the 30s?
What if Inflation falls to -5% or rises to 12%?
What if Fed Funds goes to 17% as it did in the early 80s?
What if we can't roll-over our foreign held debt, as has happened to most nations which have run up as large an external debt position as ours?