Model-Based Stress Tests: Linking Stress Tests to VaR for Market Risk

MAFC Research Paper No. 33

49 Pages Posted: 21 May 2007 Last revised: 25 Jul 2008

See all articles by Carol Alexander

Carol Alexander

University of Sussex Business School; Peking University HSBC Business School

Elizabeth A. Sheedy

Macquarie University Department of Applied Finance; Financial Research Network (FIRN); Macquarie University, Macquarie Business School

Date Written: June 2008

Abstract

Under the new capital accord stress tests are to be included in market risk regulatory capital calculations. This development necessitates a coherent and objective framework for stress testing portfolios exposed to market risk. Following recent criticism of stress testing methods our tests are conducted in the context of risk models, building on the VaR literature. First, to identify the most suitable risk models for stress testing, we apply an extensive back testing procedure that focuses on extreme market movements. We consider eight possible risk models including both conditional and unconditional models and four possible return distributions (normal, Student's t, empirical and normal mixture) applied to three heavily traded currency pairs using a sample of daily data spanning more than 20 years. Finding that risk models accommodating both volatility clustering and heavy tails are the most accurate predictors of extreme returns, we develop a corresponding model-based stress testing methodology. Our results are compared with traditional stress tests and we assess the implications for capital adequacy. On the basis of our results we conclude that the new recommendations for market risk regulatory capital calculation will have little impact on current levels of foreign exchange regulatory capital.

Keywords: Value-at-Risk models, stress testing, market risk, exchange rates, GARCH

JEL Classification: G18, G19, G21

Suggested Citation

Alexander, Carol and Sheedy, Elizabeth A., Model-Based Stress Tests: Linking Stress Tests to VaR for Market Risk (June 2008). MAFC Research Paper No. 33, Available at SSRN: https://ssrn.com/abstract=987450 or http://dx.doi.org/10.2139/ssrn.987450

Carol Alexander

University of Sussex Business School ( email )

Falmer, Brighton BN1 9SL
United Kingdom

HOME PAGE: http://www.carolalexander.org

Peking University HSBC Business School ( email )

Elizabeth A. Sheedy (Contact Author)

Macquarie University Department of Applied Finance ( email )

Room 739, 4 Eastern Road
Macquarie University
North Ryde, NSW 2109
Australia
61-2-9850 7755 (Phone)
61-2-9850 7281 (Fax)

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

Macquarie University, Macquarie Business School ( email )

New South Wales 2109
Australia

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