Glossary

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Stress Testing

Stress testing is a common method of quantifying possible losses in a portfolio or grouping of trading positions (in addition to VAR). Frequently, the price of a financial instrument generally moves in relation (or “basis”) to another, such as with natural gas and petroleum, and the pair are used to “hedge” market price exposure. Various scenarios are constructed, such as for another petroleum shock, a liquidity crisis, a real-estate recession or a credit crunch, and projections are made on how valuations of portfolio components might change. Since stress scenarios tend to shock “basis” relationships (moving one price more dramatically and hence producing an imperfect hedge), the resulting maximum loss calculations can exceed those that use a VAR methodology. The key issue with stress testing though is what probability should be given to the possible extreme event outcomes and hence what level of risk is acceptable for standard business operations.