What is the main difference between value at risk and stress testing?
Answers
Answer:
The literature about business strategy and corporate governance identifies several approaches to stress testing. Among the most popular are stylized scenarios, hypotheticals, historical scenarios.
In a historical scenario, the business, or asset class, portfolio, or individual investment is run through a simulation based on a previous crisis. Examples of historical crises include the stock market crash of October 1987, the Asian crisis of 1997, and the tech bubble bursting in 1999-2000.
A hypothetical stress test is normally more firm-specific. For example, a firm in California might stress test against a hypothetical earthquake or an oil company might stress test against the outbreak of a war in the Middle East.
Stylized scenarios are a little more scientific in the sense that only one or a few test variables are adjusted at once. For example, the stress test might involve the Dow Jones index losing 10% of its value in a week. Or it might involve a rise in the federal funds rate of 25 basis points.
VaRisk Calculations and Monte Carlo Simulations
A company's management, or investor, calculates VaR to assess the level of financial risk to the firm, or investment portfolio. Typically, VaR is compared to some predetermined risk threshold. The concept is to not take risks beyond the acceptable threshold.
Standard VaR equations have three variables:
Probability of loss
Amount of potential loss
Time frame that encompasses the probable loss
A parametric VaR model employs confidence intervals to estimate the probability of loss, profit, and maximum acceptable loss. Monte Carlo simulations are similar, except they involve thousands of tests and probabilities