While the potential regulatory benefits are notable, stress testing should be viewed by financial institutions as more than just a regulatory check-box exercise and formality burden. Given the complexity of derivatives, this type of test is a kind of risk analysis that can help uncover significant exposures to undesired market events.
Stress testing aims to quantify the impact of an event or a series of events to a bank’s trading book or a fund’s portfolio. The event may be hypothetical and refer to something that hasn’t been previously observed in the markets. It may also reflect past market experience and result in asset price movements that correspond exactly to real price movements during a certain historical time period. The end result is a return or distribution of returns that reflects how a fund or portfolio might perform should a given scenario take place. The practitioner’s focus in stress testing is on the future, even if the stress scenario mirrors historical events.