Risk Management: In the Eye of the Storm
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After VaR: Q&A with Ron Papanek
December 15, 2010
RP: The two areas I think that have gained a lot of focus recently are conditional stress testing and reverse stress testing.
Reverse stress testing is a term, interestingly enough, that was not even used at all prior to the fall of ’08. The basic concept behind a reverse stress test is identifying a particular loss threshold that, for example, might drive a firm out of business.
STM: So you look at conditions in reverse?
RP: It used to be, in a stress test, you would shock the market and look at how much money you lost. But the idea of a reverse stress test is you define how much money will kill you and then say, “How much of a market move can I handle?”
STM: So if you only have $2 billion in cash, what’s going to cause you to lose it all?
RP: Exactly. Or, for example, if you have $2 billion of cash, but you have also $1.5 billion worth of debt, it’s only a 25 percent portfolio loss that would cause you to essentially be insolvent.
STM: What about conditional stress testing?
RP: So, for example, let’s just assume that gold will get to $2,000 an ounce. A conditional stress test would say “How is the rest of my portfolio correlated with gold?” I’m not looking at just the direct sensitivity of my portfolio to gold, I’m not just shocking gold. I’m looking at how interest rates change based on historical correlations. I’m looking at how equities change. I’m looking at how all the assets in my portfolio might change given a particular shock or a macroeconomic event. The point is you’re not looking at just the direct impact, you’re looking at the indirect impact.
STM: What about counterparty risk, which people now worry about, since Lehman Brothers disappeared?
RP: There are two main challenges with counterparty risk. One is to have a methodology that will net your exposures, that will net and recognize what risks are offsetting and what are not.
And, two, you need to have the data to incorporate into the system. You need to know all your over-the-counter parties. You need to know who you purchased or sold all your transactions with.
STM: And what their financial health is.
RP: The first step is to do the calculation without any consideration of their health; it’s just to identify what the risk is.
You may have a small amount of exposure with someone that’s very vulnerable. That’s not a problem. But you may have a big amount of exposure with someone that appears safe. That big amount of exposure with someone that appears safe is probably a bigger issue for you.
STM: How do you evaluate what the riskiness of that position is if you don’t know the health of the other party?
RP: You can run stress tests on counterparty exposure as well. The market may have some assumptions about the volatility of a particular instrument, but you would run a sensitivity analysis and take a look at how your potential counterparty exposure would change if you shocked the market in a particular way. So you still would drive those changes to identify what your overall exposure is; an overall counterparty exposure is.