Wednesday, October 24, 2007

Stress Testing

A popular online encyclopedia defines a "stress test" as the following:

"Stress testing is a form of testing that is used to determine the stability of a given system or entity. It involves testing beyond normal operational capacity, often to a breaking point, in order to observe the results. Stress testing may have a more specific meaning in certain industries."

Most people in the quantitative financial community (yours truly included) have performed "stress tests" on portfolios of financial assets - sometime one has to "sum up possible futures and average to the present" (or simply ask "what is the worst thing that can happen?) to get a good idea of what your portfolio might look like when "Black Swans" arise.

It goes without saying that there is an initial decision of magnitude with regards to the stress test - how stressful do you want the test to be?

Today, the CEO of a very large investment bank that was forced to write-off over 8 Billion in financial assets stated (paraphrasing) that his "risk managers" never thought to provide a harsh stress test and that events caused asset prices to go below the "most punitive" stress event scenarios.

Quantitative aptitude (the ability to run models) is a different skill set from creativity (the ability to imagine events that might be more stressful than one has seen in the past).

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