Which price shocks should be used?

The other basic question that needs to be answered is what magnitude of price
shocks to use. A basic approach will entail undertaking research for each risk factor
to be stressed to identify the largest ever move and also the largest move in the last
ten years. Judgement must then be used to choose price shocks from the results of
the research. The size of the price shocks used may be adjusted over time as asset
return behavior changes. At the time of writing the world was in a period of high
volatility. In such an environment it may make sense to increase the magnitude of
price shocks. The price shocks used will not need to change often but should be
reviewed once a year or as dictated by market behavior and changes in portfolio
composition.
A more sophisticated approach, for individual assets, would involve the use of
extreme value theory (EVT). There are two approaches to designing stress tests
with EVT:
Ω Find the magnitude of price change that will be exceeded only, on average, once
during a specified period of time. The period of time is a subjective decision and
must be determined by the risk manager, typical periods to be considered may be
10, 20 or 50 years. If 20 years were chosen, the price change identified that would
not be exceeded on average more than once in 20 years is called the ‘20-year
return level’.
Ω The second approach is merely the inverse of the first. Given that a bank will have
identified its risk appetite (see below) in terms of the maximum loss it is prepared
to suffer, then EVT can be used to determine the likelihood of such a loss. If the
probability were considered to be too great (i.e. would occur more often than the
bank can tolerate) then the risk appetite must be revisited.