Stress testing

Some of the solutions outlined above fall into the category of ‘stress testing’, which
is vital in all markets and energy is certainly no exception. Stress testing can take
many forms, the most common being historical tests. Others will include model tests
and extreme event forecasting. A sample set of tests would include:
Ω Apply the highest observed volatility
Ω Apply the highest observed prices
Ω Combination of high prices and volatility
Ω Zero correlation
Ω Adverse correlations
Ω Six sigma event
Ω Price shock (i.e. price times ten , or divided by ten)
Ω Different price shapes (i.e. ratio summer/winter; weekday/weekend)
Ω Alternative distribution shapes
Ω Clustering extreme events
Ω Assuming particular positions cannot be hedged before expiry
While many of the tests should be automated and produced on a regular basis
(daily or weekly) stress tests need to be designed around the particular portfolio and
should be an iterative process to find particular weaknesses in the portfolio. They
are also likely to be a key part in the overall portfolio analysis that will drive the
trading and hedging strategy.
Stress tests play a vital role in setting overall liquidity and reserve requirements of
the business as well as a vital communication tool to senior management. The
single biggest danger with VaR is complacency because the portfolio has not been
appropriately stressed.
Stress testing should also encompass all the correlated risks within the business
that may not otherwise be combined. The most obvious is the combination of credit
and market risks under alternative ‘market crisis’ scenarios defaults, leading to
additional volatility, leading to more defaults.