Instead of doing financial projection on a "best estimate" basis, a
company may do stress testing where they look at how robust a financial
instrument is in certain crashes. They may test the instrument under, for
example, the following stresses:
What happens if the market crashes by more than x% this year?
What happens if interest rates go up by at least y%?
What if half the instruments in the portfolio terminate their
contacts in the 5th year?
What happens if oil prices rise by 200%?
This type of analysis has become increasingly widespread, and has been taken
up by various governmental bodies (such as the FSA in the UK) as a regulatory
requirement on certain financial institutions to ensure adequate capital
allocation levels to cover potential losses incurred during extreme, but
plausible, events. This emphasis on adequate, risk adjusted determination of
capital has been further enhanced by modifications to banking regulations such
as Basel II. Stress testing models typically allow not only the testing of
individual stressors, but also combinations of different events. There is also
usually the ability to test the current exposure to a known historical scenario
(such as the Russian debt default in 1998 or 9/11 terrorist attacks) to ensure
the liquidity of the institution.
