In this post we will be covering some of the ways in which market risk can be stress tested under the Internal Capital Adequacy and Assessment Process (ICAAP). These involve simple sensitivity analysis techniques, such as applying interest rate and equity shocks, as well as Worst-Case MTM Stress Tests.
Simple Sensitivity Analysis
Interest Rate Shocks
MTM positions are assessed for fixed income portfolio by assuming various shifts in the yield curve. The price sensitivity is measured using the duration measure.
The duration in the sensitivity analysis is calculated using the following equation
Duration = T1 / T2
CFt= Cash Flow at time t,
t = the number of periods of time until the cash flow payment
y = the current yield to maturity of the security,
n = the number of cash flows
The stress test for equity price risk assesses the impact of the fall in the stock market index. In other words, the monetary impact of a decline in the prices of all scrips in the portfolio will be assessed. This is a basic test and applied a fixed percentage shock to stock prices. It does not incorporate the sensitivity of each scrip in the portfolio to the market index.
To calculate equity shock we first calculate the total exposure in stock market. The impact of 10% fall in stock market prices shall be calculated as following:
- Fall in the stock prices = Total Exposure in Stock Market * 0.1
- Tax Adjusted Loss = Fall in the stock prices * ( 1 – Tax Rate)
- Revised Capital = Original Capital – Tax Adjusted Loss
- Revised Risk Weighted Assets = Risk Weighted Assets – Tax Adjusted Loss
- Revised CAR = Revised Capital / Revised Risk Weighted Assets
- Fall in CAR (% age points) = Original CAR – Revised CAR
The process will be repeated for a 20% and 40% shock respectively.
Worst case MTM Stress Tests
Worst case MTM stress test for the equity portfolio respectively calculates the MTM loss for the existing portfolio, if a decline in market prices were to take place, and the all time low for all securities in the portfolio over a specified period of time was breached. The primary assumption for this test is the look back period, which allows us to restrict the analysis to a certain number of days.
Worst case MTM stress test for the fixed income portfolio calculates the MTM loss for the existing portfolio, if a increase (or decrease) in interest rates were to take place, and the all time low for all securities in the portfolio was breached. The primary assumption for this test is the look back period, which allows us to restrict the analysis to a certain number of days.
We have reviewed how market risk may be stress tested. In the next post we will look at how Liquidity risk may be stress tested.