Which of the following is a valid approach to determining the magnitude of a shock for a given risk factor as part of a historical stress testing exercise?
I,Determine the maximum peak-to-trough change in the risk factor over the defined period of the historical event
II,Determine the minimum peak-to-trough change in the risk factor over the defined period of the historical event
III,Determine the total change in the risk factor between the start date and the finish date of the event regardless of peaks and troughs in between
IV. Determine the maximum single day change in the risk factor and multiply by the number of days covered by the stress event
Stress events rarely play out in a well defined period of time, and looking back it is always difficult to put exact start and end dates on historical stress events. Even after that is done, the question arises as to what magnitude of a change in a particular risk factor (for example interest rates, spreads, or exchange rates) are reasonable to consider for the purposes of the stress test.
Statements I and III correctly identify the two approaches that are acceptable and used in practice - the risk manager can either take the maximum adverse move - from peak to trough - in the risk factor, or alternatively he or she could consider the change in the risk factor from the start of the event to the end as defined for the purposes of the stress test. Between the two, the approach mentioned in statement III is considered slightly superior as it produces more believable shocks.
Statement II is incorrect because we never want to consider the minimum, and statement IV is not correct as it is likely to generate a shock of a magnitude that is not plausible. Therefore Choice 'b' is the correct answer.