Which of the following best describes this exercise?

A bank evaluates the impact of large and severe changes in certain risk factors on its risk using a quantitative valuation model.

Which of the following best describes this exercise?
A . Stress testing
B . Simulation
C . Scenario analysis
D . Sensitivity analysis

View Answer

Answer: C

Explanation:

It is important to note the difference between sensitivity analysis and stress testing. Sensitivity analysis applies to measuring the effect of changes on the outputs of a model by varying the inputs – generally one input at a time.

In scenario analysis, a number of variables may be changed at the same time to see the impact on the dependent variable. For example, a bank may measure the changes in the value of its mortgage portfolio by varying its assumptions on prepayment expectations, interest rates and other factors, using its modeling software or application. The changes in the inputs may or may not relate to integrated real world situations that may arise. Sensitivity analysis is purely a quantitative exercise, much like calculating the delta of a portfolio.

A stress test may include shocks or large changes to input parameters but it does so as part of a larger stress testing programme that generally considers the interaction of risk factors, past scenarios etc. At its simplest, a stress test may be no different from a sensitivity analysis exercise, but that is generally not what is considered a stress test at large financial institutions.

A stress test may consider multiple scenarios, for example one scenario may include the events witnessed during the Asian crisis, another may include the events of the recent credit crisis. Simulation generally refers to a Monte Carlo or historical simulation, and is often a more limited exercise.

The exercise described in the question is the closest to a scenario analysis, therefore Choice ‘c’ is the correct answer.

It is important to note that all of the choices referred to in this question are related to each other, and the boundaries between them tend to be fuzzy. At what point does a complex sensitivity analysis start resembling a scenario, or a stress test can always be debatable, but such a debate would be more about the symantics than be of any practical use.