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Improvising a stress test helps an investor in identifying the risk factors affecting a portfolio and positions themselves in such a way so as to mitigate the identified risks. Portfolio stress testing seeks to study the adverse effects of financial downturns, loss strategies and to strengthen the business under varying economic climates.Stress testing involves analyzing the impact of various risk factors in one’s portfolio and estimate the potential loss to a portfolio under adverse economic circumstances. There are methods and strategies to apply this technique and let us see what they are: Historical Stress Testing: Historical stress testing is intended to gauge the health of a portfolio. The portfolio manager identifies an adverse event that has occurred in the past and has affected the economy as a whole. An example of this could be the Sub-Prime Crisis or the 9/11 attacks. After identifying an event, the portfolio manager then proceeds to apply the same to his portfolio and gauges the impact of the same on his portfolio. The main advantage of using the historical method is that the events identified under this method have actually taken place at some time in the past. However, care must be taken to identify and use such historical events which would have relevance to the portfolio in question. CustomizedStress Testing: Whether an event that has taken place is the past is likely to recur or not remains unknown. As such, the historical stress testing may actually be for a scenario which may never occur in the future. Besides, new financial instruments are developed which get added to one’s portfolio. As such, the use of historical stress testing may not be appropriate since in the past these new financial instruments would not have existed. To overcome these limitations, Customized portfolio stress testing is used. These are tailor-made to assess the impact of risk factors if some specific adverse event were to happen. These tests are generally developed in relation to those scenarios which are likely to have a material impact on the portfolio. Reverse Stress Testing: Historical tests and Customized tests indicate the potential loss suffered if an adverse event pans out. They give an estimate of the loss on an adverse event materializing. Reverse testing on the other hand tries to arrive at an event that would lead to the failure of an organization on the whole. Reverse testing involves identifying the risks involved in a possible course of action that would lead an organization to its doom. However, reverse tests involve a lot of thought process and since they begin from the scratch and seek to identify the roots of the problem, they are often construed to be very laborious. Portfolio stress testing is essential to the banking sector to estimate the risks involved in the portfolio of the advances held by the bank and seeks to capture the risks to the various asset classes comprised in the portfolio in case of economic adversities.
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