Quick definition Stress testing is running simulations of extreme market scenarios (crashes, liquidity crises) to assess portfolio losses and identify vulnerabilities. What it is A stress test might ask: "What if the market falls 20 percent in one day? What if volatility doubles? What if credit spreads widen 500 basis points?" Banks and funds run stress tests regularly to understand downside risk and ensure adequate capital. Why it matters Stress testing reveals vulnerabilities. A portfolio might seem fine under normal conditions but collapse under extreme stress. Regulators require stress testing as part of risk management and capital adequacy. Types of stress tests Historical scenario: what happened during past crises (2008, COVID crash)? Hypothetical scenario: what if something unprecedented happened? Reverse stress test: what would cause the firm to fail? Regulatory requirements Banks must conduct stress tests quarterly and annually. Results must be published. Banks with inadequate capital based on stress tests must raise capital or reduce risk. Practical example A bank stress tests its portfolio. It assumes: - Stock market down 30 percent - Credit spreads up 300 bps - VIX up to 80 Under these conditions, the bank's portfolio loses 15 billion dollars. The bank decides it has enough capital to absorb this loss, so it is adequate. Limitations Stress tests are only as good as the scenarios. If you don't anticipate a particular crisis, the stress test won't catch it. Stress tests also assume correlations hold. In real crises, correlations break (diversification fails). See also - Value at Risk - Expected Shortfall - Risk Management - Capital Adequacy
