Stress Testing

Stress testing complements statistical risk measures by asking what happens in a specified bad scenario rather than what happens on a typical bad day. Its most valuable feature is that it can assume correlations rise toward one, which is what actually happens in a crisis and what normal risk models fail to capture. Scenarios can be historical, replaying an actual crisis, or hypothetical, constructed to probe a specific vulnerability. Its limitation is the imagination of whoever designs the scenarios: a stress test cannot examine a risk nobody thought to include.