Stress Testing for Market Risk: A Comparison of VAR Methods

The subprime crisis has shown us again that actual shocks in stressed markets are much more severe than historical scenarios. In this paper, we compare stress tests for foreign exchange positions, based on hypothetical scenarios, across a number of VaR methods. We conclude that volatility weighted historical simulation is the best one, because risk estimates change smoothly with the size of shocks and the impact of stress is also felt on short positions. It captures volatility clustering and fat tails in a simple framework.