It is widely accepted that the methods of objective risk management for financial institutions has been improved drastically. Since the advent of "RiskMetrics" by J.P. Morgan in October 1994, VaR model has been the most acknowledged tool for managing market risk. Furthermore, since being officially recognized by Basle Committee and other banking supervisory institutions, VaR model has been adopted as the most efficient method by the international financial institutions for managing their market risk. However, it is widely consented that VaR model has two major drawbacks as follows;
① VaR can`t measure the event risk under the abnormal market condition.
② VaR underestimate the risk under the Normal Distribution assumption.
In this regard, VaR model should be supplemented by a regular program of stress testing. Stress Testing is required by the Basel Committee as one of prerequisite conditions to be satisfied to use internal models. It is also certified by the Derivative Policy Group and by the G-30. However, Stress Testing guidelines are not clear, and the application and use of Stress Testing are confusing, too.
So, the purpose of this paper is pursuing the most acceptable Stress Test method in Korean financial market by some empirical tests through proper understanding of scenario analysis methods. Firstly, I tried to arrange some theories of Scenarios Analysis Method in Stress Testing and show the differences among them. Secondly, I implemented Stress Testing through two different methods; "Zeroed-Out" method and "Broken Arrow" method.
While interpreting the result of empirical tests, I concluded that the Broken Arrow method is more convincing and reliable method than Zeroed-Out method. In addition, Predicted Stress Loss(PSL) by Broken Arrow method shows more similar results to Actual Stress Loss(ASL) comparing with Narrow Stress Loss (NSL) of Zeroed-Out method especially in hectic or abnormal market conditions.
By the way, PSL by Broken Arrow method shows much more accurate estimation when ASL increased drastically, and I suggest this method be the most suitable Stress Tests method especially in hectic days.
