Implementation and Uses of Economic Capital ... - ERM Symposium

The rationale behind using a stress testing based approach
A ‘Pure’ Stochastic Simulation approach would require stochastic-on-stochastic projections to
estimate market values at future points of time across all real-world scenarios in order to construct
a distribution of change in economic value. This is computationally “extremely” intense, possibly
impractical in certain environments.
‘Secondary risk neutral scenarios’: Used to
define market value at each point of time in
the future.
t = 1
t = 2
. . .
t = 3
‘Primary real-world scenarios’: Used to produce a
range/distribution of “change in economic value” that
is then used to identify the desired level of stress.
Some Alternatives pursued by others:
-“Brute force”: Run the embedded projection at each future time force. Impractical in some modeling environments.
- Replicating portfolio to map assets & liabilities to a small set of standard financial instruments, thereby reducing the
time required to generate market value projections in the future.
- Mathematical techniques for estimation of future values (e.g. pre-generated 1000’s of “like” scenarios, matrices).
Stress Testing Approach: Apply a pre-determined level of real world stress, based on desired
confidence level, to the normal (base) condition market value balance sheet to determine the change
in value over the desired time horizon (one year). This approach is robust and it elegantly addresses
the implementation difficulties of the pure stochastic simulation approach.