Stress Scenario

Definition

Stress Scenario, in the context of Market Risk, Credit Risk or Climate-Related Risk management, is a collection of assumptions about potential future economic conditions that are not the expected outcome over an assessment horizon but do have a meaningful (material) probability to incur and would tend to induce high market, credit or insurance losses if they did occur

Stress Scenarios are a key element of Stress Testing and are subsets of more general scenarios used in Scenario Analysis

Narrative Scenarios

This type of stress scenario is typically expressed as a narrative, a verbal description of a (shorter or longer) sequence of events.

• This narrative is not, in general, a complete description of future states of the world
• The probability of a stress scenario is in general not specified and it may be exceedingly difficult to quantify objectively
• The impact of a stress scenario is also in general not specified. It will in general be highly depended on the entity under consideration

Simulated Scenarios

In various quantitative risk management contexts stress scenarios are generated programmatically using an Economic Scenario Generator. Such scenarios

• Form a complete description of future states of the world (in a probabilistic sense - they may be exceeding simplified versions)
• Are typically estimated using quantitative (historical) data and may ignore any substantial regime shifts

Structure

A scenario narrative will typically involve:

• Potentially one or more Actors (agents deciding independently). For some scenarios the "actors" may be the aggregate behaviors of individuals in an economy
• Always at least one directional change in a key metric or observable that is either subject to policy decision or is an aggregate of financial / economic conditions
• Always at least one or more Jurisdictions (economic regions under similar legal, political conditions)
• Always at least one or more Financial Markets (those will typically express / bear the ultimate impact of the scenario)
• Potentially connections, correlations, contagion, knock-on effects between Actors, Jurisdictions and Financial Markets

See Also

• 2019 Risk Scenarios
• 2020 Risk Scenarios

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