Making Scenario Analysis &
Stress Tests Work
In this article, we explore the art and science of structuring stress testing programmes for energy
andcommodityderivativesportfolios.Thetwomainareascoveredarethedesignofstressscenarios
aswellastheprocessthatneedstobeinplacetoensurethatthefirmactsontheinformationfrom
thosescenarios.Wewillfocusonoilpricescenarios,butthegeneraldiscussionappliestoanyother
energyorcommoditymarket.
By Carlos Blanco
ONE OF THE MOST important tasks of
risk managers, at firms whose earnings
Figure 1: WTICrude Oil Prompt Month Price, US$/bbl
are dependent on the evolution of ener-
gy and commodity prices, is to design
and evaluate the potential losses that
the firm could experience under stress
scenarios reflecting ‘plausible and real-
istic’ possible states of the world.
Designing realistic and plausible
stress tests is not an easy task, and risk
managers must be able to analyse and
interpret changing market conditions
and define a limited set of scenarios
that reflect possible extreme market
moves as well as breakdowns in market
relationships.
Source: NQuantXLLC,NYMEX
It is important for the team in the beginning of 2008. For portfolios that contain instruments
charge of designing stress scenarios whose value is dependent on volatility, it is important to stress
to build credibility throughout the volatility surfaces as part of the scenario.
firm, and avoid being seen as any of
the articulate oil market ‘charlatans’ Extreme Event Risk Management
The ultimate goal of risk management is to ensure that the firm can
It is important for the team in charge of
survive extreme events. However, traditional risk management focus-
designing stress scenarios to build
es too much on day to day tactical issues and does not spend enough
credibility throughout the firm
time and resources in designing and preparing contingency plans
against extreme scenarios that could wipe out the firm’s capital or
that appear on CNBC, Bloomberg or result in large financial, as well as reputational, losses.
any other news channel across the In his 2007 annual letter to shareholders, Warren Buffet wrote,
world ‘explaining’ why oil is going to
trade at much higher (or lower) levels
Figure 2: WTI Crude Oil Implied Volatility, US$
in the future with a high degree of
confidence (and very few defensible
arguments to justify their claims).
For example, around mid-July, most
analysts were predicting that oil was
going to US$200/barrel while just a
few days later, many of those same
analysts were claiming that oil was
coming down towards the
US$75/barrel level.
Oil price volatility has also increased
considerably in recent months. Figure
2 shows the evolution of the term
structure of implied volatilities since
Source: NQuantXLLC,NYMEX
10 SEPTEMBER 2008 COMMODITIES NOW
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