It is a process where model based VaR is compared with Actual performance. It tells us whether results fall within pre-specified confidence bonds as predicted by VaR models.
It seeks to determine possible change in Market Value of portfolio that could arise due to non-normal movement in one or more market parameters (such as interest rate, liquidity, inflation, Exchange rate and Stock price etc.).
Four test are applied:
1. Simple sensitivity test;
If Risk factor is exchange rate, shocks may be exchange rate +2%, 4%,6% etc.
2. Scenario test
It is leading stress testing technique. The scenario analysis specifies the shocks if possible events occur. It assesses potential consequences for a firm of an extreme. It is based on historical event or hypothetical event.
3. Maximum loss
The approach assesses the risks of portfolio by identifying most potential combination of moves of market risks
4. Extreme value theory
The theory is based on behavior of tails (i.e. very high and very low potential values) of probable distributions.