Scenario Analysis vs Stress Test vs VAR

Let's discuss: run a stress test, a scenario analysis, or a VAR for your risk management presentation next week?

The quick answer is, of course, that it depends on the message you want to convey to your audience — but I don't want to disappoint you with such a generic and safe answer.

Here you go, my friend:

• Do a scenario analysis with 10%, 25%, and 50% moves in both directions. You want to show the upside and downside of potential market moves without alarming anyone.
• The 10% move is the comfort zone within which your company should be operating normally without paying much attention to the market, unless you are too leveraged. If the company cannot operate in a 10% volatility environment, it has to put out some immediate fires elsewhere — hedging will not get it across the line.
• The 20% move is why you have a hedging program. 20% is on the low end of the annual volatility experienced in most commodities and the high end in most FX markets. 20% moves happen every 6 to 12 months in the S&P 500, when the index is experiencing a correction worth of attention by the news media but not yet deep enough to call for a change in long-term trend. You want to manage for a 20% move because you want to avoid making a catastrophic mistake by reacting to a move that can quickly fade and normalize, leaving you with significant mark-to-market against you. By hedging 20% risk, you are hedging market risk — and you are hedging yourself, your team, and everyone else around you.
• Present the 50% scenario because you want to prepare the institution for an event that can happen every 2–3 years in commodities, every 5–7 years in financial markets, or every 10 years in FX. It is a tail risk you will certainly have to survive, and it belongs in your 5-year plan. The 50% scenario is a way to imprint the image in stakeholders' minds — and this may require constant repetition.
• Don't forget to always include the upside and downside. Include the upside because the institution has to learn to receive the blessings as well — that is why they got in the business in the first place. It will help you build a sound hedging portfolio that includes options. Yes, options require payment of a premium, but they set you up to participate in beneficial moves while capping the moves that hurt. That is why we build portfolios and use a little bit of everything.

• Do a stress test scenario based on events going back 3–10 years. Include recent events and ancient events — encompassing the owner's life in the markets. You don't know which experience stuck with them and keeps them awake at night.
• The 2-way scenario analysis will not be effective. It will be met with skepticism because they are most likely opinionated about the market's direction and will second-guess the ranges you have chosen. You will spend the entire meeting trying to explain why you chose those ranges.
• It is better to come into this meeting with real-life scenarios and be prepared to run a bunch of others at their request.
• Therefore, save your file. Do not hard-code values. Link everything and make it very dynamic. You will need your model a lot. Better yet, do not make a PowerPoint presentation — go into the meeting with your tweakable model and get ready for the rapid fire.

• Just use VAR. They get it. VAR is just a number — a common denominator used to gauge the size of your company within the market. Do not overthink VAR; do it mechanically. It is worthless for risk management but it is everything to get those valuable credit lines.

Now, I'll tell you a secret. The tool that calculates scenarios, stress tests, and VAR is exactly the same one. There is no need to create one tool for each. The trick is in the starting point, the percent move used, and the wording around it.

Reach out if you have questions about setting up your model.