VAR, Value at Risk, and Stress Test

VAR (Variance, Value at Risk, Vector Autoregressive)

• Variance: A measure of a portfolio's variability.

• Value at Risk (VAR):

  • A measure to quantify investment/portfolio risk, expressed in dollars for a given probability and time horizon.

  • Emergence: Gained prominence after the 1987 stock market crash.

  • Example: A 1% one-year VAR of $10,000,000 means there's a 1% chance the portfolio will lose $10,000,000 in one year.

• Vector Autoregressive: Not discussed further due to potential confusion.

Stress Tests

• Origin: Borrowed from medical terminology where a doctor tests a patient's heart under physical stress (e.g., treadmill test).

• Application in Finance:

  • A method to assess risks to firms or portfolios beyond historical returns.

  • Focuses on vulnerabilities to various financial crises.

  • Emphasizes that extreme events (crises) are the primary stressors for firms, not just normal market variations.

  • Office of Federal Housing Enterprise Oversight (OFHEO) conducted stress tests on Fannie Mae and Freddie Mac before the 2008 crisis, but these tests proved ineffective.

Dodd-Frank Act (2010)

• Requires the Federal Reserve to conduct annual stress tests for non-bank financial institutions (already doing them for banks).

• Mandates at least three different economic scenarios in stress tests.

• The Fed gathers data from firms about their interconnectedness, assets, and safety.

• Example Scenarios:

  • Severe recession

  • Dollar depreciation or appreciation

  • Short-term liquidity crisis

• Dodd Frank Wall Street Reform and Consumer Protection Act

  • Passage into law: July 21, 2010, in response to the 2007-2008 financial crisis.

  • Significance: Most significant changes to U.S. financial regulation since the regulatory reforms following the Great Depression.

• The Dodd-Frank Act does not specify the scenarios but mandates at least three.

• Scenario analysis is considered more institutional and less emphasized in the course.

Global Adoption of Stress Tests

• The European Banking Authority (EBA) was created in 2011 post-financial crisis and conducts regular stress tests for European banks.

• The United Kingdom, China, and other countries also implement stress tests.

Skepticism and Critique of Stress Tests

• Growing skepticism about the effectiveness of stress tests in predicting outcomes during future crises.

• Anat Admati's View: A professor at Stanford, argues that stress tests are often flawed because those creating the tests lack the imagination to fully understand the dynamics of a financial panic.

• Freddie Mac Example (circa 2005):

  • Chief economist boasted about stress tests.

  • Considered a maximum 13% drop in home prices.

  • Dismissed the possibility of a larger drop, citing the absence of such events since the Great Depression.

  • Reality: Home prices fell 30% shortly thereafter, leading to the failure of Fannie Mae and Freddie Mac.

• OFHEO reports at the time hinted at some concerns but generally downplayed the risks.

• OFHEO was subsequently shut down.

Challenges and Incentives Related to Stress Tests

• Internal vs. Public Stress Tests:

  • Firms might conduct internal stress tests, but are hesitant to publicize negative results.

  • Releasing negative information could damage the firm’s reputation and deter other companies from doing business with them.

• Incentives to Whitewash Results:

  • Firms have an incentive to present favorable results when the government mandates stress test disclosures.

• Regulators' Role:

  • The challenge lies in regulators' ability and willingness to demand accurate information.

• Dodd-Frank Act and Subpoena Power:

  • The Dodd-Frank Act granted the Office of Financial Research subpoena power to demand information from firms.

  • However, obtaining accurate information remains a battle due to firms' reluctance.

Summary

VAR stands for Variance, Value at Risk, and Vector Autoregressive. Variance measures a portfolio's variability. Value at Risk (VAR) quantifies investment/portfolio risk in dollars for a given probability and time horizon, gaining prominence after the 1987 stock market crash. For example, a 1% one-year VAR of 10,000,000 means there's a 1% chance the portfolio will lose 10,000,000 in one year. Vector Autoregressive is not discussed further.

Stress tests, borrowed from medical terminology, assess risks to firms or portfolios beyond historical returns. They focus on vulnerabilities to various financial crises, emphasizing that extreme events are the primary stressors. The Office of Federal Housing Enterprise Oversight (OFHEO) conducted stress tests on Fannie Mae and Freddie Mac before the 2008 crisis, but these proved ineffective.

The Dodd-Frank Act (2010) requires the Federal Reserve to conduct annual stress tests for non-bank financial institutions and mandates at least three different economic scenarios. The Fed gathers data from firms about their interconnectedness, assets, and safety, including severe recession, dollar depreciation or appreciation, and short-term liquidity crises. The Dodd Frank Wall Street Reform and Consumer Protection Act, passed on July 21, 2010, in response to the 2007-2008 financial crisis, brought the most significant changes to U.S. financial regulation since the Great Depression. The Act does not specify the scenarios but mandates at least three. Scenario analysis is considered more institutional and less emphasized in the course.

The European Banking Authority (EBA) was created in 2011 post-financial crisis and conducts regular stress tests for European banks. The United Kingdom, China, and other countries also implement stress tests.

There is growing skepticism about the effectiveness of stress tests in predicting outcomes during future crises. Anat Admati, a professor at Stanford, argues that stress tests are often flawed because those creating the tests lack the imagination to fully understand the dynamics of a financial panic. For example, Freddie Mac's chief economist boasted about stress tests circa 2005, considering a maximum 13% drop in home prices and dismissing the possibility of a larger drop. Reality saw home prices fall 30% shortly thereafter, leading to the failure of Fannie Mae and Freddie Mac. OFHEO reports at the time hinted at some concerns but generally downplayed the risks, and OFHEO was subsequently shut down.

Firms might conduct internal stress tests but are hesitant to publicize negative results, as it could damage their reputation. Firms have an incentive to present favorable results when the government mandates stress test disclosures. The challenge lies in regulators' ability and willingness to demand accurate information. The Dodd-Frank Act granted the Office of Financial Research subpoena power to demand information from firms. However, obtaining accurate information remains a battle due to firms' reluctance.