Portfolio Value-at-Risk Stress Testing and Back Testing

Considerations for SEC Rule 18f-4 Reporting

2 primary components of the 18f-4 Derivatives VaR requirements are Stress Testing and Back Testing. Stress testing allows a fund to evaluate potential losses to the fund’s portfolio, and back testing is designed to monitor the effectiveness of a fund’s VaR model.

Historical Worst, Volatility Shocks, Curve Shifts

Stress Test
Performing a stress test on the fund daily evaluates potential losses in response to extreme but plausible market changes or changes in market risk factors that would have a significant adverse effect on the fund’s portfolio. Depending on the fund’s strategy, stress tests must be conducted no less frequently than weekly but daily would be most appropriate. This is to take into account correlations of market risk factors and resulting payments to derivatives counter-parties.

A principles-based approach is taken for stress testing as it allows funds to tailor their simulations to a fund’s particular risk factors. The specific factors to consider in a particular stress test may vary from fund to fund and will require judgment by fund risk professionals in designing stress tests with the goal of highlighting the nonlinear risk of derivatives. These factors include but are not limited to:

• revaluation using increased correlations from historical periods of extreme market stress
• volatility shocks
• both parallel/non-parallel shifts to yield curves

The rule’s principles-based approach will provide flexibility to enable those professionals to exercise their judgment in designing and implementing the stress tests.

VaR limits and stress tests are complementary and important tools to help funds manage their derivatives risk. By stress testing portfolios, funds may be able to gather information regarding “tail risks” that VaR and other analyses may miss. This allows funds to tailor the hypothetical scenario to the needs of a particular fund. While VaR, in contrast, is based on historical data.

Back Testing
On a weekly basis, a fund will backtest the results of the VaR calculation model used for the relative VaR or absolute VaR test, as applicable. Comparing its actual gain or loss for each business day with the VaR the fund had calculated for that day, and identify any instance in which the fund experiences a loss exceeding VaR calculation’s estimated loss.

Back testing will assist a fund in confirming the appropriateness of its model and related assumptions and help identify when a fund should consider model adjustments. This is an important tool for funds to use in validating and adjusting a fund’s VaR model. The risk manager may also incorporate additional elements they find important to assess whether the fund’s Var model should be adjusted.

Conclusion
The risk manager is required to run, weekly or more frequently, stress tests of derivative risks to evaluate potential losses to a fund’s portfolio under stressed conditions. In addition, they will have to provide for backtesting of the VaR calculation model that the fund uses, and report the number of exceptions it identified during the reporting period arising from backtesting.

For record-keeping provisions, the rule also requires a fund to maintain a written record of the results of any stress testing of its portfolio, the results of any VaR test backtesting it conducts, any internal reporting or escalation of material risks under the program, and any periodic reviews of the program.