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A)	Stress testing complements value at risk (VAR).

B)	It enables the risk manager to eliminate all risk from a portfolio.

C)	It can highlight weaknesses in contingency planning and assumptions.

D)	It can be used for capital allocation across business units.

Stress testing cannot be used to eliminate all risk from a position. It only highlights the extent of losses in different states and enables contingency planning, which is one of its benefits.

A)	Stress analysis has several advantages over a value at risk (VAR) only approach that includes: highlighting inappropriate assumptions, hidden vulnerabilities, and the ability to be able to forecast probability of rare but damaging events.

B)	Stress analysis can be used to enhance VAR analysis by focusing on the extent of loss in an extreme event.

C)	Scenario analysis, which is a special case of stress analysis, suffers from limitations on implementing a consistent and manageable approach.

D)	Scenario analysis can be used to model one-off hypothetical events but not actual events since their probability of occurrence is very miniscule and, as they have already occurred, they are not likely to recur.

This is the only valid use of stress analysis among the statements listed. Other statements either do not pertain to uses, even if true in some other context, or are not true.

Paula Flox, global risk manager for Green Asset Management, wants to implement a stress testing program. She asks Richard Volk, a junior analyst, to prepare a report on stress testing. When she receives the completed report, Flox is extremely unhappy because it includes only one true conclusion. Which of Volks conclusions regarding stress testing is TRUE? Stress analysis:

A)	can incorporate delta risks, but fails to account for gamma risks.

B)	is weak when it comes to highlighting effects of inappropriate assumptions.

C)	can only be used with value at risk (VAR) estimates based on normal distributions.

D)	is not useful for determining the probability of an expected loss.

Stress analysis is useful for determining the magnitude, but not necessarily the probability, of an expected loss. This is why stress testing is such a good compliment for VAR, which determines the probability for a loss, but not the magnitude. The other statements are incorrectstress testing incorporates both delta and gamma risks, it is a good way to highlight inappropriate assumptions, and it can be used with any VAR estimate.

Which of the following is NOT a damaging consequence of not conducting proper stress analysis?

A)	Risk of exposure to potential big hits to a portfolio due to second order (gamma) effects of large market moves.

B)	Exposure to risk of being taken over.

C)	Inability to proactively alter assumptions about correlation structures.

D)	Exposure to situations which could wreak havoc on a portfolio in the absence of advance contingency planning.

Stress analysis makes the risk manager become aware of the consequences of market moves, liquidity crises, and other factors that affect the business of a firm. As a result, the manager can be prepared with proper hedges and advance contingency planning to combat adverse situations. The analysis also highlights the extent of the potential loss so that the manager can decide the extent of exposure to such risk. Risk of being taken over as a target is usually not a concern of this analysis.