Finance Stress Testing

Stress testing helps a firm plan for dire economic scenarios.

A company's leadership puts into place effective risk management techniques to prevent operating losses resulting from adverse regulatory initiatives and economic developments. Finance stress testing is a method used by companies to anticipate worst case scenarios.

Definition

Finance stress testing is a simulation technique that allows department heads to assess the impact of specific conditions on corporate assets and liabilities. Stress testing is otherwise known as scenario analysis. For example, a bank may perform a stress test on its loan portfolio to gauge default levels if domestic unemployment rates rise from 7 percent to 12 percent.

Importance

Financial stress testing is a central component of a company's risk management strategy. Risk is the loss probability arising from unfavorable external developments, such as business partner defaults and security price fluctuations in financial markets. Stress testing helps a company evaluate market risk and credit risk implicit in corporate activities.

Application

Although all organizations may use finance stress testing in business decision-making processes, testing procedures are more frequent in the financial industry. Banks, insurance companies, hedge funds and private equity funds use stress testing to manage assets and monitor financial market developments.

References

• Investopedia: Stress Testing
• Investopedia: Scenario Analysis