A basic overview and discussion of interest rate risk stress-testing.
Following last year’s IRR Advisory from the regulators (indeed ever since the original Joint Policy Statement in 1996) industry experts, auditors, accountants, analysts, and regulators have been throwing around IRR stress-test terminology like everyone knows exactly what they are talking about. The word cloud to the right shows just a few of these often used, but often misunderstood terms.
Over the next several weeks I’m going to attempt to explain (in plain English I hope!) what some of these frequently used terms mean. Here’s my partial list of things I’m going to cover (in no particular order). As I get a post written I’ll hot link the text below. If you can think of anything to add I’d welcome your ideas. Please leave a comment.
- What are the basic types of IRR stress-tests?
- What is meant by a shock versus a ramp? Parallel shift versus non-parallel shifts?
- How does an earnings simulation differ from an equity value simulation? (and a follow-up post here)
- What’s the difference between a static versus a dynamic forecast?
- What is meant by steeper, flatter, or a twist?
- How good are the “experts” at predicting changes in rates?
- Where did the standard +/-200bp shock come from?
- Measuring earnings versus present value – why shock versus ramp matters.
- How many stress-test scenarios should you run?
- How much should you change rates?
- What are the problems with running a Steeper/Flatter test?
- How does the unique rate environment of today impact the stress-tests?
- What time frame is best for an earnings simulation stress-test?
- What are forward (or future) shocks?
(Please be patient. I’m writing as fast as I can…)