Stress Tests, Market Risk Measures and Extremes: Bringing Stress Tests to the Forefront of Market Risk Management

José R Aragonés, Carlos Blanco and Kevin Dowd

The field of market risk measurement and management has experienced dramatic advances in the past decade or so. From being unknown in 1990, the concept of the value-at-risk (VaR) shot to prominence over the following five years and has dominated financial risk management ever since. Value-at-risk was widely hailed as the solution to modern risk management problems, and as a key part of the defence against the risk management disasters that recurred throughout the 1990s. Since then, practices of VaR-based financial risk management have spread and become ever more sophisticated.

And yet, financial risk management disasters still recur and the past two years (2007 and 2008) have witnessed a spate of such disasters on both unprecedented frequency and an unprecedented scale. The roll call of “victims”, or, more correctly, of financial institutions that suffered huge losses as a result of their own incompetence, includes many of the alleged leaders in the business, including such hitherto esteemed institutions as Lehman Brothers, AIG, Bear Stearns, UBS, RBS, Morgan Stanley, Merrill Lynch, Citigroup and Société Générale. There can, therefore, be no denying that financial institutions are

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