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Stress testing / Liquidity and funding risk [6]

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Bullet points include: Perhaps particularly useful for portfolios which are less diversified or non-linear or where underlying risks are highly skewed Perhaps more important in bond-land or in currency-land than in equity-land E.g. bond / CDS return distributions highly skewed if issuer defaults, pegged currency values can jump dramatically if peg comes unstuck For well diversified portfolios central limit theorem hopefully (approximately) applies, smoothing out fat tails Potentially more ‘subjective’ than VaR and more time consuming E.g. how do you decide which scenarios/stresses to test and how extreme should they be? You might rely on extremes observed in the past, but will they fairly reflect the future?

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