Which historical stress scenarios should a trading book use and how are they calibrated?

Question

AcadiFi · Accepted Answer

Historical stress scenarios anchor on real market events because they capture realistic co-movements and tail dynamics that hypothetical scenarios struggle to replicate. The common library includes: October 1987 equity crash (S&P down 22% in one day), 1994 bond market sell-off (Fed hikes 250bp), 1998 LTCM/Russia crisis (credit blowout, flight to quality), 2001 dot-com and 9/11, 2008 Global Financial Crisis (Lehman week and peak stress period), 2011 European sovereign crisis, 2015 CNY devaluation, March 2020 COVID (risk parity unwind and Treasury dislocation), and 2022 gilt/LDI crisis.

Selection criteria: coverage of each major asset class, non-redundancy (pick scenarios that stress different factor combinations), recency bias but without losing structural events, and relevance to the current portfolio. Calibration typically uses a rolling window around the event peak (e.g., 10-day or 20-day shocks during Lehman week of Sept 15-26, 2008) with shocks defined as absolute differences for rates and credit spreads and relative (log returns) for equities and FX.

For a trading desk long emerging market credit, the 1998 Russia default and 2015 CNY scenarios are likely to bind. For a rates desk, 1994 and 2022 gilt LDI are critical. The Basel FRTB standardized approach uses a regulator-specified stressed period for the risk factor eligibility test.

Key FRM exam point: historical scenarios understate forward-looking risks if the portfolio has material exposure to factors that did not exist historically (e.g., crypto, SOFR basis) — these require hypothetical scenarios.

Which historical stress scenarios should a trading book use and how are they calibrated?

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