Stress testing, don’t bank on itJuly 14, 2015 - 10:38
The FCA's Thematic Review laid out the regulator's expectations for stress testing and modelling for anyone developing structured products. It makes clear that products should be stress tested in a 'real world' model.
Since the publication of the FCA paper we have seen a variety of stress test results from UK product providers but it has not been easy to identify the approach that has generated these results. One observation we do have is that many of the stress tests are obviously based on the pricing model of the issuer. We argue that using a pricing model to generate stress test results is both not what the FCA wants to see and gives an inaccurate view about how a product performs in real world scenarios.
WHAT DOES THE FCA WANT?
The Thematic Review describes in detail what the FCA expects in relation to product testing. The main points are summarised below:
- Stress tests should be forward looking and backward-looking
- They should test a product over the proposed term
- They should be used for new issues and subsequent tranches
- Firms need to undertake simulations to understand the expected profitability from the investors' perspective
- Analysis should be based on publicly available data
- Any assumptions should be reasonable
- There should be thresholds on the probability of stressed outcomes that are likely to be acceptable
- When firms outsource stress testing
- They must do DD to make sure that the methodology is robust
- That there is enough information on assumptions and outcomes
WHAT DID THE FCA FIND?
The Thematic Review applies to all product providers, says the FCA, which includes portfolio managers, but the regulator conducted its field research on retail product providers. Among this group it found most providers did some modelling. It had some obvious concerns with the limitations of relying on back testing. When it came to stress/forward testing the FCA expressed some material concerns:
- The modelling approach did not reflect the statistical properties of prices observed in the real world
- Some assumed growth rates were unrealistic
- Simulations may not reflect potential market scenarios
- External modelling was being used by some providers post launch rather than pre-launch
- Providers had not done any DD on external specialists
- The FCA reminded providers that they were responsible for modelling whether they do it in-house or commission it from a 3rd party
Professional managers that use structured products have the same obligations as retail providers.
WHY IS THE ISSUER PRICING MODEL WRONG?
Among the various approaches to stress testing we have observed in the retail market many clearly have their origins in the pricing models used by the traders that issue structured products. Providers and issuers have been quick to use pricing models to generate the implied chances of various events happening. This has to be a sensible approach since this is the basis on which the product has been priced, right? Well, no, in our opinion using the pricing model is completely wrong, and wrong for a number of reasons. Key problems include:
- The inputs to the model are not an estimate of how the underlying assets will perform
- Specifically the forward is not an estimate of the future level of the underlying. Using the pricing model is a bit like saying that the forward price is an estimate of where the index will be in six years time. The forward price is a level at which traders can buy and sell the index, but it is not an estimate of the future level
- The expected return is zero. The expected return from the pricing model for a product will always be equal to rates + funding – costs. So the output of the model will mean that the expected return based on the probabilities of the pricing model will be close to zero. If this is indeed the model that issuers and providers feel best reflects the profitability of the product from the investors perspective, then they would struggle to justify the issue
When traders start to try to use their risk-free model to generate real world scenarios by adjusting the forward, this tends to ask more question that it answers. We don’t need to look far to see that stress testing using a pricing model is the wrong approach. At an institutional level both insurance companies, pension schemes are required to do stress testing, and they rely on actuarial models. When retail investors receive their pension statements benefits are calculated on the basis of deterministic growth rates set by the FCA
It is no surprise to us therefore that when structured product providers use pricing-based models to generate the chance of kickout events occuring or chances of losing money that they tend not to show the two numbers that investors care about:
- The overall expected return
- The volatility of annualised returns
The plethora of stress testing processes and models from different providers and issuers makes side-by-side comparison of one product with another, or of one product with the 'next best alternative' almost impossible. Unless products are tested using the same process any comparative analysis is impossible.
CUBE STRESS TESTING
Through our association with Investment Product Research we are able to offer the sort of analysis that we think that the FCA is looking for and which best presents the risks and returns of a product, allowing comparisons with other structured products as well as other asset types.
- The inputs are based on the pattern of returns that we have seen from the underlying assets
- The assumptions are clear and reasonable
- The model is clear and transparent
- The outputs enable easy side by side comparison of one product with another and with the benchmark assets
Direct access to IPR offers additional functionality:
- Unlimited pre-trade stress testing
- Download data to incorporate in marketing material
David has been involved in equity derivatives, equity structuring and the structured product market for over 25 years. Before setting up CUBE in 2013 David worked at J.P. Morgan, Barclays and RBS. David has worked with and for retail product providers, discretionary managers and institutional investors.