The Stress VaR

In this paper we introduce a novel approach to risk estimation based on nonlinear factor models – the “StressVaR” (SVaR). Developed to evaluate the risk of hedge funds, the SVaR appears to be applicable to a wide range of investments. The computation of the StressVaR is a 3 step procedure whose main components we describe in relative detail. Its principle is to use the fairly short and sparse history of the hedge fund returns to identify relevant risk factors among a very broad set of possible risk sources. This risk prole is obtained by calibrating a polymodel, which is a collection of nonlinear single-factor models, as opposed to a single multi-factor model. We then use the risk profile and the very long and rich history of the factors to asses the possible impact of known past crises on the funds, unveiling their hidden risks and so called ”black swans” (Taleb [2007]).

In backtests using data of 1060 hedge funds we demonstrate that the SVaR has better or comparable properties than several common VaR measures – shows less VaR exceptions and, perhaps even more importantly, in case of an exception, by smaller amounts.