Stress testing subjects a portfolio or a set of market positions through the strains of various situations to see how they perform under these extreme situations. This can start with the simple “what-if ” analysis, by changing a few variables in a model. Stress testing is designed to diagnose exposures to extreme market volatility that are missed by VaR analysis. VaR is not designed to capture extreme market events. Stress testing must be done with an investigative view.
Once a risky situation has been identified, financial executives can decide to manage an unhealthy exposure through various choices:
Simply unwinding the position.
Pricing it differently.
Buying protective instrument.
Preparing a liquidity or funding backstop.
Restructuring the business.
An uncritical view on risk that is not sufficiently calibrated can end up overallocating capital, increasing company operating costs and reducing RAROC. Inadequate stress testing can leave a company undercapitalised until a huge disaster strikes. Thus, it has to devise risk mitigation devices, which include contingency capital as the ultimate line of defence.

Tags: market, stress