Stressing Over Stress: Why Firms Need Granular Testing to Understand Market Risks

In today's rapidly changing and volatile energy and commodity markets, trading firms and commodity brokers must constantly assess the ongoing impacts to their business. Black swan events such as pandemics, wars and regional banking crises seem to be happening more frequently. The portfolio margin system, while designed to protect against defaults, is not enough in some cases to prevent firms from going out of business.

Notable recent market events have highlighted the shortcomings of backward-looking portfolio margin models in managing risk. As such, best practice for energy traders and commodity brokers is to have robust stress testing capabilities to supplement the portfolio margin framework and optimize risk vs return for their businesses.

One such example of the shortfalls in portfolio margining is the nickel short squeeze in March 2023 when nickel prices on the London Metal Exchange’s (LME) surged 250% in intraday trading amid supply chain concerns triggered by the Russia/Ukraine conflict and highly concentrated short positions. The LME suspended nickel trading on March 8 for eight days, leaving firms unable to manage their nickel exposure. Another example is negative WTI oil prices in April 2020 that were seen in response to a collapse in oil demand due to the Covid-19 pandemic.

Portfolio margin models do not predict these extreme market movements, so how can stress testing help risk managers ensure their businesses are protected from these more extreme events?

There are three key aspects to a comprehensive stress testing framework that can enable risk managers to navigate extreme market events successfully:

Pre-emptive stress testing.

A robust risk management system should support a wide range of “always-on” stress scenarios that run intraday across all positions. Risk managers need the ability to specify different types of stress scenarios that can identify portfolio vulnerabilities to extreme market movements drawn. Key stress testing features can include:

• Multifactor grid shocks (e.g., shocking price and implied volatility)
• Combinations of different shift types (e.g., relative, absolute, standard deviation)
• Hand-picked hypothetical scenarios (e.g., curve changes, backwardation)
• Regional and industry specific shocks (e.g., stressing assets in a specific industry or region differently to other assets)
• Historical stress events (e.g., the nickel crisis)

In addition to monitoring stressed P&L, risk managers should monitor stressed Greeks to ensure hedged portfolios perform as expected in response to extreme price movements.

Real-time stress testing.

The ability to stress test in real time using live market prices, as well as evaluating positions against predetermined risk limits, enables risk managers to make informed decisions with clarity during a market crisis. Standard deviation shocks are a very powerful tool during a market crisis as they help ensure stress scenarios remain accurate during periods of extreme volatility. Another key consideration is being able to add new stress scenarios quickly and easily during a market crisis. This enables risk managers to model different market crisis outcomes based on the latest real-time data and help protect the company from unsustainable losses.

Pre-defined stress threshold limits that are automatically monitored in real time are also a useful supplement during a market crisis. Risk managers received automated notifications when predetermined stress P&L or stressed Greek risk thresholds are breached so immediate action can be taken.           

Post-crisis stress testing.

A robust stress testing framework should evolve over time in response to market crises. Recent market stresses should be added to the historical stress test suite. Stress scenarios should either be adjusted or supplemented to model new market behavior. Stress P&L and stressed Greek limit thresholds should be recalibrated post market crisis. Risk managers require a flexible stress testing framework that can continue to evolve in response to market changes and geopolitical changes.

Finding the right risk tools

The Nasdaq Risk Platform provides energy traders and commodities brokers with comprehensive and highly configurable stress testing functionality so they can be well-prepared when the next market crisis unfolds.

The system’s horizontal scalability delivers real-time and accurate risk results when they are most needed in a market crisis. This enables risk managers to make timely risk mitigation decisions to minimize losses during a black swan event.

A robust stress testing framework is a must for today’s traders and brokers to maintain agility and responsiveness amid quick-moving markets and crises. Visit here to learn more about how Nasdaq Risk Platform can help your firm gain visibility and insights or contact us to request a demo.