The concept of the Worst Case Finder was developed by the Austrian national bank to determine risks of financial instruments in banks and mutual funds via stress testing (“Leitfadenreihe zum Marktrisiko” – volume 5, “Durchführung von Krisentests”, OeNB, see PDF)
Thanks to the integrated multi-processing function even large and complex portfolios can be computed by conventional server systems within minutes.
Dynamic stress testing
In addition to the Value at risk (VaR) — which can only be applied at regular market conditions— governmental legislation demands the implementation of a suitable stress testing system.
Basic systems only assume fixed stress scenarios, e.g. interest rate increases, market breakdowns or currency fluctuations, which are not suitable for many portfolios; also portfolios undergo constant change in terms of risk factors. This is why the Worst Case Finder lets you pre-define a set of plausible scenarios and determines the risk based on the systemic lowest portfolio value within these settings.
The WCF will not only identify the worst case but also the major risk factor responsible for the potential loss, so the information can be used to create hedging positions minimising damages.
The Mahalanobis distance is a measure of the distance between points in multi-dimensional vector space where points of identical Mahalanobis-distance will form an ellipse (see diagram; the number of dimensions in vector space is determined by the number of risk factors).
The worst case can be found outside the VaR loss, excluding highly unlikely scenarios. The shape of the ellipse is subject to the correlation of these various parameters.