Volume 3 — Valuation and Risk Metrics © Copyright 2002, CCRO. All rights reserved. 30 West due to a combination of below-normal weather/temperature years, above-normal precipitation/hydro reserves, and above-normal natural gas prices for the next three years. This case for the stress test is an unusual combination that may have never occurred in the recent past (or is very unlikely to occur given the current state of the world) or has occurred but only very rarely. By evaluating the economics under a persistent set of conditions, we are in effect conducting a stress test of the dynamics of the generation asset’s economic value and its sensitivity to such extreme conditions. The following are attributes of good tests: • Stressful enough • Plausible • Key assumptions, drivers, and vulnerabilities to the portfolio and earnings identified • Risks (and results) transparent • Not compartmentalized (i.e., universal) with linkages among markets identified • Updated systematically and refreshed periodically • Appropriate for the portfolio and its risks. Below, we give a short description of one specific type of stress testing that can be performed on a given portfolio of positions or existing/projected level of activity. This type of stress test is a single-event risk test. Single-Event Risk Test Stress testing is a simulation that evaluates a portfolio’s performance under defined exceptional circumstance and quantifies the financial impact. Single-event risk is a measure of the greatest market event from the past two years (e.g., volume change, price, correlation) applied to the current portfolio. The calculation can be accomplished in either of two ways but is most applicable to trading activity. (For the purposes of this document, the calculation takes into consideration only market risk.) • Method 1 ― The user calculates a one-day VaR using historical prices from the past two years (rolling). The worst day in the two-year data set is selected and the current portfolio of positions is valued against it. • Method 2 ― The user calculate a three- or five-sigma move (i.e., a number of standard deviations based on market prices) on the current portfolio of positions.4 2.0 Applicability Sensitivity analysis, scenario analysis, and stress testing are useful to evaluate all aspects of the business (i.e., long term, short term, assets, trading, and structured transactions) under all market factors. The various portfolio components can be evaluated individually or collectively to assess the potential impact of market changes. 4 One needs to be cautious in this exercise if many prices are involved. A three– to five-sigma move for each price may lead to a very unlikely overall set of prices impacting the MTM.