With that change, the correlations between those currencies dropped markedly. In Exhibit 2, a VAR analysis would encompass the event on the left. It would not, however, encompass the event on the right. Because VAR assumes that market behavior is stable over time, it can not address risk from changes in market behavior. Stress tests are used to analyze such risks.
Stress tests can take a variety of forms.
In the most typical situation, a user specifies one or more scenarios for the performance of markets over the next day, week or month. For example, if a British bank were cross-hedging the US dollar against the Canadian dollar, a risk manager at the bank might want to explore the risk of the two currencies moving against each other. Historically, the Canadian dollar has correlated closely with the US dollar. With a stress test, the risk manager could directly analyze what might happen if the correlation between the two currencies broke down. Note that the two scenarios have nothing to do with the historical trading patterns of the two currencies.