25 August 2015
A Look at the Recent US Equity Market Drop
To say that recent activity in the US Equity market has been unprecedented would certainly be an understatement. On Friday, August 21st, and Monday, August 24th the S&P 500 index fell 3.24% and 4.02% respectively. To put these declines in perspective: based on a year's worth of data, Monday's market drop was equivalent to an over 4 standard deviation event, making these declines extreme by any statistical measure:
For some perspective, to correctly estimate last Friday's decline using a year of daily data through August 20th, a parametric VaR would require a confidence interval of 99.9984%. This equates to the probability of such an event occurring to be less than once in 10,000 observations.
On the subject of VaR, one would require using data going back to 2008 to anticipate the returns just seen on Friday, August 21st:
For Monday, August 24th's decline of 77.68 points, only a conditional VaR using 7-years of data (again, including 2008) correctly estimated the S&P 500's decline that day:
Which brings us to why stress-testing is exceedingly important as a complimentary set of exposure analysis. Here we shock an at-the-money option on the SPY's starting with data as of August 20th using a -5% move in the S&P 500 Index:
The benefit of stress-testing is its lack of reliance on statistical (historical) data. Regardless of the presence of extreme events in a given data set (or detrimentally, in this case, the lack thereof), stress-testing allows for simulation of market shocks in all environments, volatile, extreme, or not..