What is the purpose of stress testing in risk management?

Stress testing serves a crucial role in risk management by allowing organizations to assess their resilience against extreme market conditions. This process involves simulating scenarios that could potentially cause significant financial distress or loss, such as economic downturns, market crashes, or other catastrophic events. The insights gained from these simulations help firms understand how their portfolios and strategies might perform under severe stress, enabling them to identify vulnerabilities and take preemptive actions to mitigate potential risks.

In contrast, evaluating past performance of investments focuses on historical data rather than future stresses, while simulating only normal market conditions would not provide any insights into risk management under stress. Additionally, forecasting future market trends is more about predicting market behavior based on models and data, rather than testing the robustness of a portfolio against potential adverse conditions. Thus, stress testing is fundamentally about preparing for the worst-case scenarios, ensuring that firms remain viable even under the most challenging market situations.