Backtesting and stress testing

In finance, a stress test could be viewed as an analysis or simulation designed to determine the ability of a given financial instrument, such as a VaR to deal with an economic crisis. Since the first method to estimate a VaR is based on the assumption that stock returns following a normal distribution, its accuracy depends how far, in the real world, stock returns deviate from this assumption. A key component to the implementation of model-based risk management is model validation. That is, we need some way to determine whether the model chosen is accurate and performs consistently. This step is quite important both to firms and their regulators. According to Lopez (2000), we have the following table:

Name	Objectives	Methods
Backtesting	Compare observed outcomes with a model's expected output	Forecast evaluation established empirical issue with a large academic literature
Stress testing	Examples a model's expected outcomes under extreme conditions...