Systemic Risk and Stress Testing: Derivatives, XVA, and Endogenous Liquidity Amplification

Regulatory stress testing has become a central pillar of macroprudential policy, yet recent episodes of financial instability reveal structural blind spots in conventional frameworks. In particular, derivative pricing, margining, and balance-sheet valuation adjustments are often treated as exogenous, leading to a systematic underestimation of systemic risk. This paper develops a unified stress-testing framework linking derivative pricing, risk sensitivities, XVA adjustments, funding liquidity constraints, and risk-sensitive capital regulation. Volatility, correlation, and jump shocks jointly increase Greeks, margins, valuation adjustments, and capital requirements, forcing deleveraging and generating nonlinear amplification across institutions and markets. The framework integrates equity and interest-rate derivatives, dynamic hedging and P&L attribution, CVA, FVA, MVA, and KVA, wrong-way risk, collateralization, and Monte Carlo stress simulation. We derive stability conditions under which liquidity spirals emerge and discuss implications for Basel III, FRTB, and macroprudential policy.