A Portfolio Manager Questions a Risk Engine III:
Stress Testing and Multi-Factor Simulation Analysis
Yannis Sardis, 12 April 2021
We continue our Q&A session between a Portfolio Manager (PM) and a risk assessment engine, KlarityRisk (KR), focusing on a range of estimation methodologies which enable a manager to assess a portfolio’s performance in extreme market conditions, thus allowing the development of investment strategies via a diligent stress testing process which may highlight weaknesses or opportunities in hypothetical adverse market movements.
PM: In recent history, financial markets have reacted violently due to either policy decisions (e.g. Brexit) or to completely unexpected events (e.g. Covid-19 pandemic). Is there a way of proactively monitoring how my portfolio could behave if such conditions occurred again?
KR: Such a proactive assessment can be done by a Stress Testing analysis which enables you to assess the portfolio’s reaction to adverse market conditions. This can be achieved by either taking into consideration a wide list of major historical events, or by creating your own custom scenarios which are most suitable to your intuition about the current market environment and the characteristics of your investment strategy. These predefined Historical Crises scenarios are coded into our system, in compliance with the market events selected and documented according to the MSCI Standards, thus requiring no manual user intervention.
PM: What are the main criteria for selecting such a Historical Stress Testing vs. a Custom Scenario analysis?
KR: Historical Stress Testing refers to the process of stressing your current portfolio under the assumption that a past market crisis would occur again. Its advantages are that it does not require the effort to create a custom scenario, it is a regulatory-approved approach and there is a long list of historical crises to be utilized. A disadvantage, however, is that the selected historical crisis might not entirely adapt to the current investment environment and therefore it may result to skewed estimations.
On the other hand, creating a custom scenario, although requires a justification of the reasons behind your implemented changes, it empowers the stress testing assessment by allowing you to tailor the scenarios to your portfolio-specific conditions and ensure the adaptation of your investment decisions to the current market environment and driving factors.
PM: What if I do not have a strong view on what could go substantially wrong based on the current market conditions? Looking at various historical crises, we often observe that they often lack adaptation to the current market environment. Is there a mixed way to combine Historical Stress Testing and Custom Scenario analytics?
KR: In this case, the best way is to use a ‘hybrid’ model: You can utilize one of the predefined Historical Stress Scenarios and at the same time amend various factors so that they adapt suitably to current market conditions and risk factor values, as the new inputs in your Stress Testing analysis.
PM: Which range of risk factors can I stress test my portfolio against?
KR: This largely depends on your portfolio structure and composition. The risk factors to be stress-tested can indicatively include:
- Interest Rates, if there are holdings the valuation of which depends on Interest Rates, such as Options, Futures, Forwards
- Interest Rates Term Structure, if the portfolio includes Fixed Income holdings, such as Sovereign or Corporate Bonds
- FX Rates, if there are holdings that are denominated in currencies other than the portfolio’s base currency
- Index Rates, if there are holdings linked to an Index, such as Inflation Linked Bonds or Index-Tracking Funds
- Price Time Series, for equity-like instruments, such as Stocks and ETFs.
PM: Considering the market price fluctuations that we have experienced in 2020, how can I implement a scenario simulation analysis based on my intuition about an imminent price volatility spike?
KR: In such a case, you can utilize a volatility index (e.g. the VIX) and implement a Custom Stress Testing analysis based on its movements. Alternatively, you can take advantage of our system’s Stress-Testing-with-Custom-Volatility-Matrix functionality to implement the analysis based on the volatilities changes that you wish to apply.
PM: Can I simulate a Correlation dislocation between certain portfolio holdings, to reflect the view that the relationship historically displayed by my holdings may change substantially?
KR: Indeed, our risk engine allows you to implement the scenario analysis based on a custom Correlation matrix that incorporates your own views. The system enables you to extract the current correlation matrix between your portfolio risk factors and use it as a template to accommodate your prevailing market views.
PM: Our next Q&A session will address portfolio sensitivity analysis and the user’s ability to drill down to the core sources of a portfolio’s risk exposure.
FINVENT Software Solutions is a provider of financial software applications and custom engineering services. The award-winning KlarityRisk platform specializes in investment risk analytics and fixed income performance attribution reporting and it is offered to Private Wealth institutions, Asset and Hedge Fund Managers and Family Offices.
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