RiXtrema Research Paper
ROBUST RISK ESTIMATION AND HEDGING: A REVERSE STRESS
Traditional risk modeling using Value-at-Risk (VaR) is widely viewed as ill equipped for dealing with tail risks. As a result, scenario-based portfolio stress testing is increasingly being promoted as central to the risk management process. A recent innovation in portfolio stress testing endorsed by regulators, called reverse stress testing, is intended to identify economic scenarios that will threaten a financial firm’s viability, but do so without injecting the manager’s cognitive biases into stress scenario specification. While the idea is intuitively appealing, no template has been provided to operationalize the idea.
Some first steps in developing reverse stress testing approaches have begun to appear in the literature. Complexity and computational intensity appear to be important issues. A more subtle issue appearing in this emerging research is the relationship among the concepts of likelihood, plausibility, and representativeness. In this paper, we propose a novel method for reverse stress testing. The process starts with a multivariate normal distribution and uses Principal Components Analysis (PCA) along with Gram-Schmidt orthogonalization to determine scenarios leading to a specified loss level. The approach is computationally efficient. The method includes the maximum likelihood scenario, maximizes (a definition of) representativeness of the scenarios chosen, and measures the plausibility of each scenario. In addition, empirical results for sample portfolios show this method can provide new information beyond VaR and standard stress testing analyses.
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RiXtrema Research Note
CORRELATION STRESS TESTING PUZZLE
Abstract: Risk managers are frequently tasked with modeling macroeconomic scenarios and their effects on various portfolios. Macroeconomic scenarios require multiple (composite) shocks to different factors. This creates the potential for implausible shocks and counterintuitive results. In this research note, we will examine a case of a composite shock to both VIX and EUR that produces counterintuitive results and explain the reasons for the problem. We will finally see how RiXtrema’s unique Shock Plausibility measure can help users of Riskostat in avoiding this problem. Shock Plausibility shows the joint probability of all shocks, as the user is creating scenarios. It helps in design of plausible stress tests and in effectively communicating the results both within the organization and to investors.
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