Stress Testing Portfolios: Best Practices for Shockwave Propagation
Sep 19, 2016
Scenario propagation is the second stage of predictive stress testing practices, following scenario definition. This paper illustrates common pitfalls and suggests best practices for a robust propagation of the shockwave of a prospective scenario onto all relevant risk factors of a financial portfolio. The central observation: Risk managers must guard against “noise” in the predictions. Diagnostic statistics can reduce noise and ensure meaningful predictions. Key best practices include: the importance of checking compatibility between chosen shocks and the covariance matrix; the selection of an appropriate estimation window for the latter; portfolio-specific inputs on scenario design; and the importance of limiting the number of shocks.