This paper investigates an example of stress-testing a portfolio of conventional assets against market risks using artificial scenarios based around changes to the portfolio variance-covariance matrix. This includes making changes to correlations between assets to explore impacts on portfolio risks, effectively stress-testing diversification. However correlations cannot be changed arbitrarily. This paper applies two different approaches to a portfolio of four assets to illustrate them and to draw out differences in the approaches, enabling a discussion of their strengths and weaknesses.
This paper is aimed at the more advanced practitioner.
A copy of this paper has been included in the Certificate of Bank Treasury Risk (BTRM) ‘working paper series’ (BTRM Working Paper Series #5), which can be read on the BTRM’s website.
The Certificate of Bank Treasury Risk Management (BTRM – find out more about the BTRM from their website) is a course designed to empower individuals working in, or intending to work in, every aspect of bank risk management and asset-liability management (ALM). The BTRM is unique in being the only professional qualification for bank Treasury, Finance and Risk professionals that covers bank ALM, liquidity risk management, hedge accounting and operational risk.
The BTRM Working Paper Series highlights recent developments in the fields of banking, financial markets, economics and econometrics. Articles are subject to review by the BTRM Faculty prior to publication.
Download the An investigation of hypothetical variance-covariance matrix stress-testing
Q G Rayer (2016), An investigation of hypothetical variance-covariance matrix stress-testing, J Risk Management in Financial Institutions, volume 9, number 3, p264-288, summer 2016.