Portfolio Risk Management — February 7, 2022

Hands-on reverse stress testing: A practical guide to reverse stress test a portfolio

How badly could a portfolio get hurt? What scenario would be responsible for such a loss? What are the main risk drivers in this scenario and how plausible would such a scenario be? These questions are all part of what is commonly called reverse stress testing.

This paper aims to illustrate how one could follow a very pragmatic end-to-end workflow to answer the questions above.

This technical analysis includes:

  • A reverse stress test on seven different use cases across equities, rates, credit, commodity and FX strategies spanning both linear and convex portfolios
  • A review of the methods used to find optimal scenarios for both linear and nonlinear portfolios
  • Guidance on how to fit a Gaussian mixture to a set of factor returns
  • A detailed description of different types of Lasso-based regressions techniques

Author

Hassan Ennadifi

Executive Director, Product Specialist