Evaluating Stress Testing in Portfolio Risk Management

Hard Risk Management Applications Stress Testing

As a portfolio manager at a large institutional fund, you are tasked with assessing the potential impact of extreme market movements on your diversified equity portfolio. Your team conducts stress testing using various hypothetical adverse scenarios to gauge the portfolio's vulnerabilities. One of the stress tests involves a sudden 30% market decline over one week, alongside a concurrent 50% drop in oil prices.

During the review meeting, your chief risk officer suggests that the results of these stress tests should inform future asset allocation decisions. However, a debate arises regarding the implications of the stress testing results and their effectiveness in preparing for real-world risks.

Which of the following statements correctly describes a strength or limitation of using stress testing as a risk management tool in portfolio management?

Stress testing effectively captures all possible risk factors and their interdependencies, which ensures robust decision-making for asset allocation.

Stress testing can reveal portfolio vulnerabilities and improve understanding of extreme market events, but it may not account for all unknown risks.

The results of stress testing are definitive indicators of future portfolio performance and should be used as absolute guides for investment strategies.

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