Understanding Stress Testing in Risk Management

Medium Risk Management Applications Stress Testing

You are a portfolio manager at a mid-sized investment firm. Recently, management has expressed concerns about the potential impact of extreme market conditions on the firm's investment portfolio. In response, you are conducting a stress test to analyze how various hypothetical scenarios could affect portfolio returns.

Your analysis involves applying extreme but plausible movements in interest rates, equity prices, and credit spreads. You are particularly focused on how your portfolio would respond to a significant downturn in the equity market, where the S&P 500 incurs a decline of 30% over a three-month period.

After completing your stress tests, you present your findings to the investment committee. The committee asks about the utility and limitations of stress testing in risk management.

Stress testing can provide insights into extreme losses, but it does not account for correlations that may change during times of crisis.

Stress testing results are definitive and should be used as absolute measures of risk exposure.

Stress testing is primarily used to ensure compliance with regulatory capital requirements.

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