Limitations in Stress Testing Approaches

Very Hard Risk Management Applications Stress Testing

A financial analyst at a large investment firm is tasked with creating a stress testing framework to assess the impact of extreme market conditions on their diversified portfolio. The portfolio consists of equities, fixed income securities, and alternative investments. After considering various stress scenarios, the analyst decides to focus on historical crises, such as the 2008 financial crisis, the Dot-Com bubble, and the COVID-19 market crash, while also including hypothetical scenarios like a sudden geopolitical event escalating to war.

The analyst chooses to model the impact of these stress scenarios using a combination of sensitivity analysis and scenario analysis. However, during the analysis, complexities arise regarding correlations between asset classes, potential liquidity issues, and the degree of risk interconnectedness between investments.

Which of the following statements best describes a significant limitation of the analyst's stress testing approach?

Stress tests are solely reliant on historical data and do not account for future market dynamics.

Scenario analysis cannot effectively capture potential nonlinearities in risk exposures.

Sensitivity analysis assumes constant correlations during stress periods, which can lead to misleading results.

Hint

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