Implications of Stress Testing for Portfolio Management

Hard Risk Management Applications Stress Testing

A portfolio manager is evaluating the overall risk exposure of a diversified investment portfolio that consists of domestic equities, international equities, bonds, and commodities. In light of recent market volatility, the manager decides to conduct a stress test to assess how the portfolio might perform under extreme market conditions.

The stress test simulates three different scenarios: a sharp decline in equity markets, a significant rise in interest rates, and a geopolitical crisis affecting commodities. The results revealed that the portfolio would experience the largest loss in the event of a geopolitical crisis, with commodity prices plummeting and causing cascading effects across the asset classes.

Given this scenario, which statement best captures the implications of the stress testing results for the portfolio manager?

The portfolio manager should increase allocation to equities to benefit from their potential recovery.

The portfolio manager must consider diversification strategies to mitigate the specific risks highlighted by the stress test.

The portfolio manager can ignore the stress test results, as they do not reflect normal market conditions.

Hint

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