Understanding Stress Testing in Portfolio Management

Hard Risk Management Applications Stress Testing

In the context of investment portfolio management, stress testing is a critical component of risk management. An investment firm, XYZ Investments, conducts stress testing to evaluate how its portfolio would perform under various hypothetical adverse market scenarios. Recently, the firm has assessed the impacts of a significant market downturn characterized by a decrease in equity prices by 30% and a surge in interest rates by 2%. The goal is to identify potential vulnerabilities in their portfolio and make necessary adjustments to mitigate risks.

Given this situation, which of the following statements regarding the implications of the stress test results is TRUE?

Stress testing can help quantify potential losses in the event of extreme market conditions, but cannot predict future market behavior.

The results of the stress test are irrelevant if the portfolio is not fully allocated across different asset classes.

Stress testing can identify liquidity risks only when it involves historical performance data.

Hint

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