Module XV·Article III·~3 min read
Stress Testing
Portfolio Risk Management
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Stress Testing
Stress Testing: Preparing for Extreme Scenarios
Stress testing is the assessment of a portfolio's behavior under extreme but plausible scenarios. Unlike VaR and ES, which are based on historical data, stress tests allow for the modeling of scenarios that have not yet occurred.
Types of Stress Tests
| Type | Description | Examples |
|---|---|---|
| Historical | Applying past crises to the current portfolio | 2008, COVID, 2022 |
| Hypothetical | Modeling scenarios that have not occurred | China invasion of Taiwan |
| Sensitivity | Changing one factor | Rates +300bps |
| Reverse Stress | What scenario will kill the fund? | Find the breaking point |
Historical Stress Scenarios
| Event | Period | S&P 500 | 10Y Treasury | Credit Spreads |
|---|---|---|---|---|
| Black Monday | Oct 1987 | -22% (1 day) | -50bps | +100bps |
| LTCM | Aug-Sep 1998 | -19% | -100bps | +200bps |
| Dot-com Crash | 2000-2002 | -49% | -200bps | +300bps |
| GFC (Lehman) | Sep-Nov 2008 | -40% | -150bps | +600bps |
| COVID Crash | Mar 2020 | -34% | -100bps | +400bps |
| Inflation Shock | 2022 | -25% | +250bps | +150bps |
Hypothetical Scenarios
| Scenario | Parameters | Probability |
|---|---|---|
| Rates Shock | Fed Funds +500bps over 6 months | 5-10% |
| Oil Spike | Oil +100% (supply disruption) | 10-15% |
| EM Crisis | EM FX -30%, spreads +400bps | 10-15% |
| Taiwan Conflict | TSMC disruption, China sanctions | 5-10% |
| Cyber Attack | Major financial infrastructure | 5-10% |
| Pandemic 2.0 | New virus, lockdowns | 5-10% |
Sensitivity Analysis
Changing one factor all else equal:
| Factor | Shock | Impact on Portfolio |
|---|---|---|
| Equity | -30% | -15% NAV |
| Rates | +200bps | -8% NAV |
| Credit Spreads | +300bps | -5% NAV |
| FX (USD strength) | +15% | -4% NAV |
| Volatility | VIX to 40 | -10% NAV |
Reverse Stress Testing
Question: “What scenario will lead to [critical event]?”
| Critical Event | Scenario (example) |
|---|---|
| NAV -50% | Equity -60% + Rates +400bps + Credit +500bps |
| Liquidity crisis | Redemptions 30% + Margin calls + Market freeze |
| Covenant breach | NAV below $100M threshold |
| Fund closure | Drawdown > max allowed in IPS |
Stress Testing Framework
- Identify risk factors — equity, rates, credit, FX, vol
- Define scenarios — historical + hypothetical
- Map positions to factors — sensitivities
- Calculate P&L — for each scenario
- Analyze results — worst cases, concentration
- Take action — hedges, reductions
Stress Test Reporting
| Scenario | P&L Impact | LTV After | Headroom | Action Required |
|---|---|---|---|---|
| Base Case | -5% | 55% | 25% | None |
| Moderate Stress | -15% | 68% | 12% | Monitor |
| Severe Stress | -30% | 82% | -2% | Hedge tail risk |
| Extreme Stress | -50% | 95% | -15% | Review allocation |
CIO Recommendations
- Run monthly — minimum monthly stress tests
- Update scenarios — add new risks
- Act on results — stress test without action = useless
- Report to board — transparency on tail risks
- Link to limits — triggers for action
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