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Research paper

An investigation of hypothetical variance-covariance matrix stress-testing

Quintin Rayer
Journal of Risk Management in Financial Institutions, 9 (3), 264-288 (2016)
https://doi.org/10.69554/DTLE1558

Abstract

Attempting to put meaningful numbers to portfolio risks is challenging. Conventional risk measures are considered often not to fully capture all risks inherent in a portfolio, particularly under difficult market conditions. Under such conditions stress-testing against artificial scenarios may help identify and quantify risks within a portfolio. Stress-tests also help reassure a portfolio or risk manager as to how a portfolio might respond to specific concerns. This paper investigates an example of stress-testing a portfolio of conventional assets against market risks using artificial scenarios based around changes to the portfolio variance-covariance matrix. Hypothetical variance-covariance matrix stress-tests include making changes to correlations between assets to explore impacts on portfolio risks. Portfolio correlations, however, cannot be changed arbitrarily to reflect a risk manager’s concerns without running the risk of implausible stressed returns and variance-covariance matrices that are not positive semi-definite. Different methods have been proposed in the literature to overcome this. This paper applies two such methods to a portfolio of four assets with the aim of illustrating the processes involved as well as drawing out differences in the approaches, enabling a discussion of their strengths and weaknesses.

Keywords: portfolio; stress-testing; scenarios; market-risk; diversification; correlation

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Author's Biography

Quintin Rayer is a Chartered Fellow of the Chartered Institute for Securities and Investments, a Chartered Wealth Manager, holds a Physics degree from Imperial College London and a Physics doctorate from Oxford University. Quintin has applied knowledge from nuclear and aerospace engineering to areas in finance, working for actuarial and investment consultancy firms as well as a multi-national European bank for nearly ten years. Projects have included substantial and innovative development of quantitative fund selection and analysis techniques, risk-monitoring and portfolio optimisation, including in-house training for analysts and relationship managers. Quintin has completed the Sustainable Investment Professional Certification (SIPC) with the John Molson Business School, becoming this programme’s first graduate in the Channel Islands and the second in the UK.

Citation

Rayer, Quintin (2016, June 1). An investigation of hypothetical variance-covariance matrix stress-testing. In the Journal of Risk Management in Financial Institutions, Volume 9, Issue 3. https://doi.org/10.69554/DTLE1558.

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cover image, Journal of Risk Management in Financial Institutions
Journal of Risk Management in Financial Institutions
Volume 9 / Issue 3
© Henry Stewart
Publications LLP

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