Integrating Economic Scenarios into Stress Testing

Regulatory and expert scenarios are typically described in terms of a small number of key economic variables or factors. However, when applied to a portfolio, they are incomplete – they generally do not describe what occurs to all relevant market risk and credit risk factors that affect a portfolio. We need to understand how these risk factors behave, conditional on the outcome of the economic factors, and the map this to portfolio losses. We introduce a new approach called Least Squares Stress Testing (LSST). LSST is a simulation-based conditional scenario generation method that offers many advantages over more traditional analytical methods. Simulation techniques are simple, flexible, and provide very transparent results, which are auditable and easy to explain.

Dan Rosen is currently a Visiting Researcher and the first Director of the Centre for Financial Industries at the Fields Institute for Research in Mathematical Sciences, as well as an Adjunct Professor of Mathematical Finance at the University of Toronto.