How do I design hypothetical stress scenarios with a narrative and calibrated shocks?

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AcadiFi · Accepted Answer

Hypothetical scenario design follows a four-step narrative-to-shock translation. Step 1: narrative construction. Write a one-page economic story — e.g., 'Geopolitical shock in Strait of Hormuz spikes oil to $145, USD strengthens 10%, EM FX selloff, EM sovereign spreads widen 300bp, DM equities down 18%, VIX to 45, 10Y Treasury down 80bp on flight-to-quality.' Narratives should be coherent, specific, and plausible, not just the worst observed move in each factor. Step 2: primary shock selection. Identify 3 to 5 anchor shocks that drive the narrative — WTI +80%, DXY +10%, 10Y UST -80bp, EM local bonds -12%, S&P -18%, VIX from 18 to 45. Step 3: consistent propagation. Use a hybrid of expert judgment and conditional analytics (e.g., conditional covariance from a DCC-GARCH or factor model) to fill in non-anchor factors. If WTI is +80%, energy equities are probably +6%, airlines -22%, HY energy spreads +450bp. Step 4: validation. Plot the scenario's factor values against historical joint distributions to check plausibility, compute implied returns on reference portfolios, and have the business lines challenge the magnitudes. ```mermaid flowchart TD A[Narrative] --> B[Anchor
shocks] B --> C[Propagate
factors] C --> D[Plausibility
check] D --> E[Committee
sign-off] ``` FRM exam point: hypothetical scenarios are essential for reverse stress testing and for capturing risks with no historical analog.

How do I design hypothetical stress scenarios with a narrative and calibrated shocks?

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