What are the main approaches to stress testing a portfolio?

Question

AcadiFi · Accepted Answer

Stress testing asks what happens under severe but plausible conditions, often beyond the confidence level or distribution assumptions of VaR. The main approaches include historical scenarios, hypothetical scenarios, factor shocks, reverse stress tests, and portfolio-specific vulnerability tests.

Suppose Silver Coast Capital holds equities, credit, rates, and FX exposures. A historical stress might replay a crisis-style widening of spreads and equity selloff. A factor shock might raise rates by 150 basis points and widen credit spreads by 90 basis points. A reverse stress test might ask what combination of moves would create a $12 million loss or breach a liquidity limit.

```mermaid
flowchart LR
  A[Stress testing] --> B[Historical replay]
  A --> C[Hypothetical scenario]
  A --> D[Risk factor shock]
  A --> E[Reverse stress]
```

The FRM distinction is that VaR estimates a quantile under a model, while stress testing explores vulnerability under specified conditions. A good stress test is not just dramatic. It should be relevant to the portfolio, transparent enough to explain, and severe enough to reveal weaknesses that routine risk reports can hide. On the exam, also state the horizon, confidence level, data source, modeling assumption, and validation step, because those choices usually explain why two reasonable VaR answers differ materially. Practice more in our FRM question bank.

What are the main approaches to stress testing a portfolio?

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