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Risk scenarios and stress tests: which one is best for your portfolio?

A good way to gain insight into how an investment portfolio performs under difficult circumstances are scenario and stress test analyses. But there are many different types of scenarios and they all provide insight into financial risks in their own way. So which one is best for your portfolio? In this blog we briefly discuss these different types and explain the added value.

06 Jul 2020

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Historical scenarios
First off, we look at historical scenarios. These scenarios use a timeframe from the past and are simple to apply. The effects of a historic event , for example the 2008 crisis, are imitated on the current portfolio to see what the effects would be if the relevant scenario were to take place again today. Technically, you could apply the historical scenarios in a straightforward manner. For example, by looking at what a proxy (the closest benchmark for an investment) has done for equities and applying this to the part of the portfolio consisting of equities. However, you can also use a so-called multi-factorial model to repeat a historical scenario; allowing multiple proxies to have an effect on, for example, stocks. In this last example, the correlation between categories is also included in the analysis.

Stress test
Stress tests (also known as deterministic scenarios) are scenarios in which one has a specific shock in mind. For example, what happens to my portfolio if my shares decline in value by 20%? It is important that stress tests are carried out with transitive shocks. This means that the effect of a parallel decline in interest rates, to take an example, not only affects the fixed-interest part of the portfolio, but also certain shares. The shares of banks and insurers are notorious for this, as they are often very sensitive to changes in interest rates because of their business activities.

Historical scenarios versus stress test
The advantage of these stress tests compared to historical scenarios is that the latter often have specific risk characteristics that are less relevant to a given investment portfolio. An example being that a historical scenario with strong movements in equity prices is often less relevant for a portfolio with predominantly fixed-income securities. In addition, stress tests make it easier to analyse how short-term and long-term investment objectives hold up to the results of a stress test. Historical scenarios, however, have the advantage that their underlying effect is often easier to understand, especially when compared to transitive stress tests.

KAS BANK N.V. has been part of CACEIS since September 2019. CACEIS is a European specialist for the custody and administration of securities and high-quality risk and reporting services. We focus entirely on providing securities services to professional investors in the pensions and securities world. The acquisition of KAS BANK N.V. strengthens CACEIS' position in the Netherlands, Germany and the United Kingdom. Our combined product range makes us market leader in custody services and fund administration in Europe. CACEIS is part of Crédit Agricole, the world's largest cooperative financial institution.

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Mitch Loedeman

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Mitch Loedeman

Mitch Loedeman
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