Market-Driven Scenarios: An Approach for Plausible Scenario Construction

Abstract

The use of scenario analysis to better understand portfolios has increased significantly since the global financial crisis. In this article, the authors describe a stress scenario framework and process that has been developed for risk management and investment management purposes. This hybrid framework, which the authors refer to as market-driven scenarios, works as follows. Scenario forecasts of key market indicators are first formulated by market practitioners. An econometric framework then uses these indicators as inputs to imply plausible shocks to a global set of risk factors. These factor shocks are finally put into a portfolio valuation engine, yielding hypothetical fund profit and loss (P&L) that can be decomposed into its underlying drivers. Key to the effectiveness of this approach is the cross-functional involvement of investors, risk managers, and economists. In conjunction, the authors define potential geopolitical or other macro events, specify potential economic outcomes, and translate them into shocks to key policy risk variables and risk model factors. The process is completed by applying the shocks to portfolios and evaluating whether P&L outcomes are consistent with fund mandates and whether positioning is deliberate, diversified, and scaled.