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How To Apply Economic Scenarios To Aid Risk Management

Last week, we shared a post highlighting the steps to follow in order to create a joint simulation model that combines macroeconomic factors with risk factors. Once a joint simulation model is created, it can be applied to a multi-asset class portfolio to aid in risk management. Dr. Dan Rosen, Managing Director of Risk Analytics at S&P Capital IQ, demonstrated this during a recent webinar entitled “Re-Thinking Scenarios: Integrating Economic Scenarios with Advanced Scenario Analytics to Manage Investment Portfolios.”

The first step in setting up the joint simulation is to express the economic scenario in the context of the joint simulation model, and understand where it fits within the risk and economic factors included. For example, a single risk factor, such as real GDP, can be placed within the simulation in order to figure out where a base scenario would fall in the context of the joint simulation model. This process needs to be completed for all of the factors, as scenarios are expressed in terms of a specific number of key economic risk factors.

An economic scenario can then be expressed as a set of expected values of the factors conditional on the scenario to define the whole conditional distribution of the scenario.  By regressing the economic factors over each scenario against the economic factors, the methodology produces the conditional expected scenario.

Once this is done, the conditional scenarios can be run on the portfolio to see what the impact will be. Factors can be added or deleted to understand the impact of using different factors in the scenario analysis. In addition to the expected value of the P&L, this technique also allows analysis of the tail, and examination of unexpected losses.

As always, we welcome your comments and thoughts and hope that you will join us for future discussions on applying the insights of economic forecasts to portfolio management using scenario analysis techniques.

Access Dr. Rosen’s webinar presentation for more in-depth information on how to apply a joint simulation model such as this to a multi-asset class portfolio.

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