Allocating Assets in Climates of Extreme Risk: A New Paradigm for Stress Testing Portfolios

The authors extended the standard paradigm for portfolio stress testing in two ways. First, they introduced a toolkit that enables investors to envision and administer extreme scenarios. The risk model is integral to the stress test. They demonstrated the substantial impact of using historical and hypothetical covariance matrices in scenario construction. Second, they used a scenario-constrained optimization to incorporate the output of a portfolio stress test directly into an investment decision.