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Stress Testing Portfolios: Best Practices for Shockwave Propagation

Scenario propagation is the second stage of predictive stress testing practices, following scenario definition. This paper illustrates common pitfalls and suggests best practices for a robust propagation of the shockwave of a prospective scenario onto all relevant risk factors of a financial portfolio. The central observation: Risk managers must guard against “noise” in the predictions. Diagnostic statistics can reduce noise and ensure meaningful predictions. Key best practices include: the importance of checking compatibility between chosen shocks and the covariance matrix; the selection of an appropriate estimation window for the latter; portfolio-specific inputs on scenario design; and the importance of limiting the number of shocks.