risk-factor-based scenario analysis#Return to RiskMetrics

Look at [[return to risk riskMetrics]]. Some risk management theorists have a (fairly sophisticated) framework about scenarios. I feel it’s worth studying.

Given a portfolio of diverse instruments, we first identify the individual risk factors, then describe specific scenarios. Each scenario is uniquely defined by a tuple of 3 numbers for the 3 factors (if 3 factors). Under each scenario, each instrument in the portfolio can be priced.

I think one of the simplest set-up I have seen in practice is the Barcap 2D grid with stock +/- percentage changes on one axis and implied vol figures on the other axis. This grid can create many scenario for an equity derivative portfolio.

I feel it’s important to point out two factors can have non-trivial interdependence and influence each other. (Independence would be nice. In a (small) sample, you may actually observe statistical independence but in another sample of the same population you may not.) Between the risk factors, the correlation is monitored and measured.

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