Journal of Risk Model Validation

Scenario design for macrofinancial stress testing

Emanuele De Meo

  • A new empirical approach for the selection of severe-yet-plausible forward-looking scenarios for international macrofinancial stress testing is proposed.
  • The scenario design framework is suited to embed subjective views.
  • An original prior setting for multi-country large Bayesian VARs is also provided.
  • The proposed approach is effective in the selection of stress scenarios on the eve of a rare event (e.g. a pandemic); subjective views are also potentially useful in the inclusion of unprecedented events in the plausibility domain.

This paper provides a novel empirical approach to scenario design for selecting a stress scenario for international macrofinancial variables. The scenario design framework is composed of several building blocks. First, multiple scenarios on the risk factors are generated by simulating a multi-country large Bayesian vector autoregression. Second, we take the perspective of a representative investor who aims to select a severe-yet-plausible scenario for a set of systematic risk factors following a factor-investing strategy. Moreover, we compare the stress scenarios selected under different approaches to measure plausibility (the Mahalanobis distance and entropy pooling under subjective views with a clear economic narrative). Finally, we compare our scenario design approach with a historical scenario approach in terms of its ability to select a stress scenario in the run-up to a rare adverse event such as the Covid-19 pandemic. We give evidence that our framework is suitable for the selection of a proper forward-looking severe-yet-plausible macrofinancial stress scenario.

Sorry, our subscription options are not loading right now

Please try again later. Get in touch with our customer services team if this issue persists.

New to View our subscription options

You need to sign in to use this feature. If you don’t have a account, please register for a trial.

Sign in
You are currently on corporate access.

To use this feature you will need an individual account. If you have one already please sign in.

Sign in.

Alternatively you can request an individual account here