Journal of Risk Model Validation

Risk.net

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.

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