Forecasting Portfolio Risk in Normal and Stressed Markets

15 Pages Posted: 28 Nov 2001

See all articles by Vineer Bhansali

Vineer Bhansali

LongTail Alpha, LLC

Mark B. Wise

California Institute of Technology

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Abstract

The instability of historical risk factor correlations renders their use in estimating portfolio risk extremely questionable.

In periods of market stress correlations of risk factors have a tendency to quickly go well beyond estimated values. For instance, in times of severe market stress, one would expect with certainty to see the correlation of yield levels and credit spreads to go to -1, even though historical estimates will miss this region of correlation.

This event might lead to realized portfolio risk profile substantially different than what was initially estimated. The purpose of this paper is to explore the effects of correlations on fixed income portfolio risks. To achieve this,

we propose a methodology to estimate portfolio risks in both normal and stressed times using confidence weighted forecast correlations.

Keywords: risk factors, market stress, portfolio risk

JEL Classification: C40, G11, E37

Suggested Citation

Bhansali, Vineer and Wise, Mark B., Forecasting Portfolio Risk in Normal and Stressed Markets. Available at SSRN: https://ssrn.com/abstract=290915 or http://dx.doi.org/10.2139/ssrn.290915

Vineer Bhansali

LongTail Alpha, LLC ( email )

500 Newport Center Drive
Suite 820
Newport Beach, CA 92660
United States

Mark B. Wise (Contact Author)

California Institute of Technology ( email )

Pasadena, CA 91125
United States
626-395-6687 (Phone)
626-568-8473 (Fax)

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