Top 3 approaches to reveal the inherent weaknesses of financial portfolio

The recent recessionary waves have caused much stir in the financial market and have pushed many leading institutions on the brink of going belly up. The inflation, deflation debate continues unhindered without arriving at a logical conclusion gold trading is taking at a pace that has surpassed previous trends. This is a decisive point, particularly for managers of pension funds who need to assess the catalysts that can trigger a negative trend for the fund in peculiar situations. Portfolio stress testing is deemed suitable to ascertain potential outcomes. 

The approaches taken to test resilience to stress are varied. 

• Historical test is a commonly preferred tool. The fund’s current portfolio inclusive of liabilities and assets are projected on to a historical backdrop like a previous stock market plummeting or credit crisis to assess the fund’s performance if such a volatile situation is to hold sway of the market once again. This hassle free approach is wanting of depth as the probability of exactly emulating a given historic crisis seems quite bleak.

• The portfolio’s hidden risks are brutally exposed by another approach that involves hard implementing measures. A particular portfolio risk measure report is populated by static variables like the inherent relation between asset classes or assets. The stress test is conducted by pushing the correlations to the extreme ends of +1 and -1 to bring to light tail scenarios. The potential outcomes are simulated to unearth the probability of considerable negative returns under given correlation values. Volatility is another value that is stress tested to probe the performance of a portfolio when volatility spikes. By combination of variations in volatility to that of the correlation through a series of simulations will review the inherent weaknesses of the portfolio.

• The third approach takes resort to generation of potential scenarios for testing stress prepared ness of the portfolio. This is an effort intensive exercise, but the analysis is not limited to historical crisis only. The reviewer has to form a mental picture based on the current scenarios about the ways in which the events will unfold in the projected future and the impact of such events on the portfolio. You can assume the relative strength of a particular currency against the US dollar in future for-ex trading, the selling off of bonds at a given value, the performance of high priced commodities like oil and gold, and reaction of equities.  The manager can generate a slew of potential outcome scenes to evaluate the consequent impact on the portfolio.

Portfolios should be subjected toperiodical portfolio stress testing to unearth the vulnerable spots and inherent weaknesses to embrace corrective measures to rectify the same and mitigate the effects. It only demands commitment, effort and time on the part of managers to gain a comprehensive understanding.

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