Regress under stress: A simple

least-squares method for integrating

economic scenarios with risk
simulations
Accepted 2nd June, 2016

Dan Rosen
is Visiting Researcher and first Director of the Centre for Financial Industries at the Fields Institute, as well as an Adjunct Professor
of Mathematical Finance at the University of Toronto. He was the co-founder and CEO of R2 Financial Technologies, acquired by
S&P Capital IQ in 2012. Before founding R2 in 2006, Dr Rosen had a successful career over a decade at Algorithmics. He holds an
MASc and PhD from the University of Toronto.

The Fields Institute for Research in Mathematical Sciences, 222 College Street, Toronto, Ontario, M5T 3J1, Canada
E-mail: drosen@fields.utoronto.ca

David Saunders
is an Associate Professor in the Department of Statistics and Actuarial Science at the University of Waterloo. He is the author of many
articles on the subjects of risk management, portfolio optimisation and derivatives pricing. Dr Saunders holds a PhD in Mathematics
from the University of Toronto.

E-mail: dsaunders@uwaterloo.ca

Abstract We present a simple and powerful approach to create meaningful stress scenarios for
risk management and investment analysis of multi-asset portfolios, which effectively combines
economic forecasts and ‘expert’ views with portfolio simulation methods. Expert scenarios are
typically described in terms of a small number of key economic variables or factors. However,
when applied to a portfolio, they are incomplete — they generally do not describe what occurs
to all relevant market risk factors that affect the portfolio. We need to understand how these
market risk factors behave, conditional on the outcome of the economic factors. The key insight
to our approach is that the conditional expectation, and more generally the full conditional
distribution of all the factors, and of the portfolio profit and loss (P&L), can be estimated directly
from a pre-computed simulation using least squares regression. We refer to this approach as
least squares stress testing (LSST). LSST is a simulation-based conditional scenario generation
method that offers many advantages over more traditional analytical methods. Simulation
techniques are simple, flexible and provide very transparent results, which are auditable and easy
to explain. LSST can be applied to both market and credit risk stress testing with a large number
of risk factors, which can follow completely general stochastic processes, with fat-tails,
non-parametric and general co-dependence structures, autocorrelation, etc. LSST further
produces explicit risk factor P&L contributions. We demonstrate the methodology in detail with
the practical example of a multi-asset investment portfolio and economic scenarios from an
industry report.

Keywords: stress testing, risk management, conditional simulation, linear regression, scenario
generation, risk contributions

© Henry Stewart Publications 1752-8887 (2016) Vol. 9, 4 391-412 Journal of Risk Management in Financial Institutions 391
Rosen and Saunders
INTRODUCTION
Scenarios are the language o f R isk. T he quality o f
a risk m anagem ent analysis depends on o u r ability
to generate relevant forw ard-looking scenarios that
properly represent the future, and to understand
clearly how these scenarios apply to our current
situation, im pact o u r specific portfolios and provide
guidance on how to m anage their risk effectively
or take advantage o f investm ent opportunities.
A lthough scenario analysis and stress testing
have been an explicit part o f risk m anagem ent
m ethodologies and systems for over tw o decades,
the typical scenario and stress-testing tools have
not evolved m uch and are still generally quite
static and largely subjective. T he future cannot be
predicted, but the com bination o f expert econom ic
analysis w ith advanced scenario and portfolio
analytics can provide a strong basis for m anaging
risk and m ak in g better, m ore inform ed investm ent
decisions.
In this paper, we present a simple and pow erful
approach to create m eaningful stress scenarios
for risk m anagem ent and investm ent analysis o f
m ulti-asset portfolios, w hich effectively com bine
econom ic forecasts and ‘expert’ views w ith portfolio
sim ulation m ethods. T he intuition o f the approach
is straightforw ard. E xpert scenarios are typically
described in term s o f a small num ber o f key economic
variables or m arket risk factors. However, when
applied to a portfolio, they are incom plete — they
generally do not describe what happens to all relevant
market risk factors that affect the portfolio directly
(or indirectly). We need to understand how these market
risk factors behave, conditional on the outcom e o f the
econom ic factors. For example, in a scenario w ith
large gross dom estic product (GDP) grow th, equity
prices may rise to various degrees and credit default
swap (CDS) spreads contract. C onditional scenarios
can be obtained analytically for the jo in t Gaussian
and Student (distributions .1'2 T he key insight to our
approach is that the conditional expectation, or more
generally the full conditional distribution o f all the factors,
and o f the portfolio profit and loss (P&L), can be
estim ated directly from a pre-com puted sim ulation
using least squares regression (LSR). Specifically, we
regress the m arket risk factors in the sim ulation, or
directly the portfolio P&L values, on the economic
factors (or some function o f these), which define
392 J o u r n a l o f R is k M a n a g e m e n t in F in a n c ia l In s t it u t io n s
the econom ic scenario. All the conditional scenario
analytics can be derived from the regression results.
T he application o f LSR on the cross-sectional
inform ation o f a sim ulation to obtain conditional
expectations is the key com ponent o f the popular
least-squares M onte C arlo approach , 3 w idely used
to price A m erican options. H ere we show how
sim ilar ideas can also be effectively applied to
portfolio risk m anagem ent and stress testing.
W e refer to this approach as ‘least squares stress
testing’ (LSST).
LSST is a sim ulation-based m ethod that offers
m any advantages over m ore traditional analytical
m ethods, including the following:
• It can easily be applied to large portfolios and a
large num ber o f risk factors, including m arket
and credit risks.
• Simulation allows the risk factors to follow
completely general jo in t stochastic processes,
w ith fat-tails, non-param etric and general
co-dependence structures, autocorrelation, etc.
• Simulation techniques are simple, flexible and
provide very transparent results, which are
auditable and easy to explain.
• LSST conditional scenarios analytics are easy to
build on top o f any existing scenario and portfolio
simulation risk engine.
• LSST further decomposes the portfolio’s
perform ance in the simulation to produce explicit
risk factor P&L contributions.
• T he com putational efficiency o f post-sim ulation
analytics allows users to run multiple scenarios
and assumptions in real time, thus providing
multiple-portfolio views and an explicit assessment
o f m odel risk.
We focus this paper on conditional scenarios where
several factors are given fixed values, ie point scenarios.
O th er recent w ork defines m ore general views, for
example on distribution param eters (eg m om ents or
quantiles). See, for example, M eucci ,4’5 and Ardia
and M eucci .6 We note that it is easy to extend the
LSST m ethodology to m ore general views, including
bounds on the factors, views on param eters o f the
factor distributions, etc.
T h e rest o f the paper is organised as follows.
T he next section briefly introduces the problem and
describes the basic setting for analysing portfolios
Vol. 9, 4 391-412 © Henry Stewart Publications 1752-8887 (2016)
 A least-squares method for integrating economic scenarios with risk simulations
under conditional scenarios. This is followed by
a section presenting the LSST m ethodology. To
illustrate the approach, the next section presents a
real-life stress-testing example w here we analyse
the perform ance o f a typical m ulti-asset portfolio,
dependent on a large num ber o f risk factors, under
recent econom ic research report and regulatory
scenarios. Conclusions and further extensions are
given in the last section.
P O R TFO LIO ANALYSIS U N D E R
C O N D IT IO N A L S C E N A R IO S
T he general problem can be form ulated as follows.
Scenarios typically com ing from a research report
or an analyst’s views are naturally described in
term s o f a small num ber o f key econom ic variables
or risk factors. W hen applied to a given portfolio,
they do not describe w hat happens to all relevant
risk factors that affect the portfolio either directly
or indirectly. In order to apply these econom ic
scenarios to our portfolio, we have to find how
all the relevant m arket factors behave as a given
econom ic scenario unfolds. Implicitly or explicitly,
this relationship betw een all the factors m ust be
assigned, and resolved w hen the scenario is applied
to the portfolio. A simple approach com m only used
by practitioners is to elicit subjective views or expert
opinions on how some econom ic levels affect all the
m arket factors in the portfolio. Alternatively, we
focus on first applying statistical tools to m odel the
jo in t behaviour o f the factors, and use these models
to create the ‘complete scenarios’.
T he general setting is described in the following
sections.
Portfolio and market risk factors
C onsider a m ulti-asset portfolio P, w ith positions, for
example, in equities, bonds, CDSs and derivatives
in m ultiple currencies. We are interested in the P&L
distribution o f the portfolio over a single horizon T,
say one m onth or one quarter. T he discussion also
applies to m ultiple horizons.
T he portfolio P&L at the horizon is a function o f
a vector o f market, risk factors Y:
AV: = A V(Y) (1)
© Henry Stewart Publications 1752-8887 (2016) Vol. 9, 4 391-412 Journal o f Risk Management in Financial Institutions 393
M arket risk factors include equity prices and indices,
interest rate zero curves (governm ent & swap curves),
cash credit curves, CDS curves, foreign exchange (FX)
rates, com m odity prices, etc. T he num ber o f risk
factors can be large for a typical portfolio.
Market scenarios and portfolio
risk metrics
D enote a market scenario by Y=y. This is a specific
realisation o f the risk factors at T. U nder the m arket
scenario, the portfolio P&L is AV(y).
For risk analysis, we also define a jo in t distribution
ot the risk factors at the ho rizo n , F Y(y). This
distribution is used with the P&L function (1) to obtain
the portfolio’s P&L distribution via either simulation
or analytical m ethods, if tractable. Statistical risk
measures for the portfolio, such as VaR and expected
shortfall, are derived from this P&L distribution.
Economic scenarios and economic
risk factors
C onsider a vector o f econom ic factors X, and denote
by X = x () an economic scenario, w hich may come
from an econom ic report or an analyst’s projections.
Econom ic factors typically include m acro-econom ic
variables, such as G D P and unem ploym ent, or other
financial and m arket factors such as interest rates and
m arket indices. We focus on scenarios as ‘point-w ise
views’ o f the form X = x (), but the approach can be
extended to m ore general views.
Joint factor evolution model
and joint scenarios
A m odel o f the jo in t evolution o f the m arket and
econom ic factors produces a jo in t distribution at
horizon T, FXY(x, y). T he m odel and the resulting
distribution F can be com pletely general: param etric
or non-param etric, w ith fat-tailed m arginals and
general co-dependence structure.
Conditional scenarios
O u r objective is to understand the perform ance o f
the portfolio under the econom ic scenario X = x ().
Thus we need to understand how the m arket risk
Rosen and Saunders
Figure 1: Conditional scenario setting
factors behave, conditional on the defined outcom e o f
the econom ic factors. T he expected conditional market
scenario is defined as
Yo= E [Y \X = x q] (2)
M ore generally, w e can obtain the full conditional
market factor distribution
F Ylx(y \x 0) = P [Y < y \X = x 0] (3)
T h e case where the m arket and econom ic factors
follow a jo in t m ultivariate Gaussian distribution,
results in simple analytical expressions for conditional
scenarios and distributions. D enote the m ean and
covariance o f the jo in t distribution by
M=
T hen, the conditional distribution o f Y given
X = x 0 is also m ultivariate norm al w ith new mean
m and covariance m atrix B given by
rn
B = ^2 2 ” ^21 ^1 1 ^12
Figure 1 provides a simple picture o f the setting
for the 2D case, w ith one m arket factor and one
econom ic factor.
394 Journal of Risk Management in Financial Institutions
Portfolio stress testing and conditional
scenario analytics
T he im pact o f the econom ic scenario on the
portfolio’s perform ance is calculated by sim ulating
the portfolio over the conditional scenarios
(alternatively, one m ight re-w eight the original
scenarios using the conditional distribution). As
w ith expressions (2) and (3), we obtain the conditional
expected P&L scenario and the conditional distribution:
AV0= E [A V \X = x ()]
and
FAViX(y \x J = P[AV<V|X = * J (4)
N ote that, in general, because V may be nonlinear,
the expected conditional P&L scenario, AV(), is not
equal to the P&L in the expected conditional m arket
scenario, A F(y0).
All the risk metrics, including a conditional VaR or
expected shortfall are estimated from the conditional
P&L distribution. In addition, one may want to attribute
any m etric to various positions or risk factors, and
understand possible hedges.
C O N D IT IO N A L S C E N A R IO S A N D
FACTOR C O N T R IB U T IO N S USING
P O S T-S IM U LA TIO N LSST ANALYTICS
We focus on a discrete version o f the jo in t
m odel, w here w e have a (large) set o f scenarios
S = { (x , y.), j= 1,..., m) obtained from a sim ulation
from the jo in t distribution F x y at horizon T
(as m entioned earlier, F can be completely general).
Vol. 9, 4 391 -412 © Henry Stewart Publications 1752-8887 (2016)
 A least-squares method for integrating economic scenarios with risk simulations
The key insight for our approach is that the
conditional expected market scenario, and more
generally the conditional marketfactor distribution,
can be estimated directly from the matrix of
simulated scenarios using LSR.
LSR for market risk factors
Based on the set of scenarios S, we fit a general
linear model of the form
Y—BX+ U
where
Y is the vector of market factors;
X is the vector of economic factors;
B is the matrix of sensitivities of the market
factors to the economic factors;
U is the vector of errors, with zero mean, and
assumed to be independent of (or at least
uncorrelated with) the vector of economic
factors X.
Often, the vector U is assumed to have
a multivariate normal distribution, with
covariance matrix X, but this is not necessary
in our case.
This linear model (5) is not as restrictive as it
may first appear. First, the market factors Y can
be assumed to be nonlinear functions of the linear
combination of economic factors. More generally,
Y can also depend on linear combinations of nonlinear
functions of the economic factors, simply by adding
these as new explanatory variables in the regression
(as an example, consider the case where each factor
is first transformed to a Normal variable — as in
N j-th scenario;
a Gaussian copula setting—Y. =jLtPikXk+ Uj with
%=O-' (F( Y)), Xk=A>-'(F(Xfe)), k= 1,... N.
Based on expression (5), the expected conditional
market scenario is given by
yn=E[Y\X=xJ =Bx0 (6)
Under the assumptions that the errors U are
multivariate normal with mean zero and covariance
matrix X, and independent of X, the conditional
distribution of Ygiven X —x{) is also multivariate
normal with mean y() and covariance matrix X.
When U is not normally distributed, but is still
© Henry Stewart Publications 1752-8887 (2016) Vol. 9, 4 391-412 Journal of Risk Management in Financial Institutions 395
independent of X, then the conditional distribution
of Ygiven X= x()can be calculated as
P[Y< y |X=x(|]= P[BX+ U<y\X= x()J
= P[U<y-BX|X=x()]
= P[U<y-Bx„) (7)
Expression (7) can be used to sample from the
conditional distribution of Ygiven X, for example,
when a fat-tailed distribution is used for the residuals U.
Alternatively, the errors can be sampled directly using
(5) their empirical distribution (see equations 12— 14),
thus avoiding any distributional assumptions on U.
The matrix of parameters B can be estimated in
a number of ways, including LSR and maximum
likelihood estimation. We find in practice that
it is straightforward to use ordinary least squares
regression (OLSR) to estimate the parameters
associated with each component of the vector Y
separately (alternative methods of estimation include
using econometric techniques for simultaneous
equations; eg see Ruud7 for details). That is, for each
market factor, we consider the regression equation
N
Y,=l/3ikx k+a 8
( )
(3jk is the (i, L)-th component of the matrix B.
We can write expression (8) in terms of the
simulated scenarios S={(x., y), j= 1,..., m}:
N
e))
where
y- is the value of the i-th market factor under the
xk/. is the value of the fe-th economic factor under the
j-th scenario;
U- j is the value of the i-th error under the i-th scenario.
IJ J
Parameters (3ik in equation (9) are then estimated
using OLSR on each factor separately. We denote the
estimator of /3jkby j3jk. Once the parameters have been
estimated, we can construct the regression residuals:
N
( 10)
where yi() is the estimated conditional mean:
N
(ii)
Rosen and Saunders
T he em pirical estim ator for the distribution
o f U is then given by
m AL
P[ U< u ] ~ m- ]' Zl ( u<u)
j= i
w here 1(A) is equal to one if A is true and zero
if A is false (inequalities involving vectors are
interpreted com ponent-wise).
T his is equivalent to assum ing that
P\ U=uJ=^, j = 1,
From this, the resulting conditional distribution
o f the m arket scenarios is given by
P[Y=Uj + Y0] = ^ ,
N o te that this is only an approxim ation. If
the true distribution o f U is norm al w ith m ean 0
and covariance m atrix O/, then u w ill be norm al
w ith m ean 0 and covariance m atrix <J(I — H),
w here H = X (X TX)~]X r.
LSR for portfolio P&L
In the end, we are interested in com puting the
im pact o f the econom ic scenario on the perform ance
o f the portfolio. As m entioned above, this can
be calculated by first obtaining the expected
conditional m arket scenario (or perhaps a full
conditional m arket scenario distribution) and
then sim ulating the portfolio over the conditional
scenarios. A useful alternative in practice is to
first sim ulate the portfolio over the full set o f
scenarios S, and then regress the portfolio
P&L directly against the econom ic factors:
N
A R = X bkx k 7=1,...,m
w ith estim ated residuals
ij- A V j- ifa
w here the hat indicates the O L S R estimate. Based
on the regression, we obtain the conditional expected
P&L scenario:
N
AFg= E [A V | X = x j = X
396 J o u r n a l o f R is k M a n a g e m e n t in F in a n c ia l In s t it u t io n s
as well as the conditional distribution o f the P&L:
^iibjkx k0 + Ej = ^> j= l-,m (18)
( 12) k= l
J
T here are several advantages o f regressing the
portfolio P&L directly on the econom ic factors.
First, for a given portfolio, it only requires a single
regression, rather than m ultiple regressions (or a
regression to fit a system o f sim ultaneous equations).
A lthough num erical algorithm s for O L S R are now
m (13) really efficient, this is m uch simpler and may also
result in non-trivial reductions in com putation time
for some very large problems.
Secondly, and m ore im portantly, by regressing the
(14) portfolio P&L directly on the econom ic factors, we
can com pute several conditional scenario portfolio
analytics w ith a single portfolio sim ulation, w hich
is typically the most expensive com putational step.
Also, a single sim ulation can be used to explore
different sets o f econom ic factors to fix in the
conditioning. If we wish to constrain on a different
set o f econom ic factors, then the regression is rerun
to generate a new set o f residuals, over the same
sim ulation, and thus new conditional means and
distributions are obtained.
Finally, the portfolio P&L regression also has
significant m eaning in term s o f (economic) factor
contributions to a given scenario P&L, and m ore
generally to portfolio risk measures such as V aR or
expected shortfall (see R osen and Saunders8-10 and
M eucci11). Given an econom ic scenario, X = x, the
conditional portfolio P&L can be w ritten as
N N
AF(x) = X Ck='5hbkx k (19)
k=t k=t
w here C fe are the (linear) econom ic factor
(15)
contributions. M ore generally, if the portfolio
loss is w ritten as the sum o f its com ponents
n
L = h k
(i6) k=i
then, under regularity conditions on the random
variables involved (see, eg, M cNeil, Frey and
Em brechts12), the contributions o f the fc-th com ponent
to value at risk and expected shortfall are given by
(ly )
C ^ R= £ [L JL = V aR ], C f s —E[Lk \L> VaR]. (20)
Vol. 9, 4 391-412 © Henry Stewart Publications 1752-8887 (2016)
 A least-squares method for integrating economic scenarios with risk simulations
Setting, L = —A K we can estim ate the risk
contributions o f the fe-th econom ic risk factor
using the regression results:
1 techniques.13 We discuss the application o f these
,-V aR. ES
— ^ b £ xkj (21)
W
where j* is the VaR scenario, and m' is the total
num ber o f scenarios in w hich losses exceed VaR.
Heteroskedasticity
A n im p o rtan t add itional assum ption o f the
L S R m odel is th at the variance of the errors
around the regression surface is everywhere the same, ie
V(Uj = V(Y|X) = (J 2. In this case, we refer to the
errors in the regression as homoskedastic. T he situation
w here the variance o f the errors depends on the
level o f the independent variables X is referred to as
heteroskedasticity. N on-constant error variance does
not cause biased estimates, but it does pose problems
for efficiency, and the usual formulas for standard
errors o f the estimates are less accurate. Essentially,
in this case, OLS estimates are inefficient because they
give equal w eight to all observations regardless o f
the fact that those w ith large residual errors contain
less inform ation about the regression. Standard
econom etric tests for heteroskedasticity include the
W hite test and the Breusch—Pagan test (see, eg, R uud7).
T he presence o f heteroskedasticity does not
in general cause large problems for obtaining
conditional expected scenarios, but it does have
an im pact w hen we are concerned w ith the full
conditional scenario distributions.
T here are several ways to correct for
heteroskedastic errors in the regression. First, one
can add m ore independent variables or transform
both the dependent and independent variables
w ith nonlinear functions. Secondly, there are some
techniques such as weighted L S R to correct for this
(eg R u u d 7). Thirdly, we may w ant to account for
the fact that the conditional variance is not constant
in the m odel, and perhaps adjust the variance o f
the error distribution conditional on the specific
econom ic scenario (for example, by looking at the
variance surrounding that scenario, through the
n closest points or the points w ithin a given radius).
Finally, particularly for the one-dim ensional case
© Henry Stewart Publications 1752-8887 (2016) Vol. 9, 4 391-412 Journal of Risk Management in Financial Institutions 397
o f the portfolio P&L, an alternative technique
to O L S R w hen one is interested in obtaining
specific conditional quantiles or the full conditional
scenario distribution is the use o f quantile regression
techniques in a follow-up paper.
EXAMPLE
The portfolio
Consider a typical US$-based m ulti-asset portfolio
w ith positions in equities (EQ), rates (IR) and credit
(CR) in four currencies: US$, € , GBP and JPY.
Portfolio exposures are sum m arised in Figure 2. Its
m ark-to-m arket (MtM), as o f 28th April, 2015, is
US$458m , w ith US$568m in long and US$110m in
short positions. H a lf o f its M tM is in EQ, w ith the
rest split equally betw een IR and C R . In term s o f
currency exposure, alm ost 60 per cent is US$, with
32 per cent in € and just under 5 per cent for each
o f GBP and JPY. T he US E Q portfolio accounts
for alm ost a third o f the exposure, w ith diversified
positions across sectors w ith the highest exposure in
Energy (20 per cent). T he IR portfolio is long US
and G erm an G overnm ent bonds, w hile the CDS
portfolio has lo ng-short strategies w ith high-yield
and investm ent-grade single-nam e CDSs and indices
(portfolio calculations perform ed by S&P Capital
IQ Portfolio R isk; for illustrative purposes only).
Figure 3 provides a sum m ary o f the risk o f the
portfolio, m easured as 99 per cent V aR over one
m onth, and the risk contributions (stand-alone and
m arginal VaR contributions). T he EQ portfolio
accounts for half o f the exposure but almost tw o-
thirds o f the portfolio risk, w ith US E Q constituting
m ore than h alf o f this contribution (37 per cent).
In term s o f currency, US$ positions contribute
slightly m ore than h alf o f the risk, w hile € positions
contribute about 40 per cent, despite being only
32 per cent o f the portfolio exposure. T he C R
portfolio, although in principle m ore risky than
the IR portfolio, seems reasonably well hedged,
and only contributes to the total risk by 3 per cent
m ore than IR . Looking deeper into US EQ , Energy
contributes alm ost 30 per cent o f the risk (with
about 20 per cent o f exposure), and Industrials are
the second risk contributor at over 17 per cent (with
only 12 per cent o f exposure, about the same level
Rosen and Saunders

U S $ (M illio n )
NMV Long S h o rt NMV US$ € GBP JPY T otal
Portfolio 457.5 567.8 110.3 EQ 32% 11% 4% 5% S2%

EQ 221.4 225.5 4.1 IR 10% 14% 24%

IR 111.2 111.2 0.0 CR 18% 7% 24%

CR 124.9 231.1 106.2 Total 59% 32% 4% 5% 100%

Portfolio 458
EQ 221
US Equities
US EQ 136 Telecom, Utilities, 1% Consumer Disc, 7%
Materials, 0%
EU EQ 48
Information
6 8 EQ 16 Technology,
10%
JP EQ 22

IR 111
US$ 6 0 V 52

€ SOV 59

CR 125
US IG 70

US HY 60

EU HY 32

US CDS -38

Figure 2: Portfolio exposures

Key: NMV: net market value; EQ: equities; IR: interest rates; CR: credit; IG: investment grade; HY: high yield; CDS: credit default swap

uss EUR GBP JPY Total

EQ 37% 21% 4% 2% 65%

IR 3% 13% 16%

CR 13% 7% 19%

T ota l 53% 40% 4% 2% 100%

Portfolio 458 22,3 22.3

• NMV
EQ 221 17.1 14.4 ■ VaR
US EQ 136 11.5 8.3
EU EQ 48 6.2 4.6
UK EQ 16 1.5 1.0
JP EQ 22 2.7 0.6
IR 111 6.3 3.6
US$ GOV 52 2.4 0.7
EUR SOV 59 4.6 2.9
CR 12S 6.5 4.3
USIG 70 2.1 0.8
US HY 60 3.4 2.0
EU HY 32 2.1 1.5
US CDS -38 1.9 0.0
C°

Figure 3: Portfolio risk and risk contributions (VaR 99 per cent, one month)
Key: NMV: net market value; VaR: value-at-risk; EQ: equities; IR: interest rates; CR: credit; IG: investment grade; HY: high yield;
CDS: credit default swap

398 Journal of Risk Management in Financial Institutions Vol. 9, 4 391-412 © Henry Stewart Publications 1752-8887 (2016)
 A least-squares method for integrating economic scenarios with risk simulations

Table 1: Global economic scenario (one year)

Global scenario USA Eurozone UK Japan
Real GDP (% change) 3 1.5 2.8 0.8
Inflation (% change) -0.3 -0.3 0.1 0.4
IR short 0.3 0.1
IR long 2.3 0.3 - -
FX - 0.9 0.7 120.0
Key: IR: interest rates; FX: foreign exchange; GDP: gross domestic product

as Financials, H ealthcare and Telecom and below
C onsum er Staples).
The economic report and economic
scenarios
Suppose that the analysts just reviewed a new
series o f econom ic research reports (S&P econom ic
research, C redit W eek, 22nd April, 2015) from
which they draw a set o f future scenarios on the
global economy, in general, and the US econom y
specifically. We w ould like to understand how our
portfolio w ill react if these conditions unfold over
the next year. We focus on four econom ic scenarios:
• A global econom ic scenario.
• T hree US outlook scenarios.
Global economic outlook scenario
T he global scenario describes how the global economy,
after being hit in 2008 by the worst financial crisis
and recession since the Great Depression, had
started to expand again by mid 2009, and has been
expanding ever since. Econom ists expect the global
econom y to continue to grow, w ith about 3.5 per
cent real G D P grow th in 2015 and 3.9 per cent the
follow ing year. All o f this is despite a continuing
slowdown in C hina, w hile the USA, the Eurozone,
Japan and India all grow faster. T he overall picture
draws on the positives for global grow th resulting
from the decline in oil prices, the inform ation
technology revolution, the European C entral
B ank’s quantitative easing program m e and the
Federal R eserve’s caution and norm alisation o f
m onetary policy.
O f the large num ber o f econom ic variables in the
forecast (about 120), we focus on a reasonable subset
of 15 factors that are relevant to our portfolio, as
shown in Table 1. For example, Eurozone interest
rates are forecast to go dow n in 2015 from their 2014
levels, w hile the actions o f the US Federal R eserve
will result in the policy rate being raised, although
the ten-year yield stays at 2.3 per cent, below its
2014 level. G D P grow th is expected to increase to
3 per cent in the USA (from 2.4 per cent in 2014),
w h ile g ro w th in the E urozone and Japan is also
expected to increase to 1.5 per cent and 0.8 per cent,
respectively (from u n d er 1 per cent and m inus
0.1 per cent last year).
US economic outlook scenarios
A ccording to the research re p o rt on the US
economy, its grow th prospects rem ain favourable.
Still, given a slightly softer than expected start to
2015, econom ists lowered their forecast for GDP
grow th from 3.3 per cent to 3 per cent. At the time
o f the report, it seemed plausible that the Federal
R eserve w ould raise rates for the first tim e in almost
ten years. Based on this econom ic analysis, the
report presents three scenarios (Base, U p and Down)
on over 30 econom ic variables. For this example,
we construct scenarios based on a manageable set
o f seven econom ic factors. In addition to GDP,
inflation and IRs, w hich are in the Global scenario,
we include unem ploym ent, a m arket index (S&P500)
and oil prices. Table 2 presents these three econom ic
scenarios. For example, GDP grows at about 3 per cent
in the Base scenario, increases by 3.4 per cent in
the Up scenario, and grow th is merely 2.1 per cent
in the D ow n scenario. T he S&P500 is projected
to grow betw een 7.6 per cent and 10 per cent.
Also note that the D ow n scenario has an 8.5 per cent
equity g ro w th , w hich is h ig h er than the Base
scenario. A lthough perhaps counterintuitive, this is

© Henry Stewart Publications 1752-8887 (2016) Vol. 9, 4 391-412 Journal of Risk Management in Financial Institutions 399
Rosen and Saunders
Table 2: US economic scenarios (one year)
US scenario Up
Real GDP (% change) 3.4
Inflation (% change) -0.3
Unemployment (%) 5.4
IR short 0.4
IR long 2.4
S&P500(%) 10.0
Oil (US$/bbl, WTI) 50.12
Key: GDP: gross domestic product; IR, interest rates; bbl: barrel; WTI: west texas intermediate
a consequence o f the econom ists’ m odel showing
that the w eaker than expected econom ic conditions
in the D ow n scenario cause the Federal R eserve
Fund R ates to rem ain at zero well into 2017, and
this drives the stock m arket levels higher than in the
baseline case.
The jo in t fa cto r sim ulation m odel
We now construct a sim ulation m odel for the jo in t
future evolution o f the m arket factors affecting
the portfolio P&L and the econom ic factors. This
statistical model helps us translate the econom ic
forecast scenarios into m arket scenarios, w hich we
can use to simulate our investm ent portfolio and
understand its risk.
T he m odel is estim ated using quarterly data for
all the factors over about 20 years. It has a total o f
18 econom ic factors (Tables 1 and 2) and 38 m arket
factors, w hich include 13 E Q factors (10 USA,
1 Europe, 1 U K and 1 Japan); IR curves in US$
and € (8 points each); bond spreads in US$ and €
(IG and HY); CDS spreads in US$ (HY and IG);
and FX rates in € , GBP andJPY .
This jo in t factor m odel consists o f tw o
com ponents (we use in this example a simple, but
rich enough m odel to highlight the benefit o f the
LSST methodology):
• Marginal risk factor processes. Based on each
individual factor’s time series, we construct a
statistical model for its m arginal processes. We
use A R M A -G A R C H models to filter the series
and rem ove autocorrelations, etc. Although
perhaps m ore sophisticated models can be
used in practice, this suffices to generate a rich
400 Journal of Risk Management in Financial Institutions
Base Down
3 2.1
-0.3 -0.4
5.4 5.8
0.3 0
2.3 2.1
7.6 8.5
50 48.56
enough m odel for this example, and highlights
the m ain advantages o f the conditional scenario
m ethodology.
• Co-dependence structure of residuals. After each
factor’s process is estimated, we m odel their
co-dependence structure non-param etrically
using the historical residuals directly. W ith
56 factors and 20 years o f quarterly data, the
factor co-dependence is described by a matrix
o f residuals consisting o f 80 rows (80 quarters)
and 56 columns.
W e avoid the typical assum ption o f Gaussian
residuals to generate m ore m ean in g fu l stress
scenarios. T h e historical (non-param etric)
residual co-dependence allows us to capture both
non-norm al m arginal distributions w ith fat tails, as
well as m ore complex tail dependence. O f course,
w hen the num ber o f m arket factors becomes too
large, some dim ensionality reduction may be
necessary.
Figure 4 depicts the correlation m atrix implied
from the historical residuals. In general, the
correlations betw een the econom ic factors are
not as strong, except perhaps for the E Q index
and long rates, G D P and O il, and a negative
correlation betw een G D P and U nem ploym ent,
as expected. In contrast, the correlations betw een
the m arket factors are higher. T he low er left side
o f the m atrix gives the correlations betw een
the m arket and the econom ic factors, w hich are
generally not very strong. As expected, we can
see, for example, that Long R ates are positively
correlated to E Q and negatively to CDS spreads,
and O il Prices have strong correlation to Energy
E Q returns.
Vol. 9, 4 391-412 © Henry Stewart Publications 1752-8887 (2016)
 A least-squares method for integrating economic scenarios with risk simulations

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F ig u re 4: Correlation matrix of historical factor residuals

Finally, w ith the calibrated m odel, we obtain a
large num ber (say 1,000 to 10,000) o fjo in t scenarios
for the econom ic and m arket factors, using M onte
Carlo m ethods that simulate A R M A -G A R C H
processes and random ly sample from the jo in t
residuals. As specified by the econom ic scenarios,
we ru n the sim ulation for a one-year horizon, by
sim ulating four quarterly steps for each scenario.
A lthough we have a small num ber o f quarterly
residuals (80), we can generate a large num ber o f
distinct yearly scenarios (almost 41 m illion). As an
example, Figure 5 plots the jo in t quarterly residuals,
as well as 1,000 sim ulated yearly scenarios, for
2D projections o f € vs. US$ Long Rates, and for
GDP vs. U nem ploym ent. In general these scenarios
are stored in a m atrix o f 56 colum ns (the num ber
o f econom ic and m arket factors) and 1,000 rows
(the num ber o f scenarios).
Conditional scenarios
We cannot obtain analytical closed-form expressions
for either the jo in t factor d istrib u tio n or for the
conditional scenarios u n d er this fairly rich (but
still quite simple) factor m odel setting. H ow ever,
as m entioned earlier, the LSST m ethodology
can be applied in a straightforw ard way w ith the
p re -co m p u ted jo in t scenarios on the econom ic

© Henry Stewart Publications 1752-8887 (2016) Vol. 9, 4 391 -412 Journal of Risk Management in Financial Institutions 401
Rosen and Saunders
Historical Residuals
US GDP-Unemployment
Simulated Returns 1 Year
US GDP-Unemployment
y = - 3 .2 7 1 9 x - 0 .0 4 5 5
a
cc
o>
c 0.05
o -
DC
3
LLl
Figure 5: Joint economic and market factor scenarios (2D projections)
Key: GDP: gross domestic product
and m arket factors, as simulated from the model.
Figures 6 and 7 show the expected conditional
market scenarios for the Global and US Econom ic
O u tlo o k , respectively. For sim plicity, the
scenarios are expressed in standardised form , ie
as the num ber o f standard deviations from their
expected value.
In the global economic expected scenario (Figure 6)
most US E Q sectors move up m arkedly (some
by one standard deviation) as a consequence o f
beneficial econom ic conditions. However, Energy
increases only m arginally, largely due to oil prices
rem aining quite low in the forecast. C redit spreads
tend to tighten, but the im pact is less clear for IR s
in the figure, because the scenarios are expressed in
standardised form (but essentially we know that the
long end o f the US$ IR curve is at about 2.3 per cent
and the short end at 0.3 per cent).
402 Journal of Risk Management in Financial Institutions Vol. 9, 4 391-412 © Henry Stewart Publications 1752-8887 (2016)
Historical Residuals
Long Rates US-EUR
Simulated Returns 1 Year
Long Rates US-EUR
6.04
y = 0.669X - 0 .0 0 0 4
R2 = 0.68138 0.03
0 .0 ?
0.04 0.03
-
— 0.04
US Long Rate
In the US econom ic outlook scenarios, almost
all equity sectors are up in the Base (from their
expectation, w hich is generally positive) except
for Energy, Utilities and C onsum er Staples. C redit
spreads tend to decline w hile the IR term structure
rises. T he Up scenario, as expected, essentially
amplifies these effects, but not drastically. In
contrast, the D ow n scenario is a bit m ore complex.
Equity returns for some sectors (eg Telecom) are
above their m ean and for others (Energy) they are
below. IR changes are generally less than expected
for the short end o f the curve, but they are positive
and lower for the long end o f the curve. This is
quite consistent w ith the earlier explanation o f
the scenario.
O ne can understand better these conditional
scenarios by visualising simple 2D projections o f
the jo in t scenarios, the regression and the resulting
 A least-squares method for integrating economic scenarios with risk simulations

1.00

0.80

0.60
C
■ Base
0.40 1 - 1 _ a J I ......................- ■ ....
i l l
0.20 1 i « i l
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^ ^
S' S' S'
o o ^P ^p ,-P
& & & o & ° o/ • o■
k / k/ kj k/ /.-o / A

EUR
IR & CR

Figure 6: Global economic outlook — expected conditional market scenario

Key: EQ: equities; CR: credit; IR: interest rates; FX: foreign exchange

Figure 7: US outlook — expected conditional market scenarios

© Henry Stewart Publications 1752-8887 (2016) Vol. 9, 4 391-412 Journal of Risk Management in Financial Institutions 403
Rosen and Saunders
US Rate Long
Figure 8: US outlook — expected conditional scenarios (2D projections)
conditional distributions. For example, Figure 8
shows the projections o f the conditional scenarios for
a given EQ index (Industrials) against an econom ic
factor (US Long Rate). T he figure depicts both
the expected conditional scenario, as well as the
full conditional distribution for each o f the three
US econom ic outlook scenarios. (We point out
that m ost o f the factor regressions do not pass the
hom oskedasticity tests. A lthough, as m entioned
earlier, the expected conditional scenarios are not
affected strongly by this, the conditional factor
distributions are not expected to be accurate and are
only shown here for illustration purposes.)
C onditional scenarios can be very sensitive to the
econom ic variables included in the forecast or view.
T he LSST m ethodology allows a quick assessment
o f this im pact, w ith out having to re-sim ulate the
original unconditional scenarios. Take, for example,
the global outlook scenario, w hich originally
included 15 econom ic variables (Table 1). W e add
first the price o f O il to the forecast and then the US
404 Journal of Risk Management in Financial Institutions Vol. 9, 4 391-412 © Henry Stewart Publications 1752-8887 (2016)
US Rate Long
E Q Index (as given in the US outlook Base scenario
in Table 2), and then re -ru n the LSR to obtain new
conditional scenarios on the m arket factors. Figure 9
compares the expected conditional scenarios for
these three cases. Adding O il Prices to the forecast
does not affect the conditional scenario much.
However, adding in the E Q Index (which is highly
correlated to m any o f the m arket factors) affects the
scenario quite drastically. T he expected conditional
scenario becomes less bullish on equity prices, w ith
correspondingly higher credit spreads, but does not
affect IR s or FX much.
Portfolio simulation and analysis
Finally, we analyse the im pact o f the conditional
scenarios on the portfolio. To recap, the full process
essentially covers the following:
• R u n n in g a M onte Carlo (MC) sim ulation w ith,
say, 1,000 jo in t scenarios on the econom ic and
m arket factors.
 A least-squares method for integrating economic scenarios with risk simulations

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© Henry Stewart Publications 1752-8887 (2016) Vol. 9, 4 391-412 Journal of Risk Management in Financial Institutions 405
Rosen and Saunders

NMV VaR P&L Global Rel. $US P&L Global

NMV
( $ USM ) (Annual) Mean Scenario Return Million M ean Scenario

Portfolio 457.5 16 . 0 % 3.7% 8 . 1% 4 .4% P o rtfo lio 458 15.9 37.0

EQ 221 14.5 37.8

EQ 221.4 29 . 0 % 6 .7 % 17 . 1% 10 . 4 %
US EQ 136 9.7 22.1
EU EQ 48 2.6 9.8
IR 111.2 14 . 4 % 1 . 6% - 0 . 1% - 1 . 8%
GB EQ 16 0.8 1.8
CR 124.9 16 . 8 % 0 .4 % - 0 . 5% - 0 .8% JP EQ 22 1.3 4.1
IR 111 1.5 - 0.1
US$ G O V 52 0.3 - 0.7

EURSOV 59 1.3 0.6

CR 125 - 0.1 - 0.6
US IG 70 - 0.1 - 1.0

US HY 60 - 0.6 0.2
EU HY 32 0.4 1.1
US CDS -38 0.2 - 1.0

Figure 10: Portfolio P&L — expected global outlook scenario

Key: NMV: net market value; VaR: value-at-risk; P&L: profit and loss; EQ: equities; IR: interest rates; CR: credit

• Simulating the portfolio over these scenarios
and calculating P&Ls for the portfolio (and all
sub-portfolios) — this allows the ‘unconditional’
P&L portfolio distribution over one year to be
obtained, which we can also use as a basis to
understand the impact o f the stress tests.
• Creating the expected conditional scenarios for each
o f the four economic scenarios in the report.
This is done by applying the LSST methodology
on the generated scenario matrix.
• Simulating the portfolio directly over these
scenarios, and analysing the portfolio.
• Alternatively, also applying a LSR directly on the
portfolio simulated P&L values (in the unconditional
distribution), as explained earlier, to obtain the
expected conditional portfolio P&L, and also to obtain
full conditional portfolio P&L distributions. (Note
that the full conditional portfolio P&L distribution
can also be obtained by first obtaining a new set of
conditional scenarios from the factor LSR (using the
full residuals from the regressions) and re-simulating
the portfolio in each of these. This is computationally
much more costly.)
• Putting it till together to understand the impact on
the portfolio.
To begin, we look at the global outlook scenario,
which sets views on GDP, inflation, short and long
IRs and FX in the USA, Europe, UK and Japan.
Figure 10 gives the impact of the scenario on the
portfolio P&L, and contrasts it to the portfolio’s
mean P&L over the horizon and its annual VaR
(99 per cent). The global outlook scenario produces
an excess return of 4.4 per cent over the mean,
with most of it coming from the EQ portfolio,
and almost two-thirds o f this from the US EQ
portfolio alone. Both the rates and credit portfolios
have negative excess returns. The table on the
right side further breaks dow n the scenario
returns into the underlying sub-portfolio
contributions.
Figure 11 shows the impact on the Portfolio P&L
as we add additional economic variables to the global
outlook scenario (Oil Prices and the EQ Index).
As shown in Figure 9, adding Oil to the forecast
does not substantially alter the scenario itself, and
hence has a small impact on the portfolio. However,
adding the EQ Index results in much lower
expected portfolio returns, with most o f the return
coming from the EQ portfolio, as expected. At First
glance, the scenario does not significantly affect

406 Journal o f Risk Management in Financial Institutions Vol. 9, 4 391-412 © Henry Stewart Publications 1752-8887 (2016)
 A least-squares method for integrating economic scenarios with risk simulations

Portfolio P&L - Conditional Expected Scenario

Global Outlook

40.00
35.00
30.00
25.00
20.00
15.00
10.00
5.00
0.00
-5.00

0.80 Rates Portfolio USD-GOV EUR-SOV

0.60
0.40
Credit
0.20
Portfolio
m USS-IG
- 0.20 US$-HY
-0.40 EUR-HY
Credit
-0.60 Default
-0.80
Global Global + oil Global + oil + S&P 500

Figure 11: Effect of scenario variables on expected conditional portfolio P&L — global outlook scenario
Key: EQ: equities; IR: interest rates; CR: credit; IG: investment grade; HY: high yield

the positions in the Rates or the C redit portfolios.
A m ore in -d ep th look at the sub-portfolios shows
a m ore intricate story. T he scenario has opposing
effects on the US$ and the € R ates portfolios, w hich
cancel each other, because rates in the USA tend
to increase and are lowered for the € . For the C R
portfolio, the opposing effects o f the H Y and IG
positions hedge each other in the scenario.
Figure 12 shows the US outlook expected
conditional scenarios for the U S E Q portfolio, as
well as the (unconditional) m ean P&L. W e focus
now on this portfolio, as it dom inates the results.
T he portfolio, w ith an N M V o f US$136m, has an
(unconditional) m ean P&L o f alm ost US$10m and
V aR o f US$35m . T he three US outlook scenarios
result in a P&L range o f US$12m to US$15m, all
above the mean P&L. The bottom graph in Figure 13
drills d o w n to th e sector P&L con trib u tio n s
(in the m ean scenario as w ell as the th ree U S
outlook scenarios). W hile Energy has a large P&L
contribution o f alm ost US$4m to the (unconditional)
mean scenario, Industrials and Inform ation Tech are
essentially m ore dom inant in the three US outlook
scenarios. This, o f course, suggests some possible
portfolio rebalancing, if w e believe these forecasts
and w ant to take some advantage o f them.
In addition to the expected conditional scenario
P&Ls, we can com pute the full conditional
scenario P&L distributions. Table 3 summarises
the C onditional VaR (99 per cent) for the three
US outlook scenarios and compares them to the
unconditional num bers. T he U nexpected Loss
(UL) defines the worst possible deviation from the
mean at a 99 per cent confidence level (the VaR
m inus the expected P&L). For comparability, we
express the V aR as P&L, so that negative values
correspond to losses. T he U L o f US$1 lm is the
same in all three outlook scenarios, and m uch lower
than the unconditional one o f nearly US$45m .
U nder the LSR assum ption o f homoskedasticity,
the distribution around the m ean loss is the same
under every scenario, once we define the fixed

© Henry Stewart Publications 1752-8887 (2016) Vol. 9, 4 391-412 Journal of Risk Management in Financial Institutions 407
Rosen and Saunders
4.00
Figure 12: Expected conditional US EQ portfolio P&L — US outlook scenarios
Key: VaR: value-at-risk; Cons Disc: Consumer Discretionary
economic factors. The variance of this distribution
also decreases as variables are added to the forecast,
hence, the large difference from US$45m to US$1 tm.
Also note that, at the 99 per cent level, all three
outlook scenarios generate a profit!
Figure 13 further shows the impact of the
variables included in the scenarios. We progressively
remove the EQ Index and the Rates from the
forecast. The bar chart shows the expected
conditional scenario for all cases under the Base,
Up and Down scenarios as well as the conditional
UL. It also contrasts these to the unconditional
mean P&L and UL (the equivalent to not having
408 Journal of Risk Management in Financial Institutions
a Cons Disc
a Cons Staples
s Energy
□ Financials
□ Health Care
m Industrials
s Info Tech
■ Materials
□ Telecom
a Utilities
any variables in the forecast). Removing the EQ
Index from the conditioning variables results in
substantial positive additional returns in the Base and
Up scenarios, but almost no impact on the Down
scenario. Removing both the S&P500 and Rates
(thus leaving only GDP, Inflation, Unemployment
and Oil Prices), leaves the Base and Up scenarios
almost unchanged, but reduces the P&L in the
Down scenario, because the forecasts essentially
reflect slightly more bullish views. Finally, the
conditional variance and UL increase when variables
are removed from the forecast. (Much as the R 2 of a
regression always increases when more explanatory
Vol. 9, 4 391-412 © Henry Stewart Publications 1752-8887 (2016)
 A least-squares method for integrating economic scenarios with risk simulations

Base Up Down Ul

Figure 13: Effect of scenario variables on expected and unexpected conditional US EQ Portfolio P&L — US outlook scenarios
Key: UL: unexpected loss

Table 3: Expected and unexpected conditional portfolio P&L — US outlook scenarios

Scenario Mean P&L Unexpected P&L VaR
Unconditional 9.7 44.7 -35.0
Base 11.8 11.4 0.4
Up 15.3 11.4 3.9
Down 12.4 11.4 1.0
Key: P&L: profit and loss; VaR: value-at-risk

variables are added, C onditional UL always decreases
as m ore econom ic variables are fixed (and these
variables explain m ore o f the portfolio returns).
This observation depends on the assumption o f
hom oskedasticity o f the errors.) As we remove the
E Q Index and then also R ates, the conditional
UL increases from US$10m to U S$30m to US$37m.
At this point, the rem aining econom ic factors have a
smaller effect on the volatility o f the m arket factors.
T h e US outlook scenarios look quite optim istic
and do not produce any portfolio losses at the
99 per cent level (including the D ow n scenario).
As part o f a risk analysis, a fund m anager may
in addition w ant to look at dow nside econom ic
scenarios com ing, for exam ple, from regulators,
w ho have dedicated substantial efforts to understand
possible dow nfall scenarios. We test the portfolio
against the com prehensive capital analysis and
review (C C A R ) 2015 Adverse scenario,14 applied
to the same econom ic variables. C C A R scenarios
produced by the US Federal R eserve were originally
designed for regulatory stress tests for bank holding
companies w ith US$50bn or more o f total consolidated
assets. C C A R provides three scenarios: Baseline,

© Henry Stewart Publications 1752-8887 (2016) Vol. 9, 4 391-412 Journal o f Risk Management in Financial Institutions 409
Rosen and Saunders
Real GDP (% change) 0.3 30.00
Inflation (% change) 4.0 2 0 .0 0
Unemployment (%) 7.3
10.00
IR Short 2.6
IR Long 4.6
- 10.00
S&P 500 (% change) - 2 0 .5
- 20.00
Oil ($/bbl, WTI) 90.00
-30.00
* Approximate
Figure 14: Conditional expected market scenarios from CCAR Adverse economic scenario and US outlook scenarios — US EQ portfolio P&L
Key: GDP: gross domestic product; IR: interest rates; bbl: barrel; WTI: west texas intermediate; S&P: standard and poors
Adverse and Severely Adverse, on 28 variables,
including economic activity, unemployment, exchange
rates, prices, incom es and interest rates. T he
Baseline scenario is sim ilar to average projections
from surveys o f econom ic forecasters (not the
forecast o f the Federal Reserve), w hile the Adverse
and Severely Adverse scenarios are hypothetical
events designed to assess the strength o f organisations
and resilience to adverse econom ic environm ents.
In particular, the Severely Adverse scenario subjects
the banks to a full year o f global recession. As the
Severely Adverse scenario is a bit extrem e (eg a
60 per cent drop in equity markets), we focus on the
im pact o f the Adverse scenario on our portfolio.
Figure 14 summarises the Adverse C C A R
econom ic scenario, and contrasts the expected
conditional m arket factor scenarios that result from
fixing different sets o f variables w ith the US outlook
scenario results. T h e C C A R Adverse scenario causes
portfolio losses o f alm ost U S$30m (over 20 per cent
o f N M V ). R e m o v in g the E Q Index from the
forecast substantially reduces the losses, but losses
increase a little again w hen R ates are also removed.
Finally, a sig n ificant advantage o f the LSST
fram ew ork is its ability to provide risk factor
contributions. Essentially, on a conditional scenario,
the P&L contribution o f each econom ic risk factor is
410 Journal o f Risk Management in Financial Institutions
Adverse
Base Up Down CCAR
given by the product o f the portfolio regression beta
to the factor and the factor change in the scenario
(see equation 21). Figure 15 presents the econom ic
factor contributions (adding to a gross 100 per cent)
on the expected co n d itio n al C C A R scenarios
(for each o f the th ree sets o f variables). W h en
included, the E Q Index dom inates, accounting for
almost 80 per cent o f the loss. U nem ploym ent and
Inflation becom e m ore im portant w hen the EQ
Index is not present. Also, O il has a large positive
contribution once R ates are not included, because
the higher oil prices positively influence the energy
positions. This simple ability to allocate factor P&L
contributions provides a useful tool for im proving
the understanding o f scenario outcom es, m anaging
the risk o f the portfolio and constructing investm ent
strategies.
CONCLUDING REMARKS
LSST is a simple new approach to create m eaningful
stress scenarios for risk m anagem ent and investm ent
analysis o f m ulti-asset portfolios, w hich effectively
com bine econom ic forecasts and ‘expert’ views w ith
portfolio sim ulation m ethods. A lthough conditional
m arket scenarios can be obtained for simple jo in t
distributions such as Gaussian and Student t, LSST
Vol. 9, 4 391-412 © Henry Stewart Publications 1752-8887 (2016)
 A least-squares method for integrating economic scenarios with risk simulations
All Factors Less S&P 500
Figure 15: Factor risk contributions for CCAR Adverse econom ic scenarios — US EQ portfolio P&L
Key: S&P: standard and poors
derives conditional scenarios from a pre-com puted
sim ulation, for completely general jo in t distributions
and a large num ber o f factors, using LSR. T he
m ethodology is com putationally efficient and can be
built on top o f any existing scenario and portfolio
sim ulation risk engine, providing transparent results
that are auditable and easy to explain. It also defines
a natural decom position o f a portfolio’s perform ance
into risk factor P&L contributions, allows users to
ru n m ultiple scenarios and assumptions in real tim e,
and provides an explicit assessm ent o f m odel risk.
A lthough we focus this paper on point scenarios,
conditional scenarios w here factors are given fixed
values, LSST allows one to define m uch m ore
general views in term s o f distributional parameters
for the factors, etc. In particular one can also
naturally define conditional scenarios w here factors
are prioritised, by ru n n in g nested LSRs on a factor
hierarchy, w ith progressive orthogonal increm ental
contributions, at each level (hierarchical LSRs).
© Henry Stewart Publications 1752-8887 (2016) Vol. 9, 4 3 9 1-4 12 Journal of Risk Management in Financial Institutions 411
Less S&P & Rates
■ W R L D .O IL
a U S _ M K TJD X
0 US_RATE_LONG
a US_RATE_SHORT
□ US^UNEM PLOYM ENT
0 U S _ C P IJN F
□ US_REAL_GDP
□ INTERCEPT
Finally, the focus o f the paper has been largely
on explaining the basic concepts and m ethodology,
and show ing its application to a real-life problem
and portfolio. We have left some o f the m ore
advanced m athem atical concepts, such as dealing
w ith heteroskedasticity for the full conditional
distributions, as well as m ethodology extensions,
to a follow-up paper.
Acknowledgments
Support in the form o f a Discovery G rant from
the N atural Sciences and E ngineering Research
C ouncil o f Canada is gratefully acknowledged. T he
views expressed in this paper are solely those o f the
authors. We w ould like to thank R ob Hodgson, Ian
Buckley and Gajanan Kuganesan for their substantial
contributions to im plem enting the m ethodologies
and generating the examples.
Rosen and Saunders

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