Scenario Design for Macro-Financial Stress Testing

Abstract

The goal of this paper is to provide a new empirical approach to Scenario
Design for selecting a stress scenario on international Macro-Financial variables. The
Scenario Design framework is composed of a few building blocks. First, multiple scenarios on the risk factors are generated simulating a Multi-country large Bayesian VAR. Second, we take the
perspective of a representative investor who aims to select a severe yet plausible scenario
on 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 to an historical
scenario approach in terms of its ability to select a stress scenario in the eve of a rare
adverse event like the COVID-19 pandemics. We give evidence that our framework
is suitable for the selection of a proper forward-looking severe yet plausible Macro-
Financial stress scenario.

Keywords: Scenario Analysis, Scenario Design, Multi-country large Bayesian VARs, Factor mimicking portfolios, Entropy pooling, COVID-19

JEL Classification: C11, C53, G11