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Stress testing by financial intermediaries: Implications for portfolio selection and asset pricing

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  • Alexander, Gordon J.
  • Baptista, Alexandre M.

Abstract

Financial intermediaries often use stress testing to set risk exposure limits. Accordingly, we examine a model with an agent who faces stress testing constraints and another who does not. Three results are obtained. First, when there are K* binding constraints, the constrained agent's optimal portfolio exhibits (K*+2)-fund separation. Second, the effect of the constraints on the optimal portfolio is identical to that of an adjustment in the expected payoffs of the risky securities that tends to lower them. Third, a security's equilibrium expected return depends on both its systematic risk and its idiosyncratic returns in the states where the constraints bind.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Financial Intermediation.

Volume (Year): 18 (2009)
Issue (Month): 1 (January)
Pages: 65-92

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Handle: RePEc:eee:jfinin:v:18:y:2009:i:1:p:65-92

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Web page: http://www.elsevier.com/locate/inca/622875

Related research

Keywords: Stress testing Financial intermediaries Portfolio selection Asset pricing Idiosyncratic returns Risk management Regulation;

References

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Cited by:
  1. Alexander, Gordon J. & Baptista, Alexandre M. & Yan, Shu, 2012. "When more is less: Using multiple constraints to reduce tail risk," Journal of Banking & Finance, Elsevier, vol. 36(10), pages 2693-2716.
  2. Alexander, Gordon J. & Baptista, Alexandre M. & Yan, Shu, 2012. "Bank regulation and stability: An examination of the Basel market risk framework," Discussion Papers 09/2012, Deutsche Bundesbank, Research Centre.
  3. Alexander, Gordon J. & Baptista, Alexandre M. & Yan, Shu, 2014. "Bank regulation and international financial stability: A case against the 2006 Basel framework for controlling tail risk in trading books," Journal of International Money and Finance, Elsevier, vol. 43(C), pages 107-130.

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