Market Risk Stress Testing of the Portfolio in Emerging Markets

In recent years, more attention has been paid to stress testing in a broad sense, from resilience of the whole banking industry to of a traded portfolio in risk management. Emerging markets are particularly vulnerable to economic shocks, both due to the high level of correlation with developed economies and due to strong local shocks. This paper examines the effectiveness of portfolios optimized within the framework of the classical portfolio theory and consisting of emerging markets exchange-traded funds in terms of their exposure to market risk. Sensitivity analysis is employed as a stress testing model, in the context of portfolio management what narrows down to the problem of choosing the assets’ weights, since the degree of influence of an asset on a portfolio’s value in the event of a shock will depend on its share. The main hypothesis of the study is that the choice of asset weights by mean-variance optimization can lead to less efficient portfolios in terms of exposure to rare but possible extreme market events than choosing weights in simpler ways, such as “naive” diversification.