Forecasting Portfolio Risk in Normal and Stressed Markets

The instability of historical risk factor correlations renders their use in estimating portfolio risk extremely questionable. In periods of market stress correlations of risk factors have a tendency to quickly go well beyond estimated values. For instance, in times of severe market stress, one would expect with certainty to see the correlation of yield levels and credit spreads go to -1, even though historical estimates will miss this region of correlation. This event might lead to realized port...