Editing my question:
I have decided to use multiple factor model to model my stress test. I am using factor shock method to implement the propagation of shocks. I am doing this according to a book "Multi-Asset Investing: A Practical Guide to Modern Portfolio Management" by Yoram Lustig. According to this:
"The investor shocks any risk factor in the portfolio by a chosen amount. The adjusted returns of other risk factors are modelled through a covariance matrix based on their correlation with the shocked risk factor. Finally, the hypothetical impact on the portfolio is calculated."
I have run multiple factor regression on 5 factors against the assets in the portfolio and got the respective loadings (betas) for these 5 factors. I also have a covariance matrix of the factor returns. Now, I do not know how can I put a shock in this matrix. My question is how I design now that I shock one variable in the matrix and I get the returns of others. And then I can calculate the predicted/hypothetical return in that scenario.
PS: I cannot use Vector Auto Regression as it is not a recommended method for modelling stock returns. The question may be naive, may be I am missing some really basic point here.
Thanks for your reply!!
So I will explain a bit more of my problem. I want to perform a stress test on my portfolio of equities. So basically, I want to see the impact of shock in macroeconomic factors (e.g. 10 year interest rate) on the portfolio P&L. Theoretically, my approach is
- Obtain a set of relevant macroeconomic factors.
- Shock any one of these factors.
- Propagate this shock to other factors as the macroeconomic factors are generally correlated. Obtain the new values of factors.
- On the basis of risk model, calculate the portfolio P&L based on new set of risk factors.
So I want to know about some model or some similar thing that I can program, preferably in R, so that it becomes possible for me to do, say:
Change interest rate by -10% and see how it effects the portfolio P&L.
Thanks again Manurag