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.
Bibliographical noteFunding Information:
This paper has benefited from the valuable comments of two anonymous referees, Luca Benzoni, Ravi Jagannathan, S. Viswanathan, and seminar participants at the 2006 Financial Management Association Meeting in Salt Lake City, 2006 Portuguese Finance Network Conference in Porto, and 2006 Global Finance Conference in Rio de Janeiro. Two earlier versions of this paper circulated under the titles “Portfolio Selection, Asset Pricing, and Stress Testing” and “Risk Management with Stress Testing: Implications for Portfolio Selection and Asset Pricing.” The latter version won the 2006 Financial Management Association Best Paper Award in Risk Management. Baptista gratefully acknowledges research support from the School of Business at The George Washington University.
- Asset pricing
- Financial intermediaries
- Idiosyncratic returns
- Portfolio selection
- Risk management
- Stress testing