Financial Econometrics and Empirical Market Microstructure

Adaptive Stress Testing Framework

This model of systemic crises leads us to propose our Adaptive Stress Testing frame­work, which is driven by the integration of top-down and bottom-up perspectives:

I. Macro: Identify potential risks (e. g., hidden fault lines). Build a Stress Library by harnessing the intelligence of visionary thought leaders (Innovators) who perceive risks in their potential form, while they are still dormant and hidden. An example of an Innovator is Robert Shiller, who warned of the U. S. technology stock bubble in 1999 and the U. S. housing bubble in 2005.

II. Micro: Monitor visible risks in financial markets (e. g., tremors). Build Stress Indices for each macro scenario using key market factors, and monitor early warning signals (e. g., outliers).

Macro and micro perspectives are interdependent and inform each other. At the macro level, we expand our horizons with potential risks perceived by Innovators. Given that innovators are ahead of their time, however, trading based on their views is often a losing proposition. We therefore monitor confirmation that a theme has been adopted by the marketplace, and transitioned from potential to visible risk. In summary, (a) tap the social marketplace to identify a wide range of scenarios, and (b) then hone in on emerging scenarios before critical points are crossed.

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