Financial Econometrics and Empirical Market Microstructure

Backtesting StressGrades

Below we show several are early warning backtesting case studies on ETF’s representing major asset classes. We calibrated DStress for each ETF based on the largest daily drawdown dates (e. g., —9.6 % for SPY on December 1, 2008). If StressGrades are predictive, we would expect an escalation in PStress and decline and DStress as we approach the drawdown date (e. g., December 1 for SPY). In other
words, we would expect volatility to be high and rising before the peak endogenous stress events.

Again, for simplicity we use the Normal Distribution to calculate PStress in the case studies below.

Given that StressGrades are driven by volatility, we expect StressGrades to fail in predicting Black Swans, but to help in detecting Dragon Kings.