Stress testing in non-normal markets via entropy pooling

The authors introduce a novel approach to stress testing portfolios of financial assets. The technique extends the parametric entropy pooling approach to skewed and thick-tailed markets. An illustration with a portfolio of European options is presented

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The combination of trading signals, or general views on the market, within a prior risk model to compute an optimal allocation that incorporates these views is one of the main challenges in quantitative portfolio construction. Similarly, embedding stress tests in a risk model in a statistically sound way is key to a healthy risk management process.