The COVID-19 Impact: What if, and so what?

Much has been written and much more will be written about the 2020 COVID-19 pandemic that has shocked the world. That shock comes in 5 classic waves-denial, anger, bargaining, depression and finally, acceptance. The bargaining wave highlights a critical stage for us in Financial Risk Management and measures our regret at not undertaking certain actions. More importantly, it addresses the question, 'If only...,' or put more succinctly, 'What if...?'

I remember an essay question from school, back in 1982: 'Is there any point in worrying about what might happen?' We had a choice of six questions and I chose not to answer that one. But over the years, I have often reflected on how I would answer. The keyword is 'worrying.' Today, I would simply answer the question, 'No, but there is a point in preparing for what might happen!'

Scenario generation and stress testing have never been more critical than in today's volatile markets. There are many types of scenarios: historical, deterministic, Monte-Carlo, conditional, regulatory, macro-economic and those that capture the increasingly important climate risk. However, given the uncertainty in model inputs (for example, correlation estimates), forward-looking deterministic scenarios are the key for us anticipating and preparing for what might happen.

But how do we construct these scenarios given the uncertain future? The simple answer is, we can't. What we can try to do is predict scenarios that can impact our portfolios adversely. There have been winners and losers during this crisis. Financials, pharmaceuticals and selected retail sectors have outperformed, while transportation, leisure and construction have suffered. Importantly, these scenarios need to include both extreme events in the underlying risk factors and also reverse stress testing. Extreme events need to capture the so-called Black Swan events-large adverse movements in the underlying markets. Reverse stress testing captures the worst-case scenario that will cause the financial institution itself to default, taking into account credit exposure, liquidity and market movements.

We should see a slowdown in the impact of the coronavirus which is welcome news. We will likely see a recovery in the short term in the major stock exchanges as new cases decrease. We will see consumer confidence returning, and those industries ravaged by the pandemic will recover. Interest rates will remain low in the short term, both from economic and political pressure, while inflation worries will see a flight from the safe haven of AAA Sovereign debt into equities.

A second wave of the virus is likely to happen. Hopefully, an effective vaccine will be developed and the impact of a second wave will be minimal. Predicting, anticipating and forecasting through stress testing is a fundamental part of successful risk management. However, even with hundreds of stress tests, the question remains: 'What if, and so what?'

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Asset Management, Risk Management

Stress Testing , Scenario Testing , SS&C Algorithmics , COVID-19 , what if