Stress Testing

Diffusion-Augmented Reinforcement Learning for Robust Portfolio Optimization under Stress Scenarios ArXiv ID: 2510.07099 “View on arXiv” Authors: Himanshu Choudhary, Arishi Orra, Manoj Thakur Abstract In the ever-changing and intricate landscape of financial markets, portfolio optimisation remains a formidable challenge for investors and asset managers. Conventional methods often struggle to capture the complex dynamics of market behaviour and align with diverse investor preferences. To address this, we propose an innovative framework, termed Diffusion-Augmented Reinforcement Learning (DARL), which synergistically integrates Denoising Diffusion Probabilistic Models (DDPMs) with Deep Reinforcement Learning (DRL) for portfolio management. By leveraging DDPMs to generate synthetic market crash scenarios conditioned on varying stress intensities, our approach significantly enhances the robustness of training data. Empirical evaluations demonstrate that DARL outperforms traditional baselines, delivering superior risk-adjusted returns and resilience against unforeseen crises, such as the 2025 Tariff Crisis. This work offers a robust and practical methodology to bolster stress resilience in DRL-driven financial applications. ...

Chaotic Bayesian Inference: Strange Attractors as Risk Models for Black Swan Events ArXiv ID: 2509.08183 “View on arXiv” Authors: Crystal Rust Abstract We introduce a new risk modeling framework where chaotic attractors shape the geometry of Bayesian inference. By combining heavy-tailed priors with Lorenz and Rossler dynamics, the models naturally generate volatility clustering, fat tails, and extreme events. We compare two complementary approaches: Model A, which emphasizes geometric stability, and Model B, which highlights rare bursts using Fibonacci diagnostics. Together, they provide a dual perspective for systemic risk analysis, linking Black Swan theory to practical tools for stress testing and volatility monitoring. ...

Machine Learning Based Stress Testing Framework for Indian Financial Market Portfolios ArXiv ID: 2507.02011 “View on arXiv” Authors: Vidya Sagar G, Shifat Ali, Siddhartha P. Chakrabarty Abstract This paper presents a machine learning driven framework for sectoral stress testing in the Indian financial market, focusing on financial services, information technology, energy, consumer goods, and pharmaceuticals. Initially, we address the limitations observed in conventional stress testing through dimensionality reduction and latent factor modeling via Principal Component Analysis and Autoencoders. Building on this, we extend the methodology using Variational Autoencoders, which introduces a probabilistic structure to the latent space. This enables Monte Carlo-based scenario generation, allowing for more nuanced, distribution-aware simulation of stressed market conditions. The proposed framework captures complex non-linear dependencies and supports risk estimation through Value-at-Risk and Expected Shortfall. Together, these pipelines demonstrate the potential of Machine Learning approaches to improve the flexibility, robustness, and realism of financial stress testing. ...

Systemic Risk in the European Insurance Sector ArXiv ID: 2505.02635 “View on arXiv” Authors: Giovanni Bonaccolto, Nicola Borri, Andrea Consiglio, Giorgio Di Giorgio Abstract This paper investigates the dynamic interdependencies between the European insurance sector and key financial markets-equity, bond, and banking-by extending the Generalized Forecast Error Variance Decomposition framework to a broad set of performance and risk indicators. Our empirical analysis, based on a comprehensive dataset spanning January 2000 to October 2024, shows that the insurance market is not a passive receiver of external shocks but an active contributor in the propagation of systemic risk, particularly during periods of financial stress such as the subprime crisis, the European sovereign debt crisis, and the COVID-19 pandemic. Significant heterogeneity is observed across subsectors, with diversified multiline insurers and reinsurance playing key roles in shock transmission. Moreover, our granular company-level analysis reveals clusters of systemically central insurance companies, underscoring the presence of a core group that consistently exhibits high interconnectivity and influence in risk propagation. ...

Financial Wind Tunnel: A Retrieval-Augmented Market Simulator ArXiv ID: 2503.17909 “View on arXiv” Authors: Unknown Abstract Market simulator tries to create high-quality synthetic financial data that mimics real-world market dynamics, which is crucial for model development and robust assessment. Despite continuous advancements in simulation methodologies, market fluctuations vary in terms of scale and sources, but existing frameworks often excel in only specific tasks. To address this challenge, we propose Financial Wind Tunnel (FWT), a retrieval-augmented market simulator designed to generate controllable, reasonable, and adaptable market dynamics for model testing. FWT offers a more comprehensive and systematic generative capability across different data frequencies. By leveraging a retrieval method to discover cross-sectional information as the augmented condition, our diffusion-based simulator seamlessly integrates both macro- and micro-level market patterns. Furthermore, our framework allows the simulation to be controlled with wide applicability, including causal generation through “what-if” prompts or unprecedented cross-market trend synthesis. Additionally, we develop an automated optimizer for downstream quantitative models, using stress testing of simulated scenarios via FWT to enhance returns while controlling risks. Experimental results demonstrate that our approach enables the generalizable and reliable market simulation, significantly improve the performance and adaptability of downstream models, particularly in highly complex and volatile market conditions. Our code and data sample is available at https://anonymous.4open.science/r/fwt_-E852 ...

Multi-Factor Function-on-Function Regression of Bond Yields on WTI Commodity Futures Term Structure Dynamics ArXiv ID: 2412.05889 “View on arXiv” Authors: Unknown Abstract In the analysis of commodity futures, it is commonly assumed that futures prices are driven by two latent factors: short-term fluctuations and long-term equilibrium price levels. In this study, we extend this framework by introducing a novel state-space functional regression model that incorporates yield curve dynamics. Our model offers a distinct advantage in capturing the interdependencies between commodity futures and the yield curve. Through a comprehensive empirical analysis of WTI crude oil futures, using US Treasury yields as a functional predictor, we demonstrate the superior accuracy of the functional regression model compared to the Schwartz-Smith two-factor model, particularly in estimating the short-end of the futures curve. Additionally, we conduct a stress testing analysis to examine the impact of both temporary and permanent shocks to US Treasury yields on futures price estimation. ...

Portfolio Stress Testing and Value at Risk (VaR) Incorporating Current Market Conditions ArXiv ID: 2409.18970 “View on arXiv” Authors: Unknown Abstract Value at Risk (VaR) and stress testing are two of the most widely used approaches in portfolio risk management to estimate potential market value losses under adverse market moves. VaR quantifies potential loss in value over a specified horizon (such as one day or ten days) at a desired confidence level (such as 95’th percentile). In scenario design and stress testing, the goal is to construct extreme market scenarios such as those involving severe recession or a specific event of concern (such as a rapid increase in rates or a geopolitical event), and quantify potential impact of such scenarios on the portfolio. The goal of this paper is to propose an approach for incorporating prevailing market conditions in stress scenario design and estimation of VaR so that they provide more accurate and realistic insights about portfolio risk over the near term. The proposed approach is based on historical data where historical observations of market changes are given more weight if a certain period in history is “more similar” to the prevailing market conditions. Clusters of market conditions are identified using a Machine Learning approach called Variational Inference (VI) where for each cluster future changes in portfolio value are similar. VI based algorithm uses optimization techniques to obtain analytical approximations of the posterior probability density of cluster assignments (market regimes) and probabilities of different outcomes for changes in portfolio value. Covid related volatile period around the year 2020 is used to illustrate the performance of the proposed approach and in particular show how VaR and stress scenarios adapt quickly to changing market conditions. Another advantage of the proposed approach is that classification of market conditions into clusters can provide useful insights about portfolio performance under different market conditions. ...

Modeling Inverse Demand Function with Explainable Dual Neural Networks ArXiv ID: 2307.14322 “View on arXiv” Authors: Unknown Abstract Financial contagion has been widely recognized as a fundamental risk to the financial system. Particularly potent is price-mediated contagion, wherein forced liquidations by firms depress asset prices and propagate financial stress, enabling crises to proliferate across a broad spectrum of seemingly unrelated entities. Price impacts are currently modeled via exogenous inverse demand functions. However, in real-world scenarios, only the initial shocks and the final equilibrium asset prices are typically observable, leaving actual asset liquidations largely obscured. This missing data presents significant limitations to calibrating the existing models. To address these challenges, we introduce a novel dual neural network structure that operates in two sequential stages: the first neural network maps initial shocks to predicted asset liquidations, and the second network utilizes these liquidations to derive resultant equilibrium prices. This data-driven approach can capture both linear and non-linear forms without pre-specifying an analytical structure; furthermore, it functions effectively even in the absence of observable liquidation data. Experiments with simulated datasets demonstrate that our model can accurately predict equilibrium asset prices based solely on initial shocks, while revealing a strong alignment between predicted and true liquidations. Our explainable framework contributes to the understanding and modeling of price-mediated contagion and provides valuable insights for financial authorities to construct effective stress tests and regulatory policies. ...