Causal and Predictive Views and Stress Testing Article
This post contains the latest version of the Causal and Predictive Market Views and Stress Testing article by Anton Vorobets.
The Causal and Predictive Market Views and Stress Testing framework is a very powerful approach for implementing causal hypothesis about future investment market dynamics by combining Bayesian networks (BNs) with Sequential Entropy Pooling (SeqEP).
This framework is suitable for analyzing the investment risks of geopolitical events in addition to many other common cases where you wish to translate the effect of the macroeconomy into portfolio and instrument P&L.
See also Chapter 5 of the Portfolio Construction and Risk Management book as well as the Applied Quantitative Investment Management course for a detailed presentation of the Causal and Predictive Market Views and Stress Testing framework as well as Sequential Entropy Pooling.
Abstract: This article introduces a very flexible framework for causal and predictive market views and stress testing. The framework elegantly combines Bayesian networks (BNs) and Entropy Pooling (EP). In the new framework, BNs are used to generate a finite set of joint causal views/stress tests for the relevant factors of a market, while EP is used to project each of these views/stress tests over market simulations. To tie it all together, the joint view/stress test probabilities from BNs are naturally used as weights for the associated EP probability vectors to compute a single posterior probability distribution. The new framework allows us to implement market views and perform stress tests conditional on realizations of relevant market variables in a truly causal and predictive way.
Keywords: Bayesian networks, minimum relative entropy, Entropy Pooling, market views, stress testing, causality, predictiveness, Monte Carlo simulation, synthetic market generator, Python Programming Language.
Suggested Citation: Vorobets, A., Causal and Predictive Market Views and Stress Testing (May 11, 2023). Available at: https://antonvorobets.substack.com/p/causal-predictive-views-article
Video walkthrough
You can watch a video walkthrough of the Causal and Predictive Market Views and Stress Testing and its accompanying Python code below: