Using Venn: Apply Larger Scenario Shocks with New Regime-Based Model

Venn’s Scenario Analysis helps your organization understand the impact of market shocks on your investments and portfolios. After launching Scenario Analysis in the middle of 2019, the strongest feedback we received was to explore increasing the available shock size above and beyond 2 standard deviations.

We’re pleased to announce that we have released an extension of the Scenario Analysis feature that allows users to apply shocks up to 1.5x the maximum observed historical positive and negative monthly performance of market indices. When you add or modify a scenario on Venn, you can immediately see the newly available range. In some cases, this range is now almost 4x as large as what was previously available. In the case of the Bloomberg Commodity Index, the range for shocks is now -7.8 standard deviations (-31.9%) to +5 standard deviations (+20.7%), as highlighted below:

To support these more significant shocks, we needed to incorporate a model that could account for the changes in the factor correlation structure. Doris Bao, the lead quantitative researcher behind this effort, shared the following about our approach:

“Financial markets can experience regime changes. In normal times, it is reasonable to assume market returns will follow the same distribution, but when markets move dramatically, this assumption likely breaks down. As a result, we wanted to leverage a model that could capture different distributions of market returns across different regimes. And instead of asserting which regimes the market has, our preference was to let the data speak for itself.”

To accomplish this, we introduced a regime-based model that accounts for the changes in the factor correlation structure during extreme shocks. The model is called a “Gaussian Mixture Model” (or GMM), an unsupervised learning mechanism, to define four different regimes of the market, ranging from recessionary to expansionary. Depending on the specific shock assigned to a scenario index, the model produces the probabilities that represent how likely we are to be in each regime (e.g., if we shock an equity index by a large negative amount, the model will likely produce a very high probability for a crisis-related regime). Venn can then propagate the impact onto the factors and eventually onto a portfolio or investment, using its factor exposures.

Depending on the size of the scenario index shock, Venn leverages the original methodology and the new, regime-based methodology in different ways:

• For shocks less than two standard deviations, the original linear approach is used, which does not model changing market conditions.
• For shocks between two and three standard deviations, the two methodologies are blended.
• For shocks greater than three standard deviations, the regime-based methodology is used.
  
  

We’re excited this new capability is in your hands, and we look forward to continuing to learn about the ways that we can evolve and improve Venn to better meet your needs. If you have any feedback or questions, please feel free to reach out to us! 

This article is not an endorsement by Two Sigma Investor Solutions, LP or any of its affiliates (collectively, “Two Sigma”) of the topics discussed. The views expressed above reflect those of the authors and are not necessarily the views of Two Sigma. This article (i) is only for informational and educational purposes, (ii) is not intended to provide, and should not be relied upon, for investment, accounting, legal or tax advice, and (iii) is not a recommendation as to any portfolio, allocation, strategy or investment. This article is not an offer to sell or the solicitation of an offer to buy any securities or other instruments. This article is current as of the date of issuance (or any earlier date as referenced herein) and is subject to change without notice. The analytics or other services available on Venn change frequently and the content of this article should be expected to become outdated and less accurate over time. Any statements regarding planned or future development efforts for our existing or new products or services are not intended to be a promise or guarantee of future availability of products, services, or features.  Such statements merely reflect our current plans.  They are not intended to indicate when or how particular features will be offered or at what price.  These planned or future development efforts may change without notice. Two Sigma has no obligation to update the article nor does Two Sigma make any express or implied warranties or representations as to its completeness or accuracy. This material uses some trademarks owned by entities other than Two Sigma purely for identification and comment as fair nominative use. That use does not imply any association with or endorsement of the other company by Two Sigma, or vice versa. See the end of the document for other important disclaimers and disclosures. Click here for other important disclaimers and disclosures.