Stress Testing

Definition

Stress testing applies severe assumptions to model how a strategy may behave during extreme market dislocations. It often focuses on nonlinear risks: forced deleveraging, widening spreads, margin calls, redemption pressure, and impaired liquidity. Stress tests can be quantitative models, qualitative assessments, or a combination. Allocator Context Institutional allocators use stress testing to prevent “unknown unknowns” from dominating outcomes. Stress testing is especially relevant for leveraged strategies, strategies with embedded optionality, and funds with redemption features that can create liquidity mismatch. Decision Authority Stress testing outputs influence risk budgeting and committee comfort. If stress testing suggests that a strategy could breach risk limits, create liquidity strain, or trigger governance events, approval thresholds rise and ticket sizes shrink. Why It Matters for Fundraising Managers should show how stress is managed operationally: liquidity buffers, leverage limits, diversification, hedging policy, and governance escalation procedures. The allocator is evaluating whether the manager can survive stress without breaking mandate discipline. Key Takeaways Focuses on tail risk and operational stress points Particularly important for leverage and liquidity mismatch Drives sizing and approval decisions Strong controls matter more than optimistic outcomes