Stress Testing Arbitrage Strategies

Abstract

If risk for relative value arbitrage strategies is measured by traditional parallel stress tests, potential losses are obscured. Highly leveraged relative value strategies that rely on mean reversion for profitability are most susceptible to surprising losses. These losses are not well measured by the usual stress risk measurement means. The greater the leverage deployed to capture minor deviations from the norm, the greater the potential for these unanticipated losses. Even arbitrage strategies that seek a natural and necessary convergence between fungible or deliverable instruments can be subject to surprising mark-to-market changes along the path to convergence.