Historical Scenario Analysis

Historical Scenario Analysis

Historical scenario analysis is a form of backtesting that examines the risk and performance of an investment strategy at different structural breaks and structural regimes. The most common types of regime changes are from economic expansion to recessions and from high-volatility to low-volatility.

  1. High-volatility and low-volatility regimes: To illustrate this, we will use the VIX index, which gauges options implied volatility on the S&P 500 index. A five-year moving average will be computed to convert the VIX into a volatility regime indicator. The periods when the VIX is below its five-year moving average are the low-volatility regime periods.
  2. Expansions and recessions: We will use the risk parity allocation strategy that the USA created in 1993 to illustrate expansions and recessions. The beginning and end of the recession are observed in hindsight.
    Sharpe Ratio in Different Economies

These two regimes can examine the risk parity and benchmark portfolio:

  • The RP strategy is strong in a recession, while the benchmark strategy performs negatively in a recession.
  • The BM strategy struggles in low-volatility regimes, while the RP strategy performs well in both high and low volatility.
  • The BM and RP strategies have higher standard deviations in a non-recession environment.
  • The BM has lower average returns in a recession, which is indicated by excess kurtosis and negative skewness.
  • Lastly, the RP strategy also has lower average returns in the recession regime with lower kurtosis and volatility than the BM strategy.


Mark Jayden conducted a historical scenario analysis to examine the effect of regime changes on his portfolio. He observed that the portfolio had negative skewness and a fat tail to the left in a recession regime. Which of the following is the conclusion that Jayden will most likely make about the his portfolio?

  1. Lower average returns.
  2. Higher average returns.
  3. Cannot be determined.


The correct answer is A.

Excess kurtosis and negative skewness indicate lower average returns in a recession regime.

B is incorrect. Low kurtosis and positive skewness indicate a higher average return in a recession regime.

C is incorrect. It can be determined that excess kurtosis and negative skewness indicate lower average returns.

Reading 42: Backtesting and Simulation

LOS 42 (e) Evaluate and interpret a historical scenario analysis.

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