Stress testing by financial intermediaries: Implications for portfolio selection and asset pricing

Financial intermediaries often use stress testing to set risk exposure limits. Accordingly, we examine a model with an agent who faces stress testing constraints and another who does not. Three results are obtained. First, when there are K* binding constraints, the constrained agent's optimal portfolio exhibits (K*+2)-fund separation. Second, the effect of the constraints on the optimal portfolio is identical to that of an adjustment in the expected payoffs of the risky securities that tends to lower them. Third, a security's equilibrium expected return depends on both its systematic risk and its idiosyncratic returns in the states where the constraints bind.