This paper presents a machine learning driven framework for sectoral stress testing in the Indian financial market, focusing on financial services, information technology, energy, consumer goods, and pharmaceuticals. Initially, we address the limitations observed in conventional stress testing through dimensionality reduction and latent factor modeling via Principal Component Analysis and Autoencoders. Building on this, we extend the methodology using V ariational Autoencoders, which introduces a probabilistic structure to the latent space. This enables Monte Carlo-based scenario generation, allowing for more nuanced, distribution-aware simulation of stressed market conditions. The proposed framework captures complex non-linear dependencies and supports risk estimation through V alue-at-Risk and Expected Shortfall. Together, these pipelines demonstrate the potential of Machine Learning approaches to improve the flexibility, robustness, and realism of financial stress testing. Stress testing is a fundamental component of financial risk management, designed to evaluate the resilience of financial systems or portfolios under adverse market conditions [1]. By simulating extreme but plausible scenarios, stress tests provide insight into potential vulnerabilities, that may not be evident during normal periods of market operation. Regulatory institutions such as the Basel Committee on Banking Supervision (BCBS) [2] and the Reserve Bank of India (RBI) [3] have emphasized the critical role of stress testing in ensuring financial stability, particularly in the aftermath of global financial crises of 2008.

Value at Risk (VaR) and stress testing are two of the most widely used approaches in portfolio risk management to estimate potential market value losses under adverse market moves. VaR quantifies potential loss in value over a specified horizon (such as one day or ten days) at a desired confidence level (such as 95'th percentile). In scenario design and stress testing, the goal is to construct extreme market scenarios such as those involving severe recession or a specific event of concern (such as a rapid increase in rates or a geopolitical event), and quantify potential impact of such scenarios on the portfolio. The goal of this paper is to propose an approach for incorporating prevailing market conditions in stress scenario design and estimation of VaR so that they provide more accurate and realistic insights about portfolio risk over the near term. The proposed approach is based on historical data where historical observations of market changes are given more weight if a certain period in history is "more similar" to the prevailing market conditions. Clusters of market conditions are identified using a Machine Learning approach called Variational Inference (VI) where for each cluster future changes in portfolio value are similar. VI based algorithm uses optimization techniques to obtain analytical approximations of the posterior probability density of cluster assignments (market regimes) and probabilities of different outcomes for changes in portfolio value. Covid related volatile period around the year 2020 is used to illustrate the performance of the proposed approach and in particular show how VaR and stress scenarios adapt quickly to changing market conditions. Another advantage of the proposed approach is that classification of market conditions into clusters can provide useful insights about portfolio performance under different market conditions.

Stress testing refers to a set of methods and tools that assess the impact of an adverse scenario on a financial portfolio. An adverse scenario could, for example, be described as a downturn of macroeconomic and financial risk factors. Typically, a factor model links the risk factors with asset returns, which in turn allows to calculate the impact of the stress scenario on a portfolio. Using techniques from statistics and machine learning, we extend the universe of risk factors by aggregating existing risk factors into higher-level risk factors, such as a global risk factor, broad geographic regions or cyclical and non-cyclical industries. The methods developed also allow to evaluate the strength or weakness over time of aggregated risk factors, such as the intensity of global risk, which changes substantially over time.