Correlation scenarios and correlation stress testing

Arbeitspapier

We develop a general approach for stress testing correlations of financial asset portfolios. The correlation matrix of asset returns is specified in a parametric form, where correlations are represented as a function of risk factors, such as country and industry factors. A sparse factor structure linking assets and risk factors is built using Bayesian variable selection methods. Regular calibration yields a joint distribution of economically meaningful stress scenarios of the factors. As such, the method also lends itself as a reverse stress testing framework: using the Mahalanobis distance or highest density regions (HDR) on the joint risk factor distribution allows to infer worst-case correlation scenarios. We give examples of stress tests on a large portfolio of European and North American stocks.

Object Details

• Language: Englisch

References and Relationships

• Bibliographic citation: Series: IRTG 1792 Discussion Paper ; No. 2021-012

Classification and Topics

• Classification: Wirtschaft ; Portfolio Choice; Investment Decisions ; Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
• Subject: Correlation stress testing ; reverse stress testing ; factor selection ; scenario selection ; Bayesian variable selection ; market risk management

Contributors, Places and Time

• Event: Geistige Schöpfung
• (who): Packham, Natalie ; Woebbeking, Fabian
• Event: Veröffentlichung
• (who): Humboldt-Universität zu Berlin, International Research Training Group 1792 "High Dimensional Nonstationary Time Series"
• (where): Berlin
• (when): 2021

Further information

• Handle: http://hdl.handle.net/10419/235866
• Last update: 10.03.2025, 11:42 AM CET