Stressing Correlations and Volatilities – A Consistent Modeling Approach

Abstract:     
We propose a new approach to the definition of stress scenarios for volatilities and correlations. Correlations and volatilities depend on a common market factor, which is the key to stressing them in a consistent and intuitive way. Our approach is based on a new asset price model where correlations and volatilities depend on the current state of the market, which captures market-wide movements in equity-prices. For sample portfolios we compare correlations and volatilities in a normal market and under stress and explore consequences for value-at-risk.

We compare our modeling approach with multivariate GARCH models. For all data analyzed our model performs well in capturing the dynamics of volatilities and correlations.

Number of Pages in PDF File: 29

Keywords: Correlation, Volatility, Basel III, GARCH Models

JEL Classification: C13, C32, C58, G11, G12

working papers series