A Factor-Model Approach for Correlation Scenarios and Correlation Stress Testing

27 Pages Posted: 16 Aug 2018 Last revised: 21 Feb 2019

See all articles by Natalie Packham

Natalie Packham

Berlin School of Economics and Law; Humboldt University Berlin

Fabian Woebbeking

Halle Institute for Economic Research; Martin Luther University of Halle-Wittenberg

Date Written: January 28, 2019

Abstract

In 2012, JPMorgan accumulated a USD 6.2 billion loss on a credit derivatives portfolio, the so-called "London Whale", partly as a consequence of de-correlations of non-perfectly correlated positions that were supposed to hedge each other. Motivated by this case, we devise a factor model for correlations that allows for scenario-based stress testing of correlations. We derive a number of analytical results related to a portfolio of homogeneous assets. Using the concept of Mahalanobis distance, we show how to identify adverse scenarios of correlation risk. In addition, we demonstrate how correlation and volatility stress tests can be combined. As an example, we apply the factor-model approach to the "London Whale" portfolio and determine the value-at-risk impact from correlation changes. Since our findings are particularly relevant for large portfolios, where even small correlation changes can have a large impact, a further application would be to stress test portfolios of central counterparties, which are of systemically relevant size.

Keywords: Correlation Stress Testing, Scenario Selection, Market Risk, Correlation Risk, 'London Whale'

JEL Classification: G11, G32

Suggested Citation

Packham, Natalie and Woebbeking, Fabian, A Factor-Model Approach for Correlation Scenarios and Correlation Stress Testing (January 28, 2019). Available at SSRN: https://ssrn.com/abstract=3210562 or http://dx.doi.org/10.2139/ssrn.3210562

Natalie Packham

Berlin School of Economics and Law ( email )

Badensche Strasse 50-51
Berlin, D-10825
Germany

HOME PAGE: http://www.packham.net

Humboldt University Berlin ( email )

Unter den Linden 6
Berlin, AK Berlin 10099
Germany

Fabian Woebbeking (Contact Author)

Halle Institute for Economic Research ( email )

P.O. Box 11 03 61
Kleine Maerkerstrasse 8
D-06017 Halle, 06108
Germany
+49 345 7753-851 (Phone)

HOME PAGE: http://https://www.iwh-halle.de/

Martin Luther University of Halle-Wittenberg

Emil-Abderhalden-Str. 7
Halle an der Saale
06099 Halle (Saale), DE Sachsen-Anhalt 06099
Germany

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