A Bayesian Approach to Stress Testing and Scenario Analysis

Journal of Investment Management, Third Quarter, 2010

Posted: 26 Oct 2010

Date Written: July 1, 2010

Abstract

I present a new approach to stress testing that combines the elicitation of subjective (marginal or conditional) probabilities of events with the specification of a simple causal structure among them. By so doing, stress events are placed in an approximate but coherent probabilistic framework. The approach only requires the risk manager to provide simple and cognitively resonant input probabilities. The techniques of linear programming and Bayesian nets then ensure the consistency of the subjective inputs and facilitate the derivation of the desired joint probabilities.

Keywords: Stress testing, Bayesian nets, causality, diversification, Linear Programming

JEL Classification: G00

Suggested Citation

Rebonato, Riccardo, A Bayesian Approach to Stress Testing and Scenario Analysis (July 1, 2010). Journal of Investment Management, Third Quarter, 2010, Available at SSRN: https://ssrn.com/abstract=1697720

Riccardo Rebonato (Contact Author)

Royal Bank of Scotland ( email )

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