Stress-Testing with Fully Flexible Causal Inputs
Risk, 25, 4, p. 61-65 (2012)
13 Pages Posted: 7 Dec 2010 Last revised: 11 Oct 2012
Date Written: April 2, 2012
Propagating causal stress-tests or contagion on selected risk factors to all the risk drivers is a challenging task. We use Entropy Pooling by Meucci (2008) to address this issue. Our causal stress-tests comprise, but are not restricted to, stress-testing Bayesian networks. We detail the theory and we present a case study: stress-testing a market driven by swap curve, credit spreads, stock market return, stock market volatility, currency strength, inflation, and commodities. Fully commented code supporting the empirical analysis is available for download.
Keywords: Contagion, Bayesian network, entropy pooling, non-Boolean variables, prior distribution, posterior distribution, linear programming, convex programming, dual optimization, 'Fully Flexible'
JEL Classification: C1, G11
Suggested Citation: Suggested Citation