Stressing Correlations and Volatilities – A Consistent Modeling Approach
University of Applied Sciences Darmstadt
Wolfgang M. Schmidt
Frankfurt School of Finance & Management Gemeinnützige GmbH
September 16, 2011
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
Date posted: September 18, 2011