Stressing Correlations and Volatilities - A Consistent Modeling Approach
28 Pages Posted: 14 Oct 2011
Date Written: May 31, 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 proved to be superior in capturing the dynamics of volatilities and correlations.
Keywords: correlation, volatility, Basel III, GARCH models
JEL Classification: C13, C32, C58, G11, G12
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