A Probabilistic Graphical Models Approach to Model Interconnectedness
International Journal of Risk Assessment and Management 23 (2), 119-133
15 Pages Posted: 30 Nov 2017 Last revised: 7 Jul 2020
Date Written: November 27, 2017
In this paper, we show that using multiple models when executing a specific task almost unavoidably gives rise to interaction between them, especially when their number is large. We show that this interaction can lead to biased and incomplete results if treated inappropriately (which we believe is the current standard in the financial industry). We propose the use of Probabilistic Graphical Models - a machine learning technique as a remedy to this problem. We discuss some numerical aspects of our approach that will be present in any practical implementation. We then examine, in detail, a practical example of using this method in a stress testing context.
Keywords: Probabilistic Graphical Models, Stress Testing, Model Risk
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