Macroeconomic Shocks on Model Parameters: Stress Testing Mortgage Loan Default Rate

31 Pages Posted: 29 Oct 2019

See all articles by Zheqi Wang

Zheqi Wang

University of Edinburgh - Edinburgh Business School

Jonathan N. Crook

University of Edinburgh - Business School

Galina Andreeva

University of Edinburgh - Business School

Date Written: October 2, 2019

Abstract

We simulate default rate (DR) distributions based on models built on crisis and tranquil time periods using U.S. mortgage loan data to explore the impact changes in model parameters between different scenarios have on stress testing results. We apply the parameter posterior distribution obtained in a Bayesian approach to stress testing to reduce the estimation risk that results from using parameter point estimates. We compute the VaRs and required capital using a model built on crisis time period data and a Bayesian coefficient posterior distribution with both the effect of macroeconomic shocks on model parameters and the estimation risk considered. The results are compared with those obtained when coefficient changes in stress testing models or coefficient uncertainty is neglected. We find that the required capital is underestimated by nearly 40% when neither parameter instability nor estimation risk is addressed.

Keywords: Stress testing, Financial crisis, Parameter instability, Coefficient uncertainty, Default rate

JEL Classification: G21, G01, E32, E37

Suggested Citation

Wang, Zheqi and Crook, Jonathan N. and Andreeva, Galina, Macroeconomic Shocks on Model Parameters: Stress Testing Mortgage Loan Default Rate (October 2, 2019). Available at SSRN: https://ssrn.com/abstract=3472130

Zheqi Wang (Contact Author)

University of Edinburgh - Edinburgh Business School ( email )

29 Buccleuch Pl
Edinburgh, Scotland EH8 9JS
United Kingdom

Jonathan N. Crook

University of Edinburgh - Business School ( email )

University of Edinburgh
29 Buccleuch Place
Edinburgh, Scotland EH8 9JS
United Kingdom

Galina Andreeva

University of Edinburgh - Business School ( email )

University of Edinburgh
29 Buccleuch Place
Edinburgh, Scotland EH8 9JS
UNITED KINGDOM

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