Reverse Stress Testing

20 Pages Posted: 24 Mar 2020

See all articles by Claudio Albanese

Claudio Albanese

Global Valuation; CASS School of Business

Stéphane Crépey

Université d'Évry - Equipe d'Analyse et Probabilites

Stefano Iabichino

JP Morgan

Date Written: February 18, 2020

Abstract

This article outlines a framework for the analysis of extreme events based on forward-looking reverse stress testing. We carry out a portfolio simulation and identify stress scenarios which are critical for bank solvency as the ones contributing the most to cost of capital, as expressed by KVA scenario differentials.

Applications include model validation, trading limits, model risk management and hedging. A pricing model is invalid if it breaks on a path leading to stress conditions, causing alpha leaks that go undetected in market risk models such as value-at-risk (VaR), expected shortfall and stressed VaR. Trading limits are best predicated on incremental cost of capital and model risk capital can be assessed by computing cost of capital with Bayesian averages. Stress scenarios also have the potential to suggest risk-reducing hedges.

Keywords: Model Validation, Stress Testing, Reverse Stress Testing, Capital Models, Risk Margins, Trading Limits, Cost of Capital, KVA, Model Risk, Short Rate Models, PFE

JEL Classification: D81, G13, G28, G32

Suggested Citation

Albanese, Claudio and Crépey, Stéphane and Iabichino, Stefano, Reverse Stress Testing (February 18, 2020). Available at SSRN: https://ssrn.com/abstract=3544866 or http://dx.doi.org/10.2139/ssrn.3544866

Claudio Albanese (Contact Author)

Global Valuation ( email )

9 Devonshire Sq.
London, London EC2M 4YF
United Kingdom

CASS School of Business ( email )

106 Bunhill Row
London, England EC1Y 8TZ
United Kingdom

Stéphane Crépey

Université d'Évry - Equipe d'Analyse et Probabilites ( email )

Boulevard des Coquibus
F-91025 Evry Cedex
France

Stefano Iabichino

JP Morgan ( email )

London
United Kingdom

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
119
Abstract Views
512
rank
261,001
PlumX Metrics