Correlation Scenarios and Correlation Stress Testing
24 Pages Posted: 16 Jul 2021
Date Written: July 14, 2021
We develop a general approach for stress testing correlations of financial asset portfolios. The correlation matrix of asset returns is specified in a parametric form, where correlations are represented as a function of risk factors, such as country and industry factors. A sparse factor structure linking assets and risk factors is built using Bayesian variable selection methods. Regular calibration yields a joint distribution of economically meaningful stress scenarios of the factors. As such, the method also lends itself as a reverse stress testing framework: using the Mahalanobis distance or highest density regions (HDR) on the joint risk factor distribution allows to infer worst-case correlation scenarios. We give examples of stress tests on a large portfolio of European and North American stocks.
Keywords: Keywords: Correlation stress testing, reverse stress testing, factor selection, scenario selection, Bayesian variable selection, market risk management
JEL Classification: G11, G32
Suggested Citation: Suggested Citation