Correlation Scenarios and Correlation Stress Testing

24 Pages Posted: 16 Jul 2021

See all articles by Natalie Packham

Natalie Packham

Berlin School of Economics and Law; Humboldt University Berlin

Fabian Woebbeking

Goethe University Frankfurt - Department of Finance

Date Written: July 14, 2021

Abstract

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

Packham, Natalie and Woebbeking, Fabian, Correlation Scenarios and Correlation Stress Testing (July 14, 2021). Available at SSRN: https://ssrn.com/abstract=3886469 or http://dx.doi.org/10.2139/ssrn.3886469

Natalie Packham

Berlin School of Economics and Law ( email )

Badensche Strasse 50-51
Berlin, D-10825
Germany

HOME PAGE: http://www.packham.net

Humboldt University Berlin ( email )

Unter den Linden 6
Berlin, AK Berlin 10099
Germany

Fabian Woebbeking (Contact Author)

Goethe University Frankfurt - Department of Finance ( email )

Theodor-W.-Adorno-Platz 3
Frankfurt, 60323
Germany
+49 (69) 798 33731 (Phone)

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