Correlation scenarios and correlation stress testing

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 li...

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Bibliographic Details
Published in:Journal of economic behavior & organization 2023-01, Vol.205, p.55-67
Main Authors: Packham, N., Woebbeking, F.
Format: Article
Language:English
Subjects:
Bayesian variable selection
Correlation stress testing
Factor selection
Market risk management
Reverse stress testing
Scenario selection
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Summary: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.
ISSN:0167-2681
1879-1751
DOI:10.1016/j.jebo.2022.11.002