A0735
Title: Correlation scenarios and correlation stress testing
Authors: Fabian Woebbeking - IWH, Leibniz Institute for Economic Research (Germany) [presenting]
Natalie Packham - Berlin School of Economics and Law (Germany)
Abstract: A general approach is developed 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. The regular calibration yields a joint distribution of economically meaningful stress scenarios of the factors. As such, the method also lends itself to a reverse stress testing framework: using the Mahalanobis distance or Highest Density Regions (HDR) on the joint risk factor distribution allows inferring worst-case correlation scenarios. Examples of stress tests are given on a large portfolio of European and North American stocks.
