Correlation scenarios and correlation stress testing

N. Packham; F. Woebbeking

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arXiv · 2107.06839

Correlation scenarios and correlation stress testing

N. Packham·F. Woebbeking

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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.

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N. Packham, F. Woebbeking. 2021-07-14. Correlation scenarios and correlation stress testing. https://arxiv.org/abs/2107.06839

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