The quickest way to lose the money you cannot afford to lose: reverse stress testing with maximum entropy

Riccardo Rebonato

Journal of Risk

Abstract: We extend a technique devised by Saroka and Rebonato to “optimally†deform a yield curve in order to deal with a common and practically relevant class of optimization problems subject to linear constraints. In particular, we show how the idea can be applied to the case of reverse stress testing, and we present a case study to illustrate how it works. Finally, we point out a maximum-entropy interpretation of (or justification for) the procedure and present some obvious generalizations.

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