Use of stress scenarios in market risk economic capital

Alan Smillie, Eduardo Epperlein and Triyog Pandya

Journal of Risk Management in Financial Institutions, 2013, vol. 7, issue 1, 85-92

Abstract: Stress testing is increasingly being used to complement model-based estimates of risk, while stress value at risk (VaR) has been introduced to the regulatory framework for market risk capital. Stress tests, by their nature, are somewhat ad hoc and difficult to integrate with statistical measures of risk, such as VaR. This paper describes a method to combine in a consistent way stress losses with the output of the VaR model, in order to build an economic capital model for market risk. The method is based on existing components of firms' risk management systems, making it easy to implement, yet still exhibits many of the features (fat tails, tail correlations) missed by a simple model-based approach. The performance of the proposed model is examined during two market crises and it is shown that it outperforms both a purely statistical model and a purely stress test-based approach.

Keywords: market risk; economic capital; stress testing (search for similar items in EconPapers)
JEL-codes: E5 G2 (search for similar items in EconPapers)
Date: 2013
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Persistent link: https://EconPapers.repec.org/RePEc:aza:rmfi00:y:2013:v:7:i:1:p:85-92

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