Correlation scenarios and correlation stress testing

N. Packham and F. Woebbeking

Journal of Economic Behavior & Organization, 2023, vol. 205, issue C, 55-67

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.

Keywords: Correlation stress testing; Reverse stress testing; Factor selection; Scenario selection; Bayesian variable selection; Market risk management (search for similar items in EconPapers)
JEL-codes: G11 G32 (search for similar items in EconPapers)
Date: 2023
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jeborg:v:205:y:2023:i:c:p:55-67

DOI: 10.1016/j.jebo.2022.11.002

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