A Coherent Aggregation Framework for Stress Testing and Scenario Analysis

Jan Kwiatkowski and Riccardo Rebonato

Applied Mathematical Finance, 2011, vol. 18, issue 2, 139-154

Abstract: We present a methodology to aggregate in a coherent manner conditional stress losses in a trading or banking book. The approach bypasses the specification of unconditional probabilities of the individual stress events and ensures by a linear programming approach so that the (subjective or frequentist) conditional probabilities chosen by the risk manager are internally consistent. The admissibility requirement greatly reduces the degree of arbitrariness in the conditional probability matrix if this is assigned subjectively. The approach can be used to address the requirements of the regulators on the Instantaneous Risk Charge.

Keywords: Stress testing; linear programming; coherent probabilities (search for similar items in EconPapers)
Date: 2011
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DOI: 10.1080/1350486X.2010.491966

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