A financially justifiable and practically implementable approach to coherent stress testing

Riccardo Rebonato

Quantitative Finance, 2019, vol. 19, issue 5, 827-842

Abstract: We present an approach to stress testing that is both practically implementable and solidly rooted in well-established financial theory. We present our results in a Bayesian-net context, but the approach can be extended to different settings. We show (i) how the consistency and continuity conditions are satisfied; (ii) how the result of a scenario can be consistently cascaded from a small number of macrofinancial variables to the constituents of a granular portfolio; and (iii) how an approximate but robust estimate of the likelihood of a given scenario can be estimated. This is particularly important for regulatory and capital-adequacy applications.

Date: 2019
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DOI: 10.1080/14697688.2018.1532103

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