Systematic stress tests with entropic plausibility constraints
AbstractStress tests with handpicked scenarios might misrepresent risks either because dangerous scenarios are not considered or because the scenarios considered are too implausible. To overcome these two pitfalls we propose a systematic search for the worst case within a relative entropy ball of sufficiently plausible scenarios. For this purpose we use mixed scenarios, which are risk factor distributions rather than realisations. A Maximum Loss theorem explicitly gives the worst case distribution. The method is illustrated in a number of example applications: linear and quadratic portfolios, stressed default probabilities, stressed correlations, macroeconomic stress tests.
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Bibliographic InfoArticle provided by Elsevier in its journal Journal of Banking & Finance.
Volume (Year): 37 (2013)
Issue (Month): 5 ()
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Web page: http://www.elsevier.com/locate/jbf
Scenario analysis; Worst case; Risk measures; Multiple priors; Model risk; Relative entropy;
Find related papers by JEL classification:
- C18 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Methodolical Issues: General
- C44 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - Operations Research; Statistical Decision Theory
- C60 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - General
- G01 - Financial Economics - - General - - - Financial Crises
- G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
- M48 - Business Administration and Business Economics; Marketing; Accounting - - Accounting - - - Government Policy and Regulation
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