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A Coherent Aggregation Framework for Stress Testing and Scenario Analysis

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  • Jan Kwiatkowski
  • Riccardo Rebonato

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.

Suggested Citation

  • Jan Kwiatkowski & Riccardo Rebonato, 2011. "A Coherent Aggregation Framework for Stress Testing and Scenario Analysis," Applied Mathematical Finance, Taylor & Francis Journals, vol. 18(2), pages 139-154.
  • Handle: RePEc:taf:apmtfi:v:18:y:2011:i:2:p:139-154 DOI: 10.1080/1350486X.2010.491966
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    References listed on IDEAS

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    7. Dorje Brody & Joanna Syroka & Mihail Zervos, 2002. "Dynamical pricing of weather derivatives," Quantitative Finance, Taylor & Francis Journals, pages 189-198.
    8. Jurate saltyte Benth & Fred Espen Benth & Paulius Jalinskas, 2007. "A Spatial-temporal Model for Temperature with Seasonal Variance," Journal of Applied Statistics, Taylor & Francis Journals, vol. 34(7), pages 823-841.
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