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A Stylised Model for Extreme Shocks: Four Moments of the Apocalypse

Author

Listed:
  • Allan Brace

    (Group Market Risk, nabCapital, Australia)

  • Mark Lauer

    (Group Market Risk, nabCapital, Australia)

  • Milo Rado

    (Group Market Risk, nabCapital, Australia)

Abstract

We present a method for calculating the extreme tail quantiles, over arbitrary holding periods, of a continuous-time stochastic volatility model of the form proposed by Scott (1987) with correlation between the processes for volatility and price. The fat tails of this model enable a consistent, tuneable, stylised representation of non-normality in extreme moves of prices across di ering markets. Because the model is analytically intractable, four moments are derived by numeric integration and matched to a one-period version of the model, whose quantiles are then found by further numeric integration. We also present a novel Monte-Carlo simulation scheme, which we have used to confirm the accuracy of the moment-matching approximation for quantiles as extreme as one-millionth. Two methods for calibrating the model to market data are also proposed. The model is used in production stress testing at nabCapital to define consistent real-world probabilities for extreme shocks over heterogeneous holding periods.

Suggested Citation

  • Allan Brace & Mark Lauer & Milo Rado, 2008. "A Stylised Model for Extreme Shocks: Four Moments of the Apocalypse," Research Paper Series 224, Quantitative Finance Research Centre, University of Technology, Sydney.
    • Handle: RePEc:uts:rpaper:224
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    File URL: https://www.uts.edu.au/sites/default/files/qfr-archive-02/QFR-rp224.pdf
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    References listed on IDEAS

    as
    1. Jeremy Berkowitz, 1999. "A coherent framework for stress-testing," Finance and Economics Discussion Series 1999-29, Board of Governors of the Federal Reserve System (U.S.).
    2. Carol Alexander & Elizabeth Sheedy, 2007. "Model-Based Stress Tests: Linking Stress Tests to VaR for Market Risk," ICMA Centre Discussion Papers in Finance icma-dp2007-02, Henley Business School, University of Reading.
    3. Scott, Louis O., 1987. "Option Pricing when the Variance Changes Randomly: Theory, Estimation, and an Application," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 22(4), pages 419-438, December.
    4. Hull, John C & White, Alan D, 1987. "The Pricing of Options on Assets with Stochastic Volatilities," Journal of Finance, American Finance Association, vol. 42(2), pages 281-300, June.
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