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

Listed author(s):
  • Allan Brace

    (Group Market Risk, nabCapital, Australia)

  • Mark Lauer

    (Group Market Risk, nabCapital, Australia)

  • Milo Rado

    (Group Market Risk, nabCapital, Australia)

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.

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Paper provided by Quantitative Finance Research Centre, University of Technology, Sydney in its series Research Paper Series with number 224.

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Length: 25 pages
Date of creation: 01 Jun 2008
Handle: RePEc:uts:rpaper:224
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  1. 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, Reading University.
  2. 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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