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- Title
Robust Risk Estimation and Hedging: A Reverse Stress Testing Approach.
- Authors
KOPELIOVICH, YAACOV; NOVOSYOLOV, ARCADY; SATCHKOV, DANIEL; SCHACHTER, BARRY
- Abstract
Traditional risk modeling using value at risk (VaR) is widely viewed as ill-equipped for dealing with tail risks. As a result, scenario-based portfolio stress testing is increasingly being promoted as central to the risk management process. "Reverse stress testing," a recent innovation in portfolio stress testing endorsed by regulators, is intended to identify economic scenarios that will threaten a financial firm's viability without injecting the manager's cognitive biases into stress scenario specification. Although the idea is intuitively appealing, no template has been provided to operationalize the idea. Some first steps in developing reverse stress testing approaches have begun to appear in the literature. Complexity and computational intensity appear to be important issues. A more subtle issue appearing in this emerging research is the relationship among the concepts of likelihood, plausibility, and representativeness. In this article, the authors propose a novel method for reverse stress testing using principal components analysis (PCA) along with Gram-Schmidt orthogonalization to determine scenarios leading to a specified loss level. The approach is computationally efficient. The method includes the maximum likelihood scenario, maximizes (a definition of) representativeness of the scenarios chosen, and measures the plausibility of each scenario. In addition, empirical results for sample portfolios show this method can provide new information beyond VaR and standard stress testing analyses.
- Subjects
RISK management in business; FINANCIAL institutions; DODD-Frank Wall Street Reform &; Consumer Protection Act; BOARD of Governors of the Federal Reserve System (U.S.); FINANCIAL Services Authority (Great Britain)
- Publication
Journal of Derivatives, 2015, Vol 22, Issue 4, p10
- ISSN
1074-1240
- Publication type
Article
- DOI
10.3905/jod.2015.22.4.010