Journal
JOURNAL OF BANKING & FINANCE
Volume 37, Issue 5, Pages 1552-1559Publisher
ELSEVIER
DOI: 10.1016/j.jbankfin.2012.04.013
Keywords
Scenario analysis; Worst case; Risk measures; Multiple priors; Model risk; Relative entropy
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Stress 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. (C) 2012 Elsevier B.V. All rights reserved.
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