Integrating Stress Scenarios into Risk Quantification Models

Abstract

We enhance the method of integrating scenarios proposed in Ergashev (2012) into risk models. In particular, we provide additional theoretical insights of the method with focus on stress testing Value-at-Risk models. We extend the application of the method, which is originally proposed for scenario analysis in the operational risk context, to market and credit risks. We provide detailed application guidance of the method for market, credit, and operational risks. The method (i) ensures that a stressed model produces a higher risk estimate than the model based on historical data only and (ii) does not require assumptions on stressed loss distributions, thereby simplifying the scenario generation process.

Keywords: Stress test, Scenarios, VaR, Interest rate risk, Operational risk, Credit risk

JEL Classification: G32, G21, G20