Stressed Correlations and Volatilities – How to Fulfill Requirements of the Basel Committee (Becker C., Schmidt W. M.)

Basel I-III Regulation Risk-taking and Risk Management

Abstract We propose a new approach to the definition of stress scenarios for volatilities and correlations which fulfills the requirements of the Basel Committee on Banking Supervision for the quantification of market risk. Correlations and volatilities are functions of one and the same market factor, which is the key to stressing them in a consistent and intuitive way. Our approach is based on a new asset price model where correlations and volatilities depend on the current state of the market. The state of the market captures market-wide movements in equity-prices and thereby fulfills minimum requirements for risk factors stated by the Basel Committee. For sample portfolios we compare correlations and volatilities in a normal market and under stress and explore consequences for value-at-risk. Stressed value-at-risk exceeds the standard value-at-risk by a factor of 3 to 4, confirming estimates from the Basel Committee.

We finally compare our modeling approach with multivariate GARCH models. For all data analyzed our model proved to be superior in capturing the dynamics of volatilities and correlations.
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Libref/ Becker C., Schmidt W. M. (2011) "Stressed Correlations and Volatilities – How to Fulfill Requirements of the Basel Committee", pp. 1 - 27
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