Developing a stress testing framework based on market risk models

Carol Alexander, Elizabeth Sheedy*

*Corresponding author for this work

Research output: Contribution to journalArticle

68 Citations (Scopus)

Abstract

The Basel 2 Accord requires regulatory capital to cover stress tests, yet no coherent and objective framework for stress testing portfolios exists. We propose a new methodology for stress testing in the context of market risk models that can incorporate both volatility clustering and heavy tails. Empirical results compare the performance of eight risk models with four possible conditional and unconditional return distributions over different rolling estimation periods. When applied to major currency pairs using daily data spanning more than 20 years we find that stress test results should have little impact on current levels of foreign exchange regulatory capital.

Original languageEnglish
Pages (from-to)2220-2236
Number of pages17
JournalJournal of Banking and Finance
Volume32
Issue number10
DOIs
Publication statusPublished - Oct 2008

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