Factor Model for Stress-testing with a Contingent Claims Model of the Chilean Banking System

Abstract

This chapter derives risk indicators for the major Chilean banks based on contingent claims analysis, an extension of BlackScholesMerton optionpricing theory. These risk indicators are tied clearly to macroeconomic and fi nancial developments in Chile and outside, but bank responses are highly heterogeneous. To reduce the number of variables linked to the banks’ risk to a tractable number, we apply principal component analysis. Vector autoregressions of risk indicators with the most signifi cant factors show strong ties from fi nancial markets and regional developments. Impulse response functions from these factors are derived, which allow for scenario testing. The scenarios derived in the study illustrate how the magnitude and per sis tence of responses of bank credit risk can vary across banks in the system.