Abstract
We propose a new approach to the definition of stress scenarios for volatilities and correlations. Correlations and volatilities depend on a common 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, which captures market-wide movements in equity-prices. For sample portfolios we compare correlations and volatilities in a normal market and under stress and explore consequences for value-at-risk. We compare our modeling approach with multivariate GARCH models. For all data analyzed our model performs well in capturing the dynamics of volatilities and correlations under stress. ►We determine stressed correlations and value-at-risk based on new asset price model. ►This study confirms estimates and fulfills requirements of Basel III. ►Volatilities and correlations dynamically depend on common state of the market factor.
Published Version
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