Systematic multi-period stress scenarios with an application to CCP risk management

Abstract

In the aftermath of the financial crisis of 2007–2008 regulators in multiple jurisdictions have laid the foundation of new regulatory standards aiming at strengthening systemic resilience. Among different initiatives, mandatory central clearing of standardized OTC derivatives has been one of the most prominent. Because OTC derivatives entail default management procedures that are far more complex than listed derivatives, risk management procedures have to follow suit. The recent paper by Vicente et al. (2015) propose an innovative way to calculate margin requirements by using multi-period robust optimization (RO) methods that accounts for important differences between OTC and listed derivatives default procedures. Motivated by this methodology, this paper proposes a hybrid framework to construct discrete uncertainty sets, in which each element of this set can be seen as multi-period stress scenarios, which are necessary to solve the RO problem faced by the Central Counterparty (CCP). When applied to determine the margin requirements, the present method provides both qualitative and quantitative results that outperform other robust optimization models such as Ben-Tal and Nemirovski (2000) and Bertsimas and Pachamanova (2008).