Stressed Correlations and Volatilities – How to Fulfill Requirements of the Basel Committee

Christoph Becker

Frankfurt School of Finance & Management

Wolfgang M. Schmidt

Frankfurt School of Finance & Management

March 9, 2011

Presenter: Christoph Becker

Abstract:
We propose a new approach to define stress scenarios for volatilities and correlations which fulfills the requirements of the Basel Committee on Banking Supervision for quantifying market risk. Correlations and volatilities are functions of one and the same market factor, which is the key to stress 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 on 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 turned out to be superior in capturing the dynamics of volatilities and correlations.

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