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I need to implement a reverse stress testing model (definition here)

I have searched around and cannot find anything substantial on the topic. Does anyone know of any good papers/references regarding actual implementation? Please don't post links to Basel docs.

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1 Answer 1

Within the Insurance and Portfolio Management Industry there is a concept called Probability of Shortfall as well as Probability of Ruin. There were a number of papers (not on the internet) that I remember seeing on shortfall as part of my actuarial courses.

They evaluate how a certain product or strategy would impact a reduction in surplus or equity beneath some target level.

So if we take a similar approach here, you could start by identifying market shocks in isolation as well as in combination that would bring your regulatory capital below the minimum requirement. At work I run an ALM simulation for clients where I track what strategies lead to what probabilities of shortfall.

Not sure if this helps.

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Yes this is an idea however it is very quickly cursed by dimensionality as the number of risk factors increase. I am more concerned with practical implementation as most banks will have portfolios large enough that computational intensity becomes an issue. Another method that could achieve this would be monte carlo, where you just note each time your portfolio losses an amount greater than or equal to your reverse stress threshold and note the driving risk factors in this case. Again, this is not very tractable in terms of simulation costs. –  SpeedBoots Jul 19 '11 at 12:55

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