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I was looking at Basel proposed interest rate shocks. Using the standard US Treasury Yield Curve for the period starting from September 2017 to August 2019, I was able to construct Steep and Flat scenarios as highlighted in the link above. In general, they do make sense given the current yield curve for US Treasuries:

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My question now is what further adjustments do these stressed curves need? One subject that comes to mind is the "no arbitrage-ness" of the curve. Do I have to make sure that the curve does not present arbitrage opportunity? If so, how?

Any other adjustments that I need to make sure before feeding the stressed yields to valuation models and regression models with other risk factors?

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My question now is what further adjustments do these stressed curves need? One subject that comes to mind is the "no arbitrage-ness" of the curve. Do I have to make sure that the curve does not present arbitrage opportunity? If so, how?

No there is no such thing as arbitrage arising from a risk free zero curve. Any zero rate you get is by definition the risk free rate. Same for the implied forward rates.

Any other adjustments that I need to make sure before feeding the stressed yields to valuation models and regression models with other risk factors?

I am not familiar with your specific regulation. From what I know of similar market risk regulations for insurances: you should just have to apply what is precisely described in that link. Applying any change to that would not be deemed compliant with the prescribed scenario. Note that this may not make sense... as these regulatory choices are often political and not based on facts. In some specific regulation you have to only apply a shock to one “bucket” of maturities at a time; so you are still lucky to have continuous zero curve :)

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  • $\begingroup$ good to know that no arbitrage test is not required. Let's assume that this is for an unregulated financial institute. There is no hard requirement as to the buckets, that is why I was using the standard US Treasury rates instead of 19 or whatever number of buckets as specified by Basel. How would you use the flexibility of not being regulated in this context? $\endgroup$ – AK88 Sep 25 '19 at 19:48
  • $\begingroup$ What is your goal? $\endgroup$ – raptor22 Sep 26 '19 at 9:10
  • $\begingroup$ The goal is to correctly shock the yield curve and propagate the shock to other asset classes (equity, FX, spread). $\endgroup$ – AK88 Sep 26 '19 at 11:50
  • $\begingroup$ Do you mean reprice a book based on the shocked curve? Or also shocking other risk-factors? $\endgroup$ – raptor22 Sep 26 '19 at 19:21
  • $\begingroup$ Apologies for not being clear -- 1) shock the yield curves; 2) propogate the shock to other risk factors; 3) reprice the book using the shocked yield curve and its effect on other risk factors. $\endgroup$ – AK88 Sep 26 '19 at 20:00

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