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Generating historically-based stress scenarios using parsimonious factorization

Alexander Bogin (Federal Housing Finance Agency, Washington, District of Columbia, USA)
William Doerner (Capital Policy Branch, Federal Housing Finance Agency, Washington, District of Columbia, USA)

Journal of Risk Finance

ISSN: 1526-5943

Article publication date: 21 November 2014

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Abstract

Purpose

This paper aims to describe a robust empirical approach to generating plausible historically based interest rate shocks, which can be applied to any market environment. These interest rate shocks can be readily linked to movements in other key risk factors, and used to measure market risk on institutions with large fixed-income portfolios.

Design/methodology/approach

Using yield curve factorization, we parameterize a time series of historical yield curves and measure interest rate shocks as the historical change in each of the model’s factors. We then demonstrate how to add these parameterized shocks to any market environment, while retaining positive rates and plausible credit spreads. Given a set of shocked interest rate curves, joint risk factor movements are calculated based upon historical, reduced form dependencies.

Findings

Our approach is based upon yield curve parameterization and requires a parsimonious yet flexible factorization model. In the process of selecting a model, we evaluate three variants of the Nelson–Siegel approach to yield curve approximation and find that, in the current low interest rate environment, a 5-factor parameterization developed by Björk and Christensen (1999) is best suited for accurately translating historical interest rate movements into plausible, current period shocks.

Originality/value

An accurate measure of market risk can help to inform institutions about the amount of capital needed to withstand a series of adverse market events. A plausible set of shocks is required to ensure market value, and cash flow projections are indicative of meaningful market sensitivities.

Keywords

Acknowledgements

This paper draws heavily on previous work by William Segal. The author would also like to thank Scott Smith, Debra Fuller, Nataliya Polkovnichenko, Jesse Weiher and Blake Saville for significant contributions to the project. The analysis and conclusions are those of the authors and do not necessarily represent the views of the Federal Housing Finance Agency or the United States.

Citation

Bogin, A. and Doerner, W. (2014), "Generating historically-based stress scenarios using parsimonious factorization", Journal of Risk Finance, Vol. 15 No. 5, pp. 591-611. https://doi.org/10.1108/JRF-03-2014-0036

Publisher

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Emerald Group Publishing Limited

Copyright © 2014, Emerald Group Publishing Limited

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