Journal of Risk
ISSN:
1465-1211 (print)
1755-2842 (online)
Editor-in-chief: Farid AitSahlia
The quickest way to lose the money you cannot afford to lose: reverse stress testing with maximum entropy
Need to know
- This paper presents the most likely combination of risk factors that can give rise to a pre-specified loss.
- There are obvious applications to reverse stress testing.
- The paper also shows how the method can be used in the context of scenario analysis.
Abstract
We extend a technique devised by Saroka and Rebonato to “optimally” deform a yield curve in order to deal with a common and practically relevant class of optimization problems subject to linear constraints. In particular, we show how the idea can be applied to the case of reverse stress testing, and we present a case study to illustrate how it works. Finally, we point out a maximum-entropy interpretation of (or justification for) the procedure and present some obvious generalizations.
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