A factor-model approach for correlation scenarios and correlation stress-testing

A factor-model is developed for parameterising correlation matrices of financial portfolios. The factor-model structure allows to understand various drivers of correlation amongst portfolio constituents. The approach can be... [ view full abstract ]

A factor-model is developed for parameterising correlation matrices of financial portfolios. The factor-model structure allows to understand various drivers of correlation amongst portfolio constituents. The approach can be used to translate economic scenarios into constraints and changes on the dependence structure allowing to measure the impact of specific scenarios on portfolio risk. As an example, we apply the factor-model approach to the credit derivatives trading strategy by JP Morgan Chase, dubbed the London Whale, that led to losses in the magnitude of 6.2 bln USD in 2012.