Stress Testing with Bayesian Nets and Related Techniques: Meeting the Engineering Challenges

Abstract

The chapter briefly reviews the case for stress-testing risk models and recognizes the pressing ‘engineering’ problems that stand between the concept of stress testing and actually doing so for a risk model, such as a portfolio that includes a supposedly optimal allocation of assets. The chapter argues that the application of the Bayesian net ‘technology’ to stress testing introduced in the last decade lends itself particularly well to the need for a practical way to stress-test risk models. The chapter presents proposed solutions to the challenges of stress testing a model with particular reference to the use of Bayesian nets.

‘[Recent] developments will serve to further highlight the danger of […] being overly committed to an historical policy portfolio whose rigid backward-looking characterization no longer corresponds to the realities of today and tomorrow.’ ‘[W]ith its conventional (or, to be more precise, reduced-form) analytical foundation now subject to some motion, it will become even more difficult to rely just on a traditional portfolio diversification as both necessary and sufficient to deliver high returns and mitigate risks. Diversification will remain necessary, but a lot more attention will be devoted to the appropriate specification of tail scenarios and tail hedges.’ ¹

Mohamed A. El-Erian

Chief Economic Advisor at Allianz