A Black–Litterman approach to correlation stress testing

F. C. NG, Wai Keung LI, Philip L. H. YU

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2 Citations (Scopus)

Abstract

Correlation stress testing is motivated by a well-known phenomenon: correlations change under financial crises. The adjustment of correlation matrices may be required to evaluate the potential impact of these changes. Very often, some correlations are explicitly adjusted (core correlations), with the remainder left unspecified (peripheral correlations), although it would be more natural for both core correlations and peripheral correlations to vary. However, most existing methods ignore the potential change in peripheral correlations. In this paper, we propose a Black–Litterman approach to correlation stress testing in which the stress impact on the core correlations is transmitted to the peripheral correlations through the dependence structure of the empirical correlations. Copyright © 2014 Copyright Taylor & Francis Group, LLC.
Original languageEnglish
Pages (from-to)1643-1649
JournalQuantitative Finance
Volume14
Issue number9
Early online dateNov 2013
DOIs
Publication statusPublished - 2014

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Stress testing
Financial crisis
Correlation matrix
Dependence structure

Citation

Ng, F. C., Li, W. K., & Yu, P. L. H. (2014). A Black–Litterman approach to correlation stress testing. Quantitative Finance, 14(9), 1643-1649. doi: 10.1080/14697688.2013.843022

Keywords

  • Correlation stress testing
  • Scenario test
  • Black–Litterman
  • Mahalanobis distance