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A Black-Litterman approach to correlation stress testing

Author

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  • F. C. Ng
  • W. K. Li
  • Philip L. H. Yu

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.

Suggested Citation

  • F. C. Ng & W. K. Li & Philip L. H. Yu, 2014. "A Black-Litterman approach to correlation stress testing," Quantitative Finance, Taylor & Francis Journals, vol. 14(9), pages 1643-1649, September.
    • Handle: RePEc:taf:quantf:v:14:y:2014:i:9:p:1643-1649
    DOI: 10.1080/14697688.2013.843022
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    Cited by:

    1. Packham, Natalie & Woebbeking, Fabian, 2021. "Correlation scenarios and correlation stress testing," IRTG 1792 Discussion Papers 2021-012, Humboldt University of Berlin, International Research Training Group 1792 "High Dimensional Nonstationary Time Series".
    2. N. Packham & F. Woebbeking, 2021. "Correlation scenarios and correlation stress testing," Papers 2107.06839, arXiv.org, revised Sep 2022.
    3. Packham, N. & Woebbeking, F., 2023. "Correlation scenarios and correlation stress testing," Journal of Economic Behavior & Organization, Elsevier, vol. 205(C), pages 55-67.
    4. Packham, N. & Woebbeking, C.F., 2019. "A factor-model approach for correlation scenarios and correlation stress testing," Journal of Banking & Finance, Elsevier, vol. 101(C), pages 92-103.
    5. Natalie Packham & Fabian Woebbeking, 2018. "A factor-model approach for correlation scenarios and correlation stress-testing," Papers 1807.11381, arXiv.org, revised Jan 2019.

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