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Validation of stress testing models

Joseph L. Breeden** President and Chief Operating Officer, Strategic Analytics Inc., Santa Fe, NM

Abstract

Stress testing has gained importance in financial institutions with the introduction of Basel II. Although discussed from many perspectives, the predominant use for stress testing is in predicting how a portfolio would respond to changes in the macroeconomic environment. The future environment is encapsulated in a macroeconomic scenario for an extreme situation and then fed through a scenario-based forecasting model. Validating stress testing models is inherently difficult, because financial institutions do not have historical data representing portfolio performance through many severe recessions. Data availability ...

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