Stress Testing via Contamination

When working with stochastic financial models, one exploits various simplifying assumptions concerning the model, its stochastic specification, parameter values, etc. In addition, approximations are used to get a solution in an efficient way. The obtained results, recommendations for the risk and portfolio manager, should be then carefully analyzed. This is done partly under the heading “stress testing”, which is a term used in financial practice without any generally accepted definition. In this paper we suggest to exploit the contamination technique to give the “stress test” a more precise meaning. Using examples from portfolio and risk management we shall point out the directly applicable cases and will discuss also limitations of the proposed method.

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