Coherent Stress Testing: A Bayesian Approach to the Analysis of Financial Stress

In Coherent Stress Testing: A Bayesian Approach to the Analysis of Financial Stress, industry expert Riccardo Rebonato presents an all new approach to his important but often undervalued part of the risk management toolkit.

Based on the author’s extensive work, research and presentation in the area, the book fills a gap in quantitative risk management by introducing a new and very intuitively appealing approach to stress testing based on expert judgment and Bayesian networks. It constitutes a radical departure from the traditional statistical methodologies based on Economic Capital or Extreme-Value-Theory approaches.

The book is split into four parts. Part I looks at stress testing and its role in modern risk management. It discusses the distinctions between risk and uncertainty, the different types of probability that are used in risk management today and for which tasks they are best used. Stress testing is positioned as a bridge between the statistical areas where VaR can be effective and the domain of total Keynesian uncertainty. Part II lays down the quantitative foundations for the concepts described in the rest of the book. Part III takes readers through the applications of the tools discussed in part II, and introduces two different systematic approaches to obtaining a coherent stress testing output that can satisfy the ends of industry users and regulators. In part IV the author addresses more practical questions such as embedding the suggestions of the book into a viable governance structure.

“Riccardo Renato examines the deficiencies of current financial modelling practice and the limitations of the purely statistical approaches to risk quantification that underpin VaR methodology. Taking his cue from Knightian uncertainty – and Rumsfeldian unknown unknowns – the author argues that a program of stress testing carried out within a Bayesian paradigm can offer risk managers a route to redemption after the crisis. Written in his usual lucid and engaging style, Coherent Stress Testing is a thought provoking text on a vitally important issue, and a serious proposal of a workable solution.”
—Alexander J. McNeil, Maxwell Professor, Heriot-Watt University

“Riccardo Rebonato’s book shows how managerial judgments can be combined with analysis to improve the way stress testing is done. The book is well written and very timely. In the aftermath of the 2007&ndash2009 financial crisis risk management groups at all financial institutions are looking for ways they can make stress testing more effective.”
—John Hull, Maple Financial Professor of Derivatives and Risk Management, Joseph L. Rotman School of Management, University of Toronto

“Rebonato’s interesting book provides a refreshingly different and thought-provoking perspective of stress-testing and quantitative risk management – exactly what the field needs in these troubled times.”
—Rüdiger Frey, Professor of Financial Mathematics and Optimization, Universität Leipzig, Co-author of Quantitative Risk Management: Concepts, Techniques, Tools