Stress Testing Model for Credit Portfolio using Vine Copula

Abstract

Stress testing became more important on financial risk management after financial crisis of 2007–2009. The risk quantity is estimated based on the scenario that low frequency and large loss events occur on stress testing. The correlation among the variables is important, particularly the tail correlation is crucial on stress testing. In this paper, we propose the credit stress testing model with vine copula to consider detail of the tail correlation and compare this model with the expansion of one factor Merton model, which is used to evaluate the risk amount of credit portfolio. As a result, we find the average credit rating by this model clearly changes depending on the stress scenario, unlike one factor Merton model. We confirm this model captures the difference among the characteristics of industry sectors and provides the result depending on the industry sector of each borrower.