Journal of Statistical Computation and Simulation

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Stress testing correlation matrix: a maximum

empirical likelihood approach

Kwok-Wah Ho

To cite this article: Kwok-Wah Ho (2016) Stress testing correlation matrix: a maximum
empirical likelihood approach, Journal of Statistical Computation and Simulation, 86:14,
2707-2713, DOI: 10.1080/00949655.2015.1122790

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JOURNAL OF STATISTICAL COMPUTATION AND SIMULATION, 2016
VOL. 86, NO. 14, 2707–2713
http://dx.doi.org/10.1080/00949655.2015.1122790

Stress testing correlation matrix: a maximum empirical likelihood

approach
Kwok-Wah Ho
Department of Statistics, Chinese University of Hong Kong, Shatin, Hong Kong

ABSTRACT ARTICLE HISTORY

Stress testing correlation matrix is a challenging exercise for portfolio risk Received 2 September 2014
management. Most existing methods directly modify the estimated corre- Accepted 17 November 2015
lation matrix to satisfy stress conditions while maintaining positive semidef- KEYWORDS
initeness. The focus lies on technical optimization issues but the resultant Risk management; stress
stressed correlation matrices usually lack statistical interpretations. In this testing; correlation matrix;
article, we suggest a novel approach using Empirical Likelihood method empirical likelihood
to modify the probability weights of sample observations to construct a
stressed correlation matrix. The resultant correlations correspond to a stress
scenario that is nearest to the observed scenario in a Kullback–Leibler
divergence sense. Besides providing a clearer statistical interpretation, the
proposed method is non-parametric in distribution, simple in computa-
tion and free from subjective tunings. We illustrate the method through an
application to a portfolio of international assets.

1. Introduction
After the 2008 global financial crisis, banks and regulatory bodies realize that proprietary models
work well under normal market condition can fail completely under crisis. In order to assess the
ability of banks to sustain losses under extreme market conditions, bank portfolios are being tested
under stress scenarios.[1–4] For example, stress testing results can be used to determine stress-tested
Value-at-Risk for capital adequacy requirement calculations.[5,6]
It is widely observed that correlations among asset returns or risk factors under normal and stress-
ful market conditions are considerably different.[7] Therefore, it may be desirable to construct a
correlation matrix for stress testing that is different from the one estimated during normal market
condition. For instance if we are interested in stress testing a portfolio of stocks under the Euro debt
crisis scenario in 2010, it is sensible to intentionally raise the correlations of the stocks from the PIGS
(Portugal, Italy, Greece and Spain) countries to reflect the potential contagious effect in that region.
An obvious approach is to construct a matrix X by setting the core correlations of the estimated corre-
lation matrix (C) to desired stressed levels while leaving the other peripheral correlations unchanged.
The technical difficulty of this naive approach is that X may not be positive semidefinite.
In order to solve this technical problem, a major line of research focuses on finding a positive
semidefinite matrix that is nearest, with respect to a matrix norm such as Frobenius norm, to X.[5,8–
12] Remark that the Frobenius norm between two m × n matrices A and B is


 m  n
A − BF =  (Aij − Bij )2 .
i=1 j=1

CONTACT Kwok-Wah Ho kwho@sta.cuhk.edu.hk

© 2015 Informa UK Limited, trading as Taylor & Francis Group
2708 K.-W. HO

The problem then becomes a challenging optimization problem with explicit positive semidefinite
condition. While the technical problems are largely tackled in the above literature, there is a more fun-
damental issue in this approach. Minimization with respect to a chosen matrix norm does not carry
any statistical justification. We can obtain two different answers using two different matrix norms
but we can hardly understand the statistical rationale behind the difference. In other words, we basi-
cally have no understanding about the characteristics of the stress scenarios that corresponds to the
stressed correlation matrix.
Recently, Ng et al. [13] and Yu et al. [14] raise another issue about the traditional approach. They
observe that under crisis period, not only the core correlations change considerably, the peripheral
correlations also change somewhat systematically according to their historical correlations with the
core correlations. Therefore, Ng et al. [13] proposed a Black–Litterman approach and Yu et al. [14]
proposed a Bayesian approach to construct stressed correlation matrices based on this observation.
Their algorithms have the advantage of better utilizing information in the observed data to deter-
mine the peripheral correlations. Their results indicate that the resultant stressed correlation matrices
match well with the matrices under crisis period. However, their methods require subjective tuning
of some important parameters and their methods are parametric in nature assuming multivariate
Normal distributions.
In this article, we propose a novel non-parametric approach to construct the stressed correla-
tion matrix using the maximum empirical likelihood estimation (MELE) method. [15, p. 52] This
approach has at least three advantages. First, positive semidefiniteness of the stressed correlation
matrix is guaranteed implicitly. We do not need to add an additional positive semidefinite constraint
that usually leads to a complicated optimization procedure. Second, computation is simple and trans-
parent. No subjective tuning is required and therefore is well suited for routine implementation in
financial institutions. Last but not least, we can view the method as choosing a scenario that fulfills
the required stress conditions and at the same time nearest to the observed scenario with respect to
Kullback–Leibler divergence. This provides a statistical justification to the resultant stressed correla-
tion matrix. In addition to the above advantages, empirically we find that the peripheral correlations
are automatically adjusted to accommodate information from both the observed data and the stress
scenario. This aspect shares some benefits of the methods proposed in Ng et al.[13] and Yu et al.[14]
In Section 2, we first introduce the MELE method that we employ to stress correlation matrix. In
Section 3, we demonstrate our method by an application to an international asset portfolio data set.
In the last section, we give some concluding remarks and suggestions for further research.

2. MELE for stress testing correlation matrix

Consider that we have collected a random sample of n observations of p-dimensional vectors with
n larger than p. In portfolio risk management problems, we may have p returns of assets and/or
returns of risk factors such as interest rates and exchange rates. We denote this sample by a data
matrix (xik )i=1,...,p; k=1,...,n .
The basic task is to stress some of the correlations to preassigned values, probably large and posi-
tive, while keeping the whole matrix positive semidefinite. Since the correlation matrix is symmetric,
we only have p(p − 1)/2 distinct parameters. Suppose that we have m core correlations to be stressed
to values {c1 , . . . , cm }. Denote d = p(p − 1)/2 − m and {θ1 , . . . , θd } to be the remaining peripheral
correlations.
The idea of MELE [15] is to adjust the probability weights of the observed data from the empirical
weights of 1/n each to a new set of values {w1 , . . . , wn } in order to to perform parameter estimation
under given constraints. Changing the probability weights of the observed data can be viewed as
choosing a new scenario that is different from the one observed in the sample. For our problem of
constructing a correlation matrix corresponding to a scenario with specific stressed correlations, it is
equivalent to determining the peripheral correlations {θ1 , . . . , θd } with the following constraints
 JOURNAL OF STATISTICAL COMPUTATION AND SIMULATION 2709

S1. wk ≥ 0, k = 1, . . . n;
n
S2. k=1 wk = 1;
n
S3. k=1 wk xik = x̄i , i = 1, . . . , p;
n
k=1 wk xik = x̄i + si , i = 1, . . . , p;
S4. 2 2 2
n
S5. k=1 wk xuj k xvj k = x̄uj x̄vj + cj suj svj , j = 1, . . . , m.

Here x̄i and s2i denote the sample mean and sample variance of the ith asset return, respectively. The
constraints S1 and S2 ensure that (w1 · · · wn ) is a probability vector. S3 and S4 ensure that the choice
of {w1 , . . . , wk } keeps the reweighed means and reweighed variances to be the same as the original
sample means and sample variances, respectively. It is because we only want to stress the correlations
but not the means or variances. Lastly, S5 imposes the constraints of stressing the m core correlations.
The notations uj and vj in S5 naturally refers to the coordinates in the asset return vector with respect
to the jth core correlation. As a result, we have altogether 2p + m + 1 equality constraints and we
formulate the following profile Empirical Likelihood for θ = (θ1 · · · θd ),
 n
 
n
R(θ) = max nwk | wk xlj k xtj k = x̄lj x̄tj + θj slj stj , j = 1 . . . , d; S1 − S5 . (1)
w1 ,...,wn
k=1 k=1

Here lj and tj in the constraint naturally refers to the coordinates in the asset return vector with respect
to the jth peripheral correlation. The method of MELE is then to find the value of θ that maximizes
R(θ).
Given a specific value of θ, the weight vector (w1 · · · wn ) solving Equation (1) can be viewed as
a distribution (πw ) with minimum Kullback–Leibler divergence (DKL ) from the discrete uniform
distribution (πu ) on the same set of observation values while satisfying the constraints in Equation (1)
because
n
1 1/n 1 
n
DKL (πu |πw ) = log = constant − log(wk ).
n wk n
k=1 k=1
Thus maximizing the objective function in Equation (1) is equivalent to minimizing DKL (πu |πw ).
In statistical hypothesis testing literature, Kullback–Leibler divergence is equivalent to negative log-
likelihood function that is the basis for constructing test statistics. This relationship provides a
statistical justification that the estimated θ is the peripheral correlation vector that corresponds to
a stressed scenario ”nearest” to the observed scenario in the DKL sense.
Observe that through this construction, the positive semidefiniteness of the resultant correlation
matrix is implicitly guaranteed. It is because the θ values that fail to give a positive semidefinite cor-
relation matrix automatically fail to have a corresponding set of weights w1 , . . . , wn satisfying all the
constraints. In addition, this method is fully non-parametric and in particular we do not need to
assume Normality of the observations. The resulting estimate for θ is called the Maximum Empiri-
cal Likelihood estimator and we denote it by θ̂MELE . Standard Lagrange multiplier method together
with a Newton–Lagrange algorithm [15, Ch.3.14 and Ch.12.3] can be used to solve for θ̂MELE effi-
ciently. An outline of the algorithm is provided in the appendix. The algorithm converges fairly fast.
For our empirical study in next section, we use the peripheral correlations of ĈF to be described in
next section as initial values and our Matlab program only takes 104 s to converge with a PC (CPU
3.4 GHz).

3. An empirical study
In this section, we analyse a portfolio of 10 USD-denominated asset log-return data comprising the
MSCI standard Country Price Indices of Portugal, Italy, Greece, Spain, the UK, France and Germany;
2710 K.-W. HO

Table 1. Cstress (lower triangular) and Cnormal (upper triangular).

Asset 1 2 3 4 5 6 7 8 9 10
Portugal 1 0.448 0.347 0.532 0.427 0.515 0.529 −0.006 0.274 0.292
Italy 0.894 1 0.267 0.643 0.557 0.657 0.611 −0.033 0.166 0.169
Greece 0.727 0.679 1 0.319 0.271 0.317 0.332 −0.015 0.167 0.184
Spain 0.909 0.935 0.685 1 0.627 0.752 0.680 −0.042 0.174 0.182
UK 0.833 0.896 0.609 0.843 1 0.728 0.632 −0.040 0.345 0.343
France 0.898 0.963 0.698 0.923 0.945 1 0.757 −0.036 0.170 0.175
Germany 0.872 0.936 0.669 0.883 0.932 0.976 1 −0.100 0.183 0.198
US Bond −0.303 −0.294 −0.230 −0.239 −0.261 −0.257 −0.258 1 0.164 0.115
UK Bond 0.552 0.562 0.359 0.512 0.685 0.576 0.582 −0.096 1 0.979
GBP 0.567 0.582 0.378 0.532 0.707 0.596 0.600 −0.120 0.995 1

Table 2. Cstress (lower triangular) and ĈF (upper triangular).

Asset 1 2 3 4 5 6 7 8 9 10
Portugal 1 0.898 0.904 0.896 0.428 0.516 0.529 −0.006 0.274 0.291
Italy 0.894 1 0.881 0.920 0.553 0.649 0.608 −0.033 0.166 0.171
Greece 0.727 0.679 1 0.861 0.279 0.334 0.338 −0.015 0.167 0.180
Spain 0.909 0.935 0.685 1 0.620 0.735 0.674 −0.042 0.174 0.186
UK 0.833 0.896 0.609 0.843 1 0.731 0.633 −0.040 0.345 0.342
France 0.898 0.963 0.698 0.923 0.945 1 0.760 −0.036 0.170 0.173
Germany 0.872 0.936 0.669 0.883 0.932 0.976 1 −0.099 0.183 0.198
US Bond −0.303 −0.294 −0.230 −0.239 −0.261 −0.257 −0.258 1 0.164 0.115
UK Bond 0.552 0.562 0.359 0.512 0.685 0.576 0.582 −0.096 1 0.979
GBP 0.567 0.582 0.378 0.532 0.707 0.596 0.600 −0.120 0.995 1

the USA and UK Benchmark two-year Datastream Government Bond Indices and WM/Reuters
USD/GBP Closing Spot Rate. The same data set has been analysed in Ng et al.[13] and Yu et al.[14]
We follow their approach to consider the period from 2 January 1989 to 30 April 2008 as a normal
period for calculating the long-run correlation matrix (Cnormal ) and the period 4 January 2010 to 30
June 2010 to be the Euro debt crisis period for calculating the correlation matrix under crisis (Cstress ).
Table 1 contrasts the correlation matrices in these two periods. The correlations among all country
price indices are higher in the crisis period. In particular, the increase of correlations among the PIGS
countries are especially large reflecting a possible contagion effect. On the other hand, the correla-
tions of US bond return and the country price indices are much more negative in the crisis period.
These observations justify the motivation of considering a different correlation matix for stress testing
purpose.
In this exercise, we follow Ng et al. [13] and Yu et al. [14] to set all correlations among the PIGS
countries to stress level of 0.90. As mentioned in introduction, a conventional method for construct-
ing stressed correlation matrix is to first change the core correlations to desired stress values to form
a matrix X and then use a Frobenius norm to find a positive semidefinite matrix that is closest to
it. Here we contrast the stressed correlation matrix (ĈF ) constructed by this method with Cstress in
Table 2. It is natural to see that for ĈF , the correlations among the PIGS countries are almost 0.90.
However, the peripheral correlations are very different from the ones in the crisis period. Indeed the
peripheral correlations stay quite close to those of Cnormal in Table 1.
This observation motivates Ng et al. [13] and Yu et al. [14] to suggest assigning the peripheral cor-
relations to more reasonable values by exploring the time series dependence of historical correlations.
Their reported stressed correlation matrices match Cstress rather closely. Table 3 reports the Frobe-
nius norms between different stressed correlation matrices with Cstress and X. We denote the stressed
correlation matrices of Ng et al. [13], Yu et al. [14] and our empirical likelihood approach by ĈNg ,
ĈYu and ĈEL , respectively. The Frobenius norm between Cstress and ĈNg is 1.0732 and that between
 JOURNAL OF STATISTICAL COMPUTATION AND SIMULATION 2711

Table 3. Frobenius norms between correlation matrices.

ĈF ĈNg ĈYu ĈEL

Cstress 2.7227 1.0732 0.9824 1.7281
X 0.0804 3.0625 2.9128 1.5286

Table 4. Cstress (lower triangular) and ĈEL (upper triangular).

Asset 1 2 3 4 5 6 7 8 9 10
Portugal 1 0.900 0.900 0.900 0.674 0.725 0.588 −0.196 0.401 0.408
Italy 0.894 1 0.900 0.900 0.692 0.740 0.573 −0.179 0.375 0.379
Greece 0.727 0.679 1 0.900 0.664 0.701 0.578 −0.173 0.393 0.399
Spain 0.909 0.935 0.685 1 0.704 0.761 0.644 −0.185 0.369 0.374
UK 0.833 0.896 0.609 0.843 1 0.805 0.676 −0.280 0.435 0.455
France 0.898 0.963 0.698 0.923 0.945 1 0.700 −0.293 0.252 0.268
Germany 0.872 0.936 0.669 0.883 0.932 0.976 1 −0.289 0.355 0.381
US Bond −0.303 −0.294 −0.230 −0.239 −0.261 −0.257 −0.258 1 0.127 0.078
UK Bond 0.552 0.562 0.359 0.512 0.685 0.576 0.582 −0.096 1 0.988
GBP 0.567 0.582 0.378 0.532 0.707 0.596 0.600 −0.120 0.995 1

Cstress and ĈYu is 0.9824. Both values are much lower than the Frobenius norm between Cstress and
ĈF which is 2.7227.
Although their methods produce good results in terms of closeness to Cstress , there is a major
concern about their methods. Both approaches require subjective assignments of important tuning
parameters without objective guidance. Ng et al. [13] requires subjective view to assign a τ parameter
in their paper and Yu et al. [14] requires subjective choice of several hyperparameter values in their
Bayesian approach. In order to apply their methods properly, an applicant has to be well experienced
and also be willing to spend time on tuning. This can create real obstacles in practical stress testing
exercises.
In contrast, the proposed empirical likelihood approach is free from tuning. Given the data and the
correlation constraints, only one stressed correlation matrix can be produced. If a bank employs the
proposed method to produce a stressed correlation matrix, regulators can easily understand, check
and even reproduce it. The transparency and simplicity of our method is a major advantage in practi-
cal consideration. However, because of the objective nature of the proposed method, the performance
of ĈEL in terms of closeness to Cstress is not as good as those of ĈNg and ĈYu . We can see from Table 3
that the Frobenius distance from ĈEL to Cstress is 1.7281 which is not as good as the performances of
ĈNg and ĈYu but is much better than that of ĈF in this respect.
To further illustrate the advantage of the empirical likelihood approach, we report ĈEL in Table 4
with a comparison with Cstress . First, we observe the stressed correlations are exactly 0.90 that is
desirable. Second, comparing with the performance of ĈF in Table 2, we can see that most of the
peripheral correlations of ĈEL are driven much closer to those of Cstress . Although the empirical like-
lihood approach does not require any subjective tuning, the peripheral correlations are automatically
adjusted to accommodate information from both the observed data and the stress scenario. This
aspect shares some benefits of the methods proposed in Ng et al.[13] and Yu et al.[14]

4. Conclusion
In this paper, we propose a method using empirical likelihood approach to construct a stressed corre-
lation matrix for portfolio risk management. The constructed matrix has a clear statistical meaning.
It corresponds to a stress scenario that is nearest, in the Kullback–Leibler divergence sense, to the
observed scenario. The method is non-parametric, simple and objective. Therefore it is suitable for
practical risk management applications. One possible extension of this research is to consider other
2712 K.-W. HO

divergence measures like power divergence (see, e.g. [16, Ch.7] ). We shall explore this direction and
compare the results in another paper.

Disclosure statement
No potential conflict of interest was reported by the author.

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Appendix
In this section we outline the Lagrange multiplier method from Owen [15] that we used to find θ̂MELE = arg maxθ R(θ )
in Equation (1). To simplify the presentation, we first define standardized returns (yik )i=1,...,p;k=1,...,n as:
xik − x̄i
yik = , i = 1, . . . , p; k = 1, . . . , n.
si
While S1 and S2 remains unchanged, it is easy to check that S3 to S5 can be rewritten equivalently as
n
S3∗ . k=1 wk yik = 0, i = 1, . . . , p;
n
S4∗ . k=1 wk yik = 1, i = 1, . . . , p;
2
n
S5∗ . k=1 wk yuj k yvj k = cj , j = 1, . . . , m.

The empirical likelihood equation (1) can be rewritten equivalently as

 n
 n
R(θ) = max nwk wk ylj k ytj k = θj , j = 1 . . . , d; S1, S2, S3∗ − S5∗ .
w1 ,...,wn
k=1 k=1

The Lagrangian can be written as

 

n 
n 
n
T
L= log(nwk ) + γ wk − 1 − nλ wk zk − η(θ ) , (A1)
k=1 k=1 k=1
 JOURNAL OF STATISTICAL COMPUTATION AND SIMULATION 2713

where zk = (yl1 k yt1 k · · · yld k ytd k y1k · · · ypk y1k

2 − 1 · · · y2 − 1 y
pk u1 k yv1 k − c1 · · · yum k yvm k − cm ) and η(θ ) = (θ1 · · ·
T

θd 0 · · · 0)T using the notations in S3∗ to S5∗ . Regarding the Lagrangian, the first term takes care the objective function
together with S1. The second term refers to S2 while the third term for the rest of the constraints. First-order condition
with respect to wk gives
nλT (wk zk ) − wk γ = 1, (A2)

1
⇒ wk = . (A3)
nλT zk − γ
Summing Equation (A2) over k = 1, . . . , n and using the first-order conditions with respect to λ and γ , we get
γ = n(λT η(θ ) − 1) (A4)
Putting Equation (A4) into Equation (A3), we have
1
wk = . (A5)
n(1 + λT (zk − η(θ )))
Using Equations (A4) and (A5), the Lagrangian (A1) can now be greatly reduced to

n
L(λ, θ) = − log(1 + λT (zk − η(θ ))). (A6)
k=1

Thus θ̂MELE can be fond by solving maxθ minλ L(λ, θ). We adopt the non-nested Newton–Lagrange algorithm which
is faster than nested algorithms. The updating step from the ith to (i + 1)th iteration is
(λi+1 T θi+1 T ) = (λi T θi T ) − τ g(λi , θi )H −1 (λi , θi ), (A7)
where g(λ, θ ) and H(λ, θ) are gradient vector and Hessian matrix of L(λ, θ), respectively, and τ is chosen to be 0.1 that
gives stable convergence in our empirical study. We omit further details and the formulas of g(λ, θ) and H(λ, θ) can be
found in Ch. 12.4 of Owen.[15]