Edinburgh Research Explorer

Reducing estimation risk using a Bayesian posterior distribution approach: Application to stress testing mortgage loan default

Research output: Contribution to journalArticle

Original languageEnglish
Pages (from-to)725-738
JournalEuropean Journal of Operational Research
Volume287
Issue number2
Early online date18 May 2020
DOIs
Publication statusPublished - 1 Dec 2020

Abstract

We propose a new stress testing method to model coefficient uncertainty in addition to macroeconomic stress. Based on U.S. mortgage loan data, we model the probability of default at account level using discrete time hazard analysis. We employ both the frequentist and Bayesian methods in parameter estimation and default rate (DR) stress testing. By applying the Bayesian parameter posterior distribution, which includes all ranges of possible parameter estimates, obtained in the Bayesian approach to simulating the DR distribution, we reduce the estimation risk coming from employing point estimates in stress testing. Since estimation risk, a commonly neglected source of risk, is addressed in our method, we obtain more prudential forecasts of credit losses. We find that the simulated DR distribution obtained using the Bayesian approach with the parameter posterior distribution has a standard deviation 10.7 times as large as that using the frequentist approach with parameter mean estimates. Moreover, the 99% values at risk (VaR) using the Bayesian posterior distribution approach is around 6.5 times the VaR at the same probability level using the point estimate approach.

    Research areas

  • OR in banking, stress testing, estimation risk, Bayesian posterior distribution approach, probability of default

ID: 143826721