Methodology for Determining Market Risk Scenarios
Description
The FHFA methodology to construct a historically-based shock for a given interest rate is to measure the absolute change at each term point on the corresponding yield curve over a six-month horizon, and then impose that absolute change on the current measure of that yield curve. However, because the current rate environment may differ significantly from the historical rate environment, imposing the historical shock on the current rate can result in a shock scenario that is implausible. Implausible shock scenarios include any that contain negative values for interest rates, and those where the resulting spread between any two different interest rates is inconsistent with the historically observed spread. To ensure that the resulting shock scenarios are plausible, FHFA uses a technique known as parsimonious factorization to represent each yield curve as a five-factor equation, and then applies measures of the shock made in parameter space to the current yield curve parameters to determine the shocked yield curve. This approach facilitates a straightforward means to impose constraints on generating the shock scenario that ensure its plausibility.
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