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This paper describes purposes and principles of stress testing used in credit risk. One particular issue is stressing transition matrices among pools, for instance Probability of Default (PD) pools or Loss Given Default (LGD) pools. A possible approach to handle this problem is based on factor model assumed by the Basel Committee on Banking Supervision (BCBS), which is known as Merton or Vasicek model. In this paper, the model is generalized for transitions to more states than only the Default state, thus the theory can be used on transition matrices.
The theory is applied to the example of hypothetical mortgage loan portfolio, where the practical properties of Matrix stressing are shown.