Modeling risk in a dynamically changing world: from association to causation

Sokolov, Yuri (2012): Modeling risk in a dynamically changing world: from association to causation.

Abstract

The current crisis causes numerous economic uncertainties, such as a break-up of the European currency union, and a Greek exit from the euro area to boost the competitiveness by means of devaluation of national currency. When a factor such as exchange rate is expected to have a significant effect on the borrowers’ creditworthiness or a shift in risk regime may have occurred, risk management models based on backward-looking statistical methods are inadequate.

Unlike the other approaches to risk modeling, the discussed approach for dynamic risk modeling doesn't ignore causation in favor of correlation and thus it is far more proactive. In contrast to existing risk models, FX rate is considered as a causal factor, which induces a negative correlation among default realizations and reveals ex ante dangerous risk concentrations with the clear economic and behavioral content.

• Item Type: MPRA Paper
• Language: English
• Keywords: Correlation; causation; dynamic risk modeling; credit portfolio management; factor modeling; competitiveness; exchange rate; FEBA approach
• Subjects: G - Financial Economics > G2 - Financial Institutions and Services > G28 - Government Policy and Regulation; G - Financial Economics > G3 - Corporate Finance and Governance > G32 - Financing Policy ; Financial Risk and Risk Management ; Capital and Ownership Structure ; Value of Firms ; Goodwill; G - Financial Economics > G3 - Corporate Finance and Governance > G30 - General; E - Macroeconomics and Monetary Economics > E3 - Prices, Business Fluctuations, and Cycles > E37 - Forecasting and Simulation: Models and Applications; G - Financial Economics > G2 - Financial Institutions and Services > G21 - Banks ; Depository Institutions ; Micro Finance Institutions ; Mortgages; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E47 - Forecasting and Simulation: Models and Applications; G - Financial Economics > G2 - Financial Institutions and Services > G20 - General

References

BCBS, "International Convergence of Capital Measurement and Capital Standards. A Revised Framework", 2004, BIS

BCBS, "Range of practices and issues in economic capital frameworks", 2009a, BIS

BCBS, "Findings on the interaction of market and credit risk", 2009b, Working Paper 16, BIS

BCBS, "Messages from the academic literature on risk measurement for the trading book", 2011, WP 19

BIS, 64-th Annual Report, 1994

Breuer T., Jandačka M., Rheinberger K., "Regulatory capital for market and credit risk interaction: is current regulation always conservative?" 2008, Deutsche Bundesbank, Discussion Paper No 14/2008

Čihák M., "Introduction to Applied Stress Testing", 2007, IMF Working Paper, International Monetary Fund

Credit Suisse Financial Products, CreditRisk+, 1997

Das S., Duffie D., Kapadia N., Saita L., "Common failings: How corporate defaults correlate", 2007, “The journal of finance”, vol. LXII, NO. 1

Drehmann M., Sorensen S., Stringa M., 'Integrating credit and interest rate risk: A theoretical framework and an application to banks' balance sheets", 2006

ECB, ”The use of portfolio credit risk models in central banks”, 2007, occasional paper series no 64, 2007, ECB

Egloff D., Leippold M., Vanini M., "A simple model of credit contagion", 2006

FitchRatings, Basel II Correlation Values: An Empirical Analysis of EL, UL, and the IRB Model, 2008, Available at www.fitchresearch.com

The Joint Forum, "Cross-sectoral review of group-wide identification and management of risk concentrations", 2008, BIS

The Joint Forum, "Trends in risk integration and aggregation", 2003, BIS

Kealhofer S., "Portfolio management of default risk", 1997, KMV

Krugman P., "Why Devalue?" 2010, NYT

Li D., "On default correlation: A copula function approach", 2000, RiskMetrics Group

Lucas D., "Default Correlation: From Definition to Proposed ", 2008, UBS Solutions CDO Research

Lucas D., "Default correlation and credit analysis", 1995, The Journal of Fixed Income, 5

Lutkebohmert E., "Concentration risk in credit portfolios. EAA lecture notes", 2009, Springer

Ostry J., Ghosh A., Chamon M., "Two Targets, Two Instruments: Monetary and Exchange Rate Policies in Emerging Market Economies", 2012, IMF

Pearl J., “Causal inference in statistics: An overview”, 2009, Statistics Surveys, Vol. 3 (2009)

Pu X., Zhao X., "Correlation in Credit Risk", OCC Economics Working Paper 2009-5, 2010, Office of the Comptroller of the Currency

Roubini N., "Roubini Says Greek Austerity Measures Will Worsen Debt Dynamics", 2012, Bloomberg BusinessWeek

Sokolov Y., "Interaction between market and credit risk: Focus on the endogeneity of aggregate risk", 2009, MPRA. Available at http://mpra.ub.uni-muenchen.de/18245

Sokolov Y., "Business cycle effects on portfolio credit risk: A simple FX Adjustment for a factor model", MPRA, 2010. Available at http://mpra.ub.uni-muenchen.de/27321

S&P, "Rating Methodology: Evaluating the Issuer", 2011, http://www.standardandpoors.com/spf/pdf/fixedincome/methodology.pdf

Zhou C., "An analysis of default correlations and multiple defaults" 2001, The Review of Financial Studies