On the interaction between market and credit risk: a factor-augmented vector autoregressive (FAVAR) approach

Roberta Fiori () and Simonetta Iannotti ()
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Roberta Fiori: Bank of Italy
Simonetta Iannotti: Bank for International Settlements

No 779, Temi di discussione (Economic working papers) from Bank of Italy, Economic Research and International Relations Area

Abstract: The aim of the paper is to understand the interaction between market and credit risk. Using a comprehensive set of Italian data, we apply a factor model to identify the common sources of risk driving fluctuations in the real and financial sectors. The common latent factors are then inserted in a VAR framework via a Factor Augmented Vector Autoregressive (FAVAR) approach to analyse the role of risk interactions with monetary policy shocks. We find that the impact of a restrictive monetary policy shock on credit risk is amplified when considering the feedback effect deriving from macroeconomic and equity market risk. Thus, neglecting dynamic interactions among risks may lead to biased estimates of the overall risk measure. The approach provides a framework for modelling macro and financial feedback dynamics, shedding some light on the complex interdependence between the financial sector and the real economy.

Keywords: FAVAR approach; credit risk; market risk; factor model (search for similar items in EconPapers)
JEL-codes: C32 E44 G21 (search for similar items in EconPapers)
Date: 2010-10
New Economics Papers: this item is included in nep-ban and nep-mic
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:bdi:wptemi:td_779_10

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