Multivariate dependence of implied volatilities from equity options as measure of systemic risk

Andreas Jobst ()

International Review of Financial Analysis, 2013, vol. 28, issue C, 112-129

Abstract: This paper presents a methodology to examine the multivariate tail dependence of the implied volatility of equity options as an early warning indicator of systemic risk within the financial sector. Using non-parametric methods of estimating changes in the dependence structure in response to common shocks affecting individual risk profiles, possible linkages during periods of stress are quantifiable while recognizing that large shocks are transmitted across financial markets differently than small shocks. Before and during the initial phase of the financial crisis, we find that systemic risk increased globally as early as February 2007 — months before the unraveling of the U.S. subprime mortgage crisis and long before the collapse of Lehman Brothers. The average (multivariate) dependence among a global sample of banks and insurance companies increased by almost 30% while joint tail risk declined by about the same order of magnitude, indicating that co-movements of large changes in equity volatility were more likely to occur and responses to extreme shocks became more differentiated as distress escalated. The key policy consideration flowing from our analysis is that complementary measures of joint tail risk at high data frequency are essential to the robust measurement of systemic risk, which could enhance market-based early warning mechanisms as part of macroprudential surveillance.

Keywords: Early warning; Dependence; Correlation; Co-movement; Systemic risk; Extreme value theory; Generalized extreme value; Entropy; Financial contagion; Macroprudential surveillance (search for similar items in EconPapers)
JEL-codes: C46 C51 G01 G21 G28 (search for similar items in EconPapers)
Date: 2013
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Citations: View citations in EconPapers (13)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:finana:v:28:y:2013:i:c:p:112-129

DOI: 10.1016/j.irfa.2013.01.005

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