Risk-neutral systemic risk indicators

Allan M. Malz

No 607, Staff Reports from Federal Reserve Bank of New York

Abstract: This paper describes a set of indicators of systemic risk computed from current market prices of equity and equity index options. It displays results from a prototype version, computed daily from January 2006 to January 2013. The indicators represent a systemic risk event as the realization of an extreme loss on a portfolio of large-intermediary equities. The technique for computing them combines risk-neutral return distributions with implied return correlations drawn from option prices, tying together the single-firm return distributions via a copula to simulate the joint distribution and thus the financial-sector portfolio return distribution. The indicators can be computed daily using only current market prices; no historical data are involved. They are therefore forward-looking and can exploit all the information impounded in current prices. However, the indicators blend both market expectations and the market's desire to protect itself against volatility and tail risk, so they cannot be readily decomposed into these two elements. The paper presents evidence that the indicators have some predictive power for systemic risk events and that they can serve as a meaningful market-adjusted point of comparison for fundamentals-based systemic risk indicators.

Keywords: systemic risk; option pricing; copula methods; risk-neutral distributions; implied correlation (search for similar items in EconPapers)
JEL-codes: G01 G13 G17 G18 G21 (search for similar items in EconPapers)
Date: 2013
New Economics Papers: this item is included in nep-ban and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

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