Worst-case higher moment risk measure: Addressing distributional shifts and procyclicality

Carlos Castro-Iragorri, Fabio Gómez and Nancy Quiceno

Finance Research Letters, 2024, vol. 65, issue C

Abstract: This paper addresses the inherent procyclicality in widely adopted financial risk measures, such as expected shortfall (ES). We propose an innovative approach utilizing the worst-case higher moment (HM) risk measure, which offers a robust solution to distributional shifts by incorporating adaptive features. Empirical results using historical S&P500 returns indicate that worst-case HM risk measures significantly reduce the underestimation of risk and provide more stable risk assessments throughout the financial cycle compared to traditional ES predictions. These results suggest that worst-case HM risk measures represent a viable alternative to regulatory add-ons for stress testing and procyclicality mitigation in financial risk management.

Keywords: Procyclicality; Higher moment risk; Stress testing; Expected shortfall (search for similar items in EconPapers)
JEL-codes: C58 G17 G32 (search for similar items in EconPapers)
Date: 2024
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Persistent link: https://EconPapers.repec.org/RePEc:eee:finlet:v:65:y:2024:i:c:s154461232400610x

DOI: 10.1016/j.frl.2024.105580

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