A new family of modified Gaussian copulas for market consistent valuation of government guarantees

Roy Cerqueti (), Francesco Cesarone (), Maria C. Heusch () and Carlo D. Mottura ()
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Roy Cerqueti: Sapienza University of Rome
Francesco Cesarone: Roma Tre University
Maria C. Heusch: Roma Tre University
Carlo D. Mottura: Roma Tre University

Review of Managerial Science, 2024, vol. 18, issue 7, No 9, 1985-2005

Abstract: Abstract This paper deals with a copula-based stochastic dependence problem in the context of financial risks. We discuss the financial framework for assessing the theoretical up-front value of government guarantees on bank liabilities. EU States widely use these contracts to improve the financial system’s stability and manage the banking sector in crisis situations; in Italy, they have also been used to address the consequences of the Covid-19 emergency. From a market viewpoint, we deal with a defaultable guarantee contract where the State-guarantor and the bank-borrower are both subject to default risk, and their risks are interconnected. We show that the classical Gaussian copula is not satisfactory for modeling the dependence among the considered risks. Indeed, using the benchmark market model for credit risk portfolio management, we highlight some contradictory results observed for the up-front values of the guarantee when the default intensity of the guarantor is smaller than that of the borrower. Then, we introduce a new family of modified Gaussian copulas that overcomes the limitations of the standard approach, allowing to determine realistic results in terms of the guarantees “mark-to-model” value when the benchmark market model does not work. Numerical simulations validate the theoretical proposal.

Keywords: Gaussian copulas; Stochastic dependence; Default risks; Government guarantee; Financial crisis; 62H05; 91-10; 91G30 (search for similar items in EconPapers)
Date: 2024
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DOI: 10.1007/s11846-022-00600-1

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