Pro-Cyclicality of Traditional Risk Measurements: Quantifying and Highlighting Factors at its Source

Marcel Br\"autigam, Michel Dacorogna and Marie Kratz

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Abstract: Since the introduction of risk-based solvency regulation, pro-cyclicality has been a subject of concerns from all market participants. Here, we lay down a methodology to evaluate the amount of pro-cyclicality in the way finnancial institutions measure risk, and identify factors explaining this pro-cyclical behavior. We introduce a new indicator based on the Sample Quantile Process (SQP, a dynamic generalization of Value-at-Risk), conditioned on realized volatility to quantify the pro-cyclicality, and evaluate its amount in the markets, considering 11 stock indices as realizations of the SQP. Then we determine two main factors explaining the pro-cyclicality: the clustering and return-to-the-mean of volatility, as it could have been anticipated but not quantified before, and, more surprisingly, the very way risk is measured, independently of this return-to-the-mean effect.

Date: 2019-03, Revised 2019-12
New Economics Papers: this item is included in nep-ban and nep-rmg
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Persistent link: https://EconPapers.repec.org/RePEc:arx:papers:1903.03969

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