Measuring adequately the benefit of diversification in the extreme quantiles: An inquiry into covariation on the brink of catastrophe

Pierre-Charles Pradier, Guillaume Rideau () and Sakina Rrguiti ()
Additional contact information
Guillaume Rideau: Groupe BPCE, Département Risques Participations Non Bancaires
Sakina Rrguiti: Université Paris 1 Panthéon-Sorbonne, Centre d'Economie de la Sorbonne et Groupe BPCE

Documents de travail du Centre d'Economie de la Sorbonne from Université Panthéon-Sorbonne (Paris 1), Centre d'Economie de la Sorbonne

Abstract: The aim of this work is to better understand the nature of covariation in the vicinity of extremes on financial data and assess whether the usual assumptions and covariation measures fits the actual data. For simplicity, we consider pairs of random variables. In order to identify the shape of the covariation all along the distribution, and particularly as the extreme quantiles are approached, we describe the contribution of each of the variables from a random couple to the quantiles of the weighted sum of these variables. This approach makes sense since it can be interpreted in terms of Value-at-Risk in a financial institution: the VaR of the sum of variables may represent the capital requiremet for a diversified conglomerate, while the sum of VaR of the variables would correspond to the capital requirements for the components of the conglomerate, without taking diversification into account. The ratio of these two quantities appears as a good measure of both the benefit of diversification and the decorrelation of variables. We thus compare the values of quantiles and ratio taken from a representative dataset to the values obtained from various simulations relying on the usual assumptions. The result of this comparison is that the usual assumptions do not correctly model the covariation of the real-word data. In particular, the usual assumptions tend to exaggerate the correlation in the vicinity of extreme loss while the benefit of diversification is uniform across distribution. Additional simulations and modelling assumptions may be required to assess the generality of this result

Keywords: Financial Conglomerates; Diversification; Value-at-Risk; Capital requirements (search for similar items in EconPapers)
JEL-codes: G20 G21 G22 G28 (search for similar items in EconPapers)
Pages: 17 pages
Date: 2022-11
New Economics Papers: this item is included in nep-rmg
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Downloads: (external link)
http://mse.univ-paris1.fr/pub/mse/CES2022/22021.pdf (application/pdf)
https://shs.hal.science/halshs-03887413

Related works:
Working Paper: Measuring adequately the benefit of diversification in the extreme quantiles: An inquiry into covariation on the brink of catastrophe (2022)
Working Paper: Measuring adequately the benefit of diversification in the extreme quantiles: An inquiry into covariation on the brink of catastrophe (2022)
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Persistent link: https://EconPapers.repec.org/RePEc:mse:cesdoc:22021

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