Scandinavian Working Papers in Economics

Working Paper Series,
Sveriges Riksbank (Central Bank of Sweden)

No 308: Modeling financial sector joint tail risk in the euro area

André Lucas (), Bernd Schwaab () and Xin Zhang ()
Additional contact information
André Lucas: VU University Amsterdam, Postal: De Boelelaan 1105, 1081 HV Amsterdam
Bernd Schwaab: European Central Bank, Postal: Kaiserstrasse 29, 60311 Frankfurt, Germany
Xin Zhang: Research Department, Central Bank of Sweden, Postal: Sveriges Riksbank, SE-103 37 Stockholm, Sweden

Abstract: We develop a novel high-dimensional non-Gaussian modeling framework to infer measures of conditional and joint default risk for many financial sector firms. The model is based on a dynamic Generalized Hyperbolic Skewed-t block-equicorrelation copula with time-varying volatility and dependence parameters that naturally accommodates asymmetries, heavy tails, as well as non-linear and time-varying default dependence. We apply a conditional law of large numbers in this setting to define joint and conditional risk measures that can be evaluated quickly and reliably. We apply the modeling framework to assess the joint risk from multiple defaults in the euro area during the 2008–2012 financial and sovereign debt crisis. We document unprecedented tail risks during 2011–2012, as well as their steep decline after subsequent policy actions.

Keywords: dynamic equicorrelation; generalized hyperbolic distribution; law of large numbers; large portfolio approximation

JEL-codes: C32; G21

42 pages, June 1, 2015

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