Measuring Potential Market Risk

Abstract

The difference between market risk and potential market risk is emphasized and a measure of the latter risk is proposed. Specifically, it is argued that the spectrum of smooth Lyapunov exponents can be utilized in what we call (λ, σ2)-analysis, which is a method to monitor the aforementioned risk measures. The reason is that these exponents focus on the stability properties (λ) of the stochastic dynamic system generating asset returns, while more traditional risk measures such as value-at-risk are concerned with the distribution of returns (σ2).

Keywords: market risk, potential market risk, smooth Lyapunov exponents, stochastic dynamic system, value-at-risk

JEL Classification: G11