Probabilistic Approach to Measuring Early-Warning Signals of Systemic Contagion Risk
International Journal of Financial Engineering, Vol. 5, No. 2 (2018) 1850010
Hong Kong Institute for Monetary and Financial Research (HKIMR) Research Paper WP No. 18/2015
25 Pages Posted: 1 Sep 2015 Last revised: 4 Aug 2022
Date Written: February 13, 2018
Abstract
This working paper was written by Cho-Hoi Hui (Hong Kong Monetary Authority), Chi-Fai Lo (The Chinese University of Hong Kong), Xiao-Fen Zheng (The Chinese University of Hong Kong) and Tom Fong (Hong Kong Monetary Authority).
This paper proposes a model based on probability density functions associated with dynamics of underlying asset prices to measure contagion-induced systemic risk in the market.
The two new risk measures with closed-form formulas derived from the model are:
(1) the rate of change of the probability of triggering a shock determined by the joint dynamics of prices of systemically important assets/entities and less important ones; and
(2) the distress correlation between the two types of assets/entities, which can provide forward-looking signals of such risk.
The model is applied to the euro-area sovereign debt crisis and demonstrates how systemic liquidity shocks can build up in the sovereign debt market due to contagion between sovereign risk of small countries (i.e., Portugal) and systemically important countries (i.e., Italy and Spain). A signal of the rate of change of the joint probability appeared in April 2011 before the systemic liquidity shock occurred in November 2011. There exist endogenous critical levels of sovereign spreads, above which the signal materializes.
Keywords: systemic risk; probability density distributions; contagion
JEL Classification: F30, G13
Suggested Citation: Suggested Citation