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

Institute for Monetary and Financial Research, Hong Kong, Probabilistic Approach to Measuring Early-Warning Signals of Systemic Contagion Risk (February 13, 2018). 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, Available at SSRN: https://ssrn.com/abstract=2653482 or http://dx.doi.org/10.2139/ssrn.2653482

Hong Kong Institute for Monetary and Financial Research (Contact Author)

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