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On the interaction between market and credit risk: a factor-augmented vector autoregressive (FAVAR) approach

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  • Roberta Fiori

    ()
    (Bank of Italy)

  • Simonetta Iannotti

    ()
    (Bank for International Settlements)

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    Abstract

    The aim of the paper is to understand the interaction between market and credit risk. Using a comprehensive set of Italian data, we apply a factor model to identify the common sources of risk driving fluctuations in the real and financial sectors. The common latent factors are then inserted in a VAR framework via a Factor Augmented Vector Autoregressive (FAVAR) approach to analyse the role of risk interactions with monetary policy shocks. We find that the impact of a restrictive monetary policy shock on credit risk is amplified when considering the feedback effect deriving from macroeconomic and equity market risk. Thus, neglecting dynamic interactions among risks may lead to biased estimates of the overall risk measure. The approach provides a framework for modelling macro and financial feedback dynamics, shedding some light on the complex interdependence between the financial sector and the real economy.

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    File URL: http://www.bancaditalia.it/pubblicazioni/econo/temidi/td10/td779_10/en_td_779_10/en_tema_779.pdf
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    Bibliographic Info

    Paper provided by Bank of Italy, Economic Research and International Relations Area in its series Temi di discussione (Economic working papers) with number 779.

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    Date of creation: Oct 2010
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    Handle: RePEc:bdi:wptemi:td_779_10

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    Web page: http://www.bancaditalia.it
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    Related research

    Keywords: FAVAR approach; credit risk; market risk; factor model;

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    1. Lutz Kilian, 1998. "Small-Sample Confidence Intervals For Impulse Response Functions," The Review of Economics and Statistics, MIT Press, vol. 80(2), pages 218-230, May.
    2. James H. Stock & Mark W. Watson, 2005. "Implications of Dynamic Factor Models for VAR Analysis," NBER Working Papers 11467, National Bureau of Economic Research, Inc.
    3. Ben S. Bernanke & Jean Boivin & Piotr Eliasz, 2004. "Measuring the effects of monetary policy: a factor-augmented vector autoregressive (FAVAR) approach," Finance and Economics Discussion Series 2004-03, Board of Governors of the Federal Reserve System (U.S.).
    4. Stock, James H & Watson, Mark W, 2002. "Macroeconomic Forecasting Using Diffusion Indexes," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(2), pages 147-62, April.
    5. Jushan Bai & Serena Ng, 2004. "Evaluating Latent and Observed Factors in Macroeconomics and Financ," Econometrics 0408007, EconWPA.
    6. Moench, Emanuel, 2008. "Forecasting the yield curve in a data-rich environment: A no-arbitrage factor-augmented VAR approach," Journal of Econometrics, Elsevier, vol. 146(1), pages 26-43, September.
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