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On the Aggregation of Market and Credit Risks

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  • Carol Alexandra

    ()
    (ICMA Centre, University of Reading)

  • Jacques Pezier

    ()
    (ICMA Centre, University of Reading)

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    Abstract

    This paper presents a new approach to aggregating market and credit risks in large complex financial firms, banks in particular. By identifying risk factors that are common to many business activities, dependencies between different risk types across various lines of business can be properly accounted for in the aggregate risk estimate. The risk factor aggregation model is illustrated using historical data on market and credit risk factors that are common to many business units, including interest rates, credit spreads, equity indices and implied volatilities. Economic capital estimates obtained using the model are compared with the economic capital data from several major banks. Applications to optimal risk diversification shows that, whilst the independent control of economic capital by business unit can be sub-optimal, the risk factor aggregation approach has the great advantage of allowing both risks and returns in different business activities to be modeled in the same framework. We show that this greatly facilitates the constrained optimization of a risk/return objective.

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    File URL: http://www.icmacentre.ac.uk/pdf/discussion/DP2003-13.pdf
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    Bibliographic Info

    Paper provided by Henley Business School, Reading University in its series ICMA Centre Discussion Papers in Finance with number icma-dp2003-13.

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    Length: 30 pages
    Date of creation: Oct 2003
    Date of revision:
    Handle: RePEc:rdg:icmadp:icma-dp2003-13

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    Web page: http://www.henley.reading.ac.uk/
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    Related research

    Keywords: Risk economic; capital market; risk aggregation; risk diversification; value-at-risk; factor model; risk adjust return on capital;

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    1. Ross, Stephen A., 1976. "The arbitrage theory of capital asset pricing," Journal of Economic Theory, Elsevier, vol. 13(3), pages 341-360, December.
    2. Roll, Richard & Ross, Stephen A, 1980. " An Empirical Investigation of the Arbitrage Pricing Theory," Journal of Finance, American Finance Association, vol. 35(5), pages 1073-1103, December.
    3. Duffie, Darrell & Singleton, Kenneth J, 1997. " An Econometric Model of the Term Structure of Interest-Rate Swap Yields," Journal of Finance, American Finance Association, vol. 52(4), pages 1287-1321, September.
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    12. Pierre Collin-Dufresne, 2001. "The Determinants of Credit Spread Changes," Journal of Finance, American Finance Association, vol. 56(6), pages 2177-2207, December.
    13. Solnik, Bruno, 1983. " International Arbitrage Pricing Theory," Journal of Finance, American Finance Association, vol. 38(2), pages 449-57, May.
    14. Charles S. Morris & Robert Neal & Douglas Rolph, 1998. "Credit spreads and interest rates : a cointegration approach," Research Working Paper 98-08, Federal Reserve Bank of Kansas City.
    15. Gregory R. Duffee, 1996. "Treasury yields and corporate bond yield spreads: an empirical analysis," Finance and Economics Discussion Series 96-20, Board of Governors of the Federal Reserve System (U.S.).
    16. Priestley, Richard, 1996. "The arbitrage pricing theory, macroeconomic and financial factors, and expectations generating processes," Journal of Banking & Finance, Elsevier, vol. 20(5), pages 869-890, June.
    17. Connor, Gregory & Korajczyk, Robert A, 1993. " A Test for the Number of Factors in an Approximate Factor Model," Journal of Finance, American Finance Association, vol. 48(4), pages 1263-91, September.
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