On the Aggregation of Market and Credit Risks
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.
|Date of creation:||Oct 2003|
|Date of revision:|
|Contact details of provider:|| Postal: PO Box 218, Whiteknights, Reading, Berks, RG6 6AA|
Phone: +44 (0) 118 378 8226
Fax: +44 (0) 118 975 0236
Web page: http://www.henley.reading.ac.uk/
More information through EDIRC
References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Ross, Stephen A., 1976. "The arbitrage theory of capital asset pricing," Journal of Economic Theory, Elsevier, vol. 13(3), pages 341-360, December.
- Ammer, John & Campbell, John, 1993.
"What Moves the Stock and Bond Markets? A Variance Decomposition for Long-Term Asset Returns,"
3382857, Harvard University Department of Economics.
- Campbell, John Y & Ammer, John, 1993. " What Moves the Stock and Bond Markets? A Variance Decomposition for Long-Term Asset Returns," Journal of Finance, American Finance Association, vol. 48(1), pages 3-37, March.
- John Y. Campbell & John Ammer, 1991. "What Moves the Stock and Bond Markets? A Variance Decomposition for Long-Term Asset Returns," NBER Working Papers 3760, National Bureau of Economic Research, Inc.
- Campbell, J.Y. & Ammer, J., 1991. "What Moves The Stock And Bond Markets? A Variance Decomposition For Long- Term Asset Returns," Papers 127, Princeton, Department of Economics - Financial Research Center.
- Chan, Louis K. C. & Karceski, Jason & Lakonishok, Josef, 1998. "The Risk and Return from Factors," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 33(02), pages 159-188, June.
- Charles S. Morris & Robert Neal & Doug Rolph, 1998. "Credit spreads and interest rates : a cointegration approach," Research Working Paper 98-08, Federal Reserve Bank of Kansas City.
- 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.
- Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
- Pierre Collin-Dufresne, 2001. "The Determinants of Credit Spread Changes," Journal of Finance, American Finance Association, vol. 56(6), pages 2177-2207, December.
- Merton, Robert C., 1973.
"On the pricing of corporate debt: the risk structure of interest rates,"
684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
- Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-70, May.
- 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.
- 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.
- Longstaff, Francis A & Schwartz, Eduardo S, 1995. " A Simple Approach to Valuing Risky Fixed and Floating Rate Debt," Journal of Finance, American Finance Association, vol. 50(3), pages 789-819, July.
- 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.
- Duffie, Darrell & Singleton, Kenneth J, 1999. "Modeling Term Structures of Defaultable Bonds," Review of Financial Studies, Society for Financial Studies, vol. 12(4), pages 687-720.
- Blume, Marshall E & Keim, Donald B & Patel, Sandeep A, 1991. " Returns and Volatility of Low-Grade Bonds: 1977-1989," Journal of Finance, American Finance Association, vol. 46(1), pages 49-74, March.
- Gregory Connor and Robert A. Korajczyk., 1988. "The Attributes, Behavior and Performance of U.S. Mutual Funds," Research Program in Finance Working Papers 181, University of California at Berkeley.
- Solnik, Bruno, 1983. " International Arbitrage Pricing Theory," Journal of Finance, American Finance Association, vol. 38(2), pages 449-57, May.
- 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.).
When requesting a correction, please mention this item's handle: RePEc:rdg:icmadp:icma-dp2003-13. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Marie Pearson)
If references are entirely missing, you can add them using this form.