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On the Aggregation of Market and Credit Risks

Author

Listed:
  • Carol Alexandra

    () (ICMA Centre, University of Reading)

  • Jacques Pezier

    () (ICMA Centre, University of Reading)

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.

Suggested Citation

  • Carol Alexandra & Jacques Pezier, 2003. "On the Aggregation of Market and Credit Risks," ICMA Centre Discussion Papers in Finance icma-dp2003-13, Henley Business School, Reading University.
  • Handle: RePEc:rdg:icmadp:icma-dp2003-13
    as

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    File URL: http://www.icmacentre.ac.uk/pdf/discussion/DP2003-13.pdf
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    References listed on IDEAS

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    Cited by:

    1. Grundke, Peter, 2010. "Top-down approaches for integrated risk management: How accurate are they?," European Journal of Operational Research, Elsevier, vol. 203(3), pages 662-672, June.
    2. repec:asi:adprev:2017:p:100-119 is not listed on IDEAS

    More about this item

    Keywords

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

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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