April 28, 2014: IAQF/Thalesians Seminar Series

Risk-Neutral Systemic Risk Indicators

A Talk by Allan Malz

Abstract
This paper describes a set of indicators of systemic risk computed from current market prices of equity and equity index options. It displays results from a prototype version, computed daily from January 2006 to January 2013. The indicators represent a systemic risk event as the realization of an extreme loss on a portfolio of large- intermediary equities. The technique for computing them combines risk-neutral return distributions with implied return correlations drawn from option prices, tying together the single-firm return distributions via a copula to simulate the joint distribution and thus the financial-sector portfolio return distribution. The indicators can be computed daily using only current market prices; no historical data are involved. They are therefore forward-looking and can exploit all the information impounded in current prices. However, the indicators blend both market expectations and the market’s desire to protect itself against volatility and tail risk, so they cannot be readily decomposed into these two elements. The paper presents evidence that the indicators have some predictive power for systemic risk events and that they can serve as a meaningful market-adjusted point of comparison for fundamentals-based systemic risk indicators.

Biography
Allan M. Malz is Senior Analytical Advisor in the Markets Group at the Federal Reserve Bank of New York, where he has worked on implementation of the Fed's emergency liquidity programs to address the financial crisis. He is the author of Financial Risk Management: Models, History, and Institutions (Wiley, 2011), a survey of quantitative risk management tools and of the public policy issues raised by the financial crisis. Before rejoining the Fed, he was chief risk officer at several multi-strategy hedge fund management firms. Previously, Malz was head of research at RiskMetrics Group, which he joined on its spinoff from J.P. Morgan. Malz spent his earlier career at the New York Fed as a researcher and foreign exchange trader. His research, which includes forecasting financial crises, risk measurement for options, and estimation of risk-neutral probability distributions, has been published in a number of industry and academic journals. Malz holds a Ph.D. in Economics from Columbia University, where he also teaches a graduate course on risk management.