Systemic Risk: CoVaR, Comovement, and Portfolio Selection

Abstract

Systemic risk concerns the impact of an individual entity on a financial system, while (extreme) comovement measures one individual (extreme) loss given another individual (extreme) loss. A natural and challenging question is how to measure and forecast the collective impact of two individual losses on systemic risk, conditional on certain predictors and the comovement of these two individuals. We introduce a novel systemic risk measure, CoVaRCM, which integrates both comovement and predictor variables to assess the joint effect of two individual losses on systemic risk. Since the comovement event in our model depends on predictors and has zero probability, we employ a three-quantile regression model to conduct an efficient inference. We propose two metrics to compare CoVaRCM with the more conventional CoVaR, which does not account for comovement. Finally, we discuss a statistical inference procedure for portfolio selection via minimizing a systemic risk measure.