Report

Risk-neutral systemic risk indicators

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.

Keywords: systemic risk; option pricing; copula methods; risk-neutral distributions; implied correlation;

JEL Classification: G01; G13; G17; G18; G21;

Bibliographic Information

Provider: Federal Reserve Bank of New York

Part of Series: Staff Reports

Publication Date: 2013

Number: 607