Modelling Systemic and Sovereign Risks

Dale F Gray and Andreas A Jobst

Contents

Introduction to 'Lessons from the Financial Crisis'

1.

The Credit Crunch of 2007: What Went Wrong? Why? What Lessons Can be Learned?

2.

Underwriting versus Economy: A New Approach to Decomposing Mortgage Losses

3.

The Shadow Banking System and Hyman Minsky’s Economic Journey

4.

The Collapse of the Icelandic Banking System

5.

The Quant Crunch Experience and the Future of Quantitative Investing

6.

No Margin for Error: The Impact of the Credit Crisis on Derivatives Markets

7.

The Re-Emergence of Distressed Exchanges in Corporate Restructurings

8.

Modelling Systemic and Sovereign Risks

9.

Measuring and Managing Risk in Innovative Financial Instruments

10.

Forecasting Extreme Risk of Equity Portfolios with Fundamental Factors

11.

Limits of Implied Credit Correlation Metrics Before and During the Crisis

12.

Another view on the pricing of MBSs, CMOs and CDOs of ABS

13.

Pricing of Credit Derivatives with and without Counterparty and Collateral Adjustments

14.

A Practical Guide to Monte Carlo CVA

15.

The Endogenous Dynamics of Markets: Price Impact, Feedback Loops and Instabilities

16.

Market Panics: Correlation Dynamics, Dispersion and Tails

17.

Financial Complexity and Systemic Stability in Trading Markets

18.

The Martingale Theory of Bubbles: Implications for the Valuation of Derivatives and Detecting Bubbles

19.

Managing through a Crisis: Practical Insights and Lessons Learned for Quantitatively Managed Equity Portfolios

20.

Active Risk Management: A Credit Investor’s Perspective

21.

Investment Strategy Returns: Volatility, Asymmetry, Fat Tails and the Nature of Alpha

The complex interactions, spillovers and feedbacks of the global crisis that began in 2007 remind us how important it is to improve our analysis and modelling of financial crises and sovereign risk. This chapter provides a broad framework to examine how vulnerabilities can build up and suddenly erupt in a financial crisis with potentially disastrous feedback effects for sovereign debt and economic growth. Traditional macroeconomic analysis overlooks the importance of risk, which makes it ill suited to examine interconnectedness and transmission mechanisms in response to common shocks. Against this background, the chapter discusses lessons from the crisis and new directions for research on modelling financial crises and sovereign risk. It shows how risk management tools and contingent claims analysis (CCA) can be applied in new ways to measure and analyse financial system and sovereign risk. A new framework (“Systemic CCA”) is presented, which can help the measurement, analysis and management of financial sector systemic risk, tail risk and associated government implicit and explicit guarantees (contingent liabilities).

Since October 2008, unprecedented and sweeping government

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