Marking systemic portfolio risk with the Merton model

The downside risk of a portfolio of assets is generally substantially higher than the downside risk of its components. In times of crisis, when assets tend to have high correlation, the understanding of this difference can be crucial in managing the systemic risk of a portfolio. In this article, Alex Langnau and Daniel Cangemi generalise Merton’s option formula in the presence of jumps to the multi-asset case. The methodology provides a new way to mark and risk-manage the systemic risk of portfolios in a systematic way

It has been argued that one of the factors that triggered the downfall of Long-Term Capital Management (LTCM) was its failure to properly incorporate fat tails of asset price distributions into investment decisions as well as risk management (Lowenstein, 2000). Today, financial institutions systematically deduce fat tails from the option markets and incorporate this information consistently into the pricing as well as the risk management framework.

Despite this progress, it is interesting to