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A General Approach to Integrated Risk Management with Skewed, Fat-tailed Risks
Company: Federal Reserve Bank of New York
Year Of Publication: 2004
Month Of Publication: April
Pages: 53
Download Count: 1666
View Count: 9706
Comment Num: 0
Language: EN
Source:
Who Can Read: Free
Date: 5-31-2004
Publisher: Administrator
Summary
Abstract: The goal of integrated risk management in a financial institution is to measure and manage risk and capital across a range of diverse business activities. This requires an approach foraggregating risk types (market, credit, and operational) whose distributional shapes vary considerably. In this paper, we construct the joint risk distribution for a typical large, internationally active bankusing the method of copulas. This technique allows us to incorporate realistic marginal distributions that capture some of the essential empirical features of these risks like skewness and fat-tails whileallowing for a rich dependence structure.We explore the impact of business mix and inter-risk correlations on total risk, whethermeasured by value-at-risk or expected shortfall. Our findings indicate that risk measurements areespecially sensitive to assumptions about operational exposure and operational correlation with otherrisk types. The choice of copula, which determines the level of tail dependence, also has a significant effect on risk. We then compare the copula-based method with several conventional approaches to computing risk, each of which may be thought of as an approximation. One easily implemented approximation, which uses empirical correlations and quantile estimates, tracks the copula approach surprisingly well. In contrast, the additive approximation, which assumes no diversification benefit, overestimates risk by 20-35%.
Author(s)
Rosenberg, Joshua Sign in to follow this author
Schuermann, Til Sign in to follow this author
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