Measuring systemic risk using vine-copula

• Published in: Economic modelling 2016-02, Vol.53, p.63-74
• Main Authors: Pourkhanali, Armin, Kim, Jong-Min, Tafakori, Laleh, Fard, Farzad Alavi
• Format: Article
• Language: English
• Subjects: Correlation analysis; Credit default swaps; Credit risk; Default; Financial institutions; International finance; Partial correlation; Risk assessment; Risk factors; Studies; Vine copula
• ISSN: 0264-9993; 1873-6122
• DOI: 10.1016/j.econmod.2015.11.010

We present an intuitive model of systemic risk to analyse the complex interdependencies between different borrowers. We characterise systemic risk by the way that financial institutions are interconnected. Using their probability of default, we classify different international financial institutions into five rating groups. Then we use the state-of-the-art canonical (C-) and D-vine copulae to investigate the partial correlation structure between the rating groups. Amongst many interesting findings, we discover that the second tier financial institutions pay a larger contribution to the systemic risk than the top tier borrowers. Further, we discuss an application of our methodology for pricing credit derivative swaps. •We put to work the recently developed C-vine and D-vine copulae for the analysis of interdependencies among financial institutions for systemic risk measurement.•We measured the partial correlation of the rating classes between Jan 2005 to Jan 2015, which includes the global financial crisis, and the following European debt crisis.•Amongst many interesting findings, we discover that the second tier financial institutions pay a larger contribution to the systemic risk than the top tier borrowers.