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Speaker:
Michel Dacorogna (University of Zurich)

Pro-Cyclicality of Traditional Risk Measurements: Quantifying and Highlighting Factors at its Source

Abstract

Since the introduction of risk-based solvency regulation, pro-cyclicality has been a subject of concerns from all market participants. Here, we lay down a methodology to evaluate the amount of pro-cyclicality in the way financial institutions measure risk, and identify factors explaining this pro-cyclical behavior. We introduce a new indicator based on the Sample Quantile Process (SQP, a dynamic  generalization of Value-at-Risk), conditioned on realized volatility to quantify the pro-cyclicality, and evaluate its amount in the markets, considering 11 stock indices as realizations of the SQP. Then we determine two main factors explaining the pro-cyclicality: the clustering and return-to-the-mean of volatility, as it could have been anticipated but not quantified before, and, moresurprisingly, the very way risk is measured, independently of this return-to-the-mean effect.

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