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Systemic risk index reaches unprecedented levels

Posted on 06-Sep-2011 by raisepartner

Concerns on the sensitivity of financial markets

“We are moving into a dangerous period,” president of the World Bank Robert Zoellick said in an interview with Bloomberg Television in Singapore today. “While the U.S. is likely to avoid a return to recession, escaping with slow growth, the euro zone is facing a particularly sensitive time.” (source: Bloomberg [1])

Do quantitative indicators confirm the worries formulated these past months?

The cross-sector correlation level as a relevant systemic risk indicator

The ability of market actors to analyze the real economic dynamics of listed companies plays a crucial role in the stability of financial markets. Industrial sectors do not all have the same fundamental characteristics such as market size and dynamics or supply/demand balance; hence the dynamics of the industrial sector indices usually exhibit some level of independence in normal market conditions.

When the systemic risk is high, the behavior of market actors tends to be driven by a few causal factors (among which liquidity) and all sectors become highly correlated.

Systemic risk higher than in 2008

The current level of cross-sector correlations suggests that the systemic risk is already higher than it was late 2008. The RP Quant Systemic Risk Index, an aggregated indicator of correlations across the Dow Jones industrial sectors, reached an unprecedented high end of August (220 vs. 210 in 2008):

The value of the index recently jumped from 100 to more than 200 because most cross-sector correlations exceeded 90% these past weeks!

The evolution of the RP Quant Systemic Index since 2007 suggests that financial markets conditions have never returned to normal since the 2008 crisis: the index remains larger than 100 during the whole period. The emergency liquidity injections allowed to limit the damages but do not provide a sustainable solution to the financial market situation.

The implied volatility index (VIX), which provides a measure of instantaneous risk aversion, has not reached its 2008 level yet. But in the current context, the extreme sensitivity of the financial markets could lead the index to similar levels if no sustainable agreement is found between European leaders.

These quantitative observations confirm the concerns brought up by many actors, and underline the necessity to make a concrete step towards what Lord Gladwyn called “the necessity for European political integration” in [2].

The model behind the RP Quant Systemic Risk Index

The RP Quant Systemic Risk Index is a daily aggregated indicator of correlations across the 10 Dow Jones industrial sectors: Basic Materials, Consumer Goods, Consumer Services, Finances, Health Care, Industries, Oil & Gas, Technology, Telecommunications, Utilities.

The index is defined as follows:

where the dynamics of the cross-sector correlations ρ_ij (t) is captured via a proprietary risk model based on adaptive estimation techniques in the lines of Spokoiny and Mercurio [3].

Read the french version

References

[1] http://www.bloomberg.com/news/2011-09-06/zoellick-says-world-in-dangerous-period-as-europe-turmoil-adds-to-risks.html
[2] Journal of International Affairs, 1967, No4, Vol.43
[3] Danilo Mercurio and Vladimir Spokoiny , Statistical inference for time-inhomogeneous volatility models. Ann. Statist. Volume 32, Number 2, 2004