Risk Models after the Credit Crisis

31 Pages Posted: 15 Dec 2009 Last revised: 13 Jun 2011

See all articles by Rob van den Goorbergh

Rob van den Goorbergh

APG Asset Management

Onno W. Steenbeek

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE); APG All Pensions Group

Roderick Molenaar

Robeco Asset Management

Peter Vlaar

Algemene Pensioen Groep (APG)

Date Written: June 10, 2011

Abstract

The 2008 credit crisis came as a complete surprise to most financial practitioners and academics. As risk models had largely been unable to predict the crisis and its impact on volatilities and correlations, the usefulness of such models has been widely called into question. This paper proposes a new model to remedy a number of important flaws. First, the possible start of a crisis is modeled by including a low-probability jump process. These jumps are associated with a significant drop in the stock market, lower risk-free interest rates, and a strong increase in credit spreads. Second, the risk characteristics of the crisis are captured by allowing for time-varying volatilities and correlations. Time variation in correlations is due to the changing importance of two sources: monetary shocks leading to a positive stock-bond correlation, and risk-aversion (or 'flight-to-safety') shocks leading to a negative stock-bond correlation. The model stays within the essentially affine class, thereby allowing for closed-form solutions for arbitrage-free nominal and real bond prices of all maturities. Moreover, equity options and swaption prices are included in the estimation procedure to enhance the proper modeling of the volatility on the equity and interest rate markets. The model captures a large part of the time-variation in financial risks for pension funds, due to both changing volatilities and correlations.

Keywords: essentially affine macro-finance term structure model, time-varying volatilities and correlations, jumps, options, swaptions, asset liability management

JEL Classification: E34, G13

Suggested Citation

van den Goorbergh, Rob and Steenbeek, Onno W. and Molenaar, Roderick and Vlaar, Peter, Risk Models after the Credit Crisis (June 10, 2011). Available at SSRN: https://ssrn.com/abstract=1521061 or http://dx.doi.org/10.2139/ssrn.1521061

Rob Van den Goorbergh

APG Asset Management ( email )

P.O. Box 75283
1070 AG Amsterdam
Netherlands

HOME PAGE: http://www.apg.nl/apgsite/pages/english/

Onno W. Steenbeek

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE) ( email )

Dept. of Finance, H14-1
P.O. Box 1738
3000 DR Rotterdam, 3000DR
Netherlands
+31-10-4081400 (Phone)
+31-10-4089165 (Fax)

HOME PAGE: http://people.few.eur.nl/steenbeek/

APG All Pensions Group ( email )

Gustav Mahlerplein 3
P.O. Box 75283
1070 AG Amsterdam
Netherlands
+31-20-6049122 (Phone)
+31-20-4059176 (Fax)

HOME PAGE: http://www.apg.nl

Roderick Molenaar

Robeco Asset Management ( email )

Weena 850
Rotterdam, 3014 DA
Netherlands

Peter Vlaar (Contact Author)

Algemene Pensioen Groep (APG) ( email )

P.O. Box 75283
Amsterdam, 1070 AG
Netherlands

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