Principal Components as a Measure of Systemic Risk

30 Pages Posted: 5 Apr 2010

See all articles by Mark Kritzman

Mark Kritzman

Windham Capital Management

Yuanzhen Li

Windham Capital Management

Sebastien Page

State Street Associates

Roberto Rigobon

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER)

Date Written: March 31, 2010

Abstract

The U.S. government’s failure to provide oversight and prudent regulation of the financial markets, together with excessive risk taking by some financial institutions, pushed the world financial system to the brink of systemic failure in 2008. As a consequence of this near catastrophe, both regulators and investors have become keenly interested in developing tools for monitoring systemic risk. But this is easier said than done. Securitization, private transacting, and “flexible” accounting prevent us from directly observing the many explicit linkages of financial institutions. As an alternative, we introduce a measure of implied systemic risk called the absorption ratio, which equals the fraction of the total variance of a set of asset returns explained or “absorbed” by a fixed number of eigenvectors. The absorption ratio captures the extent to which markets are unified or tightly coupled. When markets are tightly coupled, they become more fragile in the sense that negative shocks propagate more quickly and broadly than when markets are loosely linked.

Keywords: Systemic risk, principal components

JEL Classification: C10, G00

Suggested Citation

Kritzman, Mark and Li, Yuanzhen and Page, Sebastien and Rigobon, Roberto, Principal Components as a Measure of Systemic Risk (March 31, 2010). Available at SSRN: https://ssrn.com/abstract=1582687 or http://dx.doi.org/10.2139/ssrn.1582687

Mark Kritzman

Windham Capital Management ( email )

5 Revere Street
Cambridge, MA 02138
United States
617-576-7360 (Phone)
617-576-7359 (Fax)

Yuanzhen Li

Windham Capital Management ( email )

5 Revere Street
Cambridge, MA 02138
United States

Sebastien Page (Contact Author)

State Street Associates ( email )

138 Mount Auburn Street
Cambridge, MA 02138
United States
617-234-9462 (Phone)
617-234-9478 (Fax)

Roberto Rigobon

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

E52-447
Cambridge, MA 02142
United States
617-258-8374 (Phone)
617-258-6855 (Fax)

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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