Modeling Risk Weighted Assets and the Risk Sensitivity of Related Capital Requirements

22 Pages Posted: 18 Mar 2013

See all articles by Ernst Eberlein

Ernst Eberlein

University of Freiburg

Dilip B. Madan

University of Maryland - Robert H. Smith School of Business

Wim Schoutens

KU Leuven - Department of Mathematics

Multiple version iconThere are 2 versions of this paper

Date Written: December 10, 2012

Abstract

The use of internal Bank models for meeting capital requirements has been approved for some time. Regulators then face issues of model approval necessitating some public domain analysis of model performance. This paper presents a new approach to risk model evaluation using forward looking risk neutral probabilities. In addition to VaR and CVaR we analyse a new measure termed here RWAVaR that was proposed in Carr, Madan and Vicente Alvarez (2011). The new measure is a formalization of the popular concept of risk weighted assets used in the Basel approach to capital requirements. The formalization allows for a possible leveraging of information contained in bid and ask prices and the study reports on the potential of this approach. Capital measures using RWAVaR are observed to be sensitive to volatility, the volatility of volatility, the skewness of return distributions and the volatility spread across maturities. Movements in bid ask spreads also strongly influence capital requirements. Additionally there is a potential for some procyclicality to be built into the requirements, particularly when one adapts requirements to movements in liquidity spreads.

Suggested Citation

Eberlein, Ernst and Madan, Dilip B. and Schoutens, Wim, Modeling Risk Weighted Assets and the Risk Sensitivity of Related Capital Requirements (December 10, 2012). Available at SSRN: https://ssrn.com/abstract=2234789 or http://dx.doi.org/10.2139/ssrn.2234789

Ernst Eberlein

University of Freiburg ( email )

Department of Mathematical Stochastics
Eckerstrasse 1
D-79104, Freiburg
Germany
++49 761 203 5660 (Phone)
++49 761 203 5661 (Fax)

Dilip B. Madan (Contact Author)

University of Maryland - Robert H. Smith School of Business ( email )

College Park, MD 20742-1815
United States
301-405-2127 (Phone)
301-314-9157 (Fax)

Wim Schoutens

KU Leuven - Department of Mathematics ( email )

Celestijnenlaan 200 B
Leuven, B-3001
Belgium

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