Probabilistic Approach to Measuring Early-Warning Signals of Systemic Contagion Risk

International Journal of Financial Engineering, Vol. 5, No. 2 (2018) 1850010

25 Pages Posted: 1 Sep 2015 Last revised: 19 Jul 2018

See all articles by Cho-Hoi Hui

Cho-Hoi Hui

Hong Kong Monetary Authority - Research Department

Chi-Fai Lo

The Chinese University of Hong Kong

Xiao Fen Zheng

The Chinese University of Hong Kong

Tom Fong

Hong Kong Monetary Authority

Date Written: February 13, 2018

Abstract

This paper proposes a model based on probability density functions associated with dynamics of underlying asset prices to measure contagion-induced systemic risk in the market.

The two new risk measures with closed-form formulas derived from the model are:

(1) the rate of change of the probability of triggering a shock determined by the joint dynamics of prices of systemically important assets/entities and less important ones; and

(2) the distress correlation between the two types of assets/entities, which can provide forward-looking signals of such risk.

The model is applied to the euro-area sovereign debt crisis and demonstrates how systemic liquidity shocks can build up in the sovereign debt market due to contagion between sovereign risk of small countries (i.e., Portugal) and systemically important countries (i.e., Italy and Spain). A signal of the rate of change of the joint probability appeared in April 2011 before the systemic liquidity shock occurred in November 2011. There exist endogenous critical levels of sovereign spreads, above which the signal materializes.

Keywords: systemic risk; probability density distributions; contagion

JEL Classification: F30, G13

Suggested Citation

Hui, Cho-Hoi and Lo, Chi-Fai and Zheng, Xiao Fen and Fong, Tom, Probabilistic Approach to Measuring Early-Warning Signals of Systemic Contagion Risk (February 13, 2018). International Journal of Financial Engineering, Vol. 5, No. 2 (2018) 1850010. Available at SSRN: https://ssrn.com/abstract=2653482 or http://dx.doi.org/10.2139/ssrn.2653482

Cho-Hoi Hui (Contact Author)

Hong Kong Monetary Authority - Research Department ( email )

Hong Kong
China

Chi-Fai Lo

The Chinese University of Hong Kong ( email )

Department of Physics
Shatin, N.T., Hong Kong
China

Xiao Fen Zheng

The Chinese University of Hong Kong ( email )

Shatin, N.T.
Hong Kong
China

Tom Fong

Hong Kong Monetary Authority ( email )

55/F, Two International Finance Centre, Central
Hong Kong
Hong Kong

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