Managing Adverse Dependence for Portfolios of Collateral in Financial Infrastructures

Abstract

We propose a framework that allows a portfolio manager to quantify the probability of simultaneous losses in multiple assets of a collateral portfolio. Using this framework, we propose a methodology to conduct stress tests on the market value of the portfolio of collateral when undesirable extreme dependence occurs. This framework permits us to quantify the potential impact on the portfolio returns of systemic events that change, or 'break down', the historical comovement structure, imposing an adverse extreme dependence. We illustrate our framework using securities pledged as collateral in the Canadian securities clearing and settlement system.

Keywords: Collateral under extreme events, Copulas, Frechet bounds, Financial risk management, Extreme value theory

JEL Classification: G00, G10, C10