COMMERCIAL AND INDUSTRIAL MATHEMATICS

Tom Hurd (McMaster)
Contagion channels for financial systemic risk (Slides)

Financial systemic risk (SR) is the risk that an economic shock triggers a chain of failures or significant losses in markets or financial institutions. It results in serious economic impact, including increases in the cost of capital and decreases in its availability. There are many distinct channels of SR, including correlated asset shocks, default contagion, funding liquidity contagion and market illiquidity effects. My talk will focus on computational methods, both Monte Carlo and analytic, for the contagion channels of SR that lead to cascading chains of defaulted and illiquid financial institutions. A number of deliberately simplified modelling frameworks, beginning with the Eisenberg-Noe 2001 model, aim to reveal pure contagion effects in isolation from other SR channels. It turns out there is a large amount of commonality amongst these contagion models, which means that similar computational algorithms work even as their financial mechanisms differ. Towards the end we will explore what can happen in networks when two separate contagion mechanisms intertwine to create a "double cascade".

Alex Krenin (IBM)
Multivariate Poisson Processes and their Applications in Operational Risk Modeling

Estimation of Economic Capital of a financial institution requires modeling of operational losses of the business units of a financial organization. Operational losses are usually represented as an aggregate sum of the losses incurred by the operational events of the business units. Simulation of these events requires introduction of a co-dependence structure for realistic description of the loss process. In this paper, we discuss some of the approaches to this modeling problem. We propose a backward simulation method to model the operational events. We also consider the corresponding calibration problem. Finally, we discuss the aggregation problem for loss distributions. Joint work with
Konrad Duch and Yijun Jiang.

Andrei Kirilenko, MIT
High Frequency Trading (Slides)

High frequency trading is a recent innovation in financial intermediation that does not fit neatly into a standard liquidity-provision framework. While the net contribution of high frequency trading to market dynamics is still not fully understood, their mere presence has already shaken the confidence of traditional market participants in the stability and fairness of the financial market system as a whole.

Peter Christoffersen, Rotman School of Management, U of Toronto
Illiquidity Premia in the Equity Options Market (Slides)

Illiquidity is well-known to be a significant determinant of stock and bond returns. We are the first to report on illiquidity premia in equity option markets using a large cross- section of firms. An increase in option illiquidity decreases the current option price and predicts higher expected delta-hedged option returns. This e§ect is statistically and economically significant, and it is consistent with existing evidence that market makers in the equity options market hold net long positions. The illiquidity premium is robust across puts and calls, across maturities and moneyness, as well as across di§erent empirical approaches. It is also robust when controlling for various firm- specific variables, including standard measures of illiquidity of the underlying stock. For long term options, we find evidence of a liquidity risk factor.

Tobias Adrian, Federal Reserve Bank of New York
Intermediary Leverage Cycles and Financial Stability

We present a theory of financial intermediary leverage cycles within a dynamic model of the macroeconomy. Intermediaries face risk-based funding constraints that give rise to procyclical leverage. The pricing of risk varies as a function of intermediary leverage, and asset return exposure to intermediary leverage shocks earns a positive risk premium. Relative to an economy with constant leverage, financial intermediaries generate higher consumption growth and lower consumption volatility in normal times, at the cost of endogenous systemic financial risk. The severity of systemic crisis depends on intermediaries’ leverage and net worth. Regulations that tighten funding constraints affect the systemic risk-return trade-off by lowering the likelihood of systemic crises at the cost of higher pricing of risk.

William F. Shadwick, Omega Analysis Limited
Market Cycles, Risk and Early Warning of Asset Price Bubbles (Slides)

(Joint work with Ana Cascon and William H. Shadwick)

Empirical studies employing new risk measurement technology reveal recurring ‘risk anomalies’ in historic data.These provide reliable early warnings of emerging asset price bubbles in the expansion phases and early indicators of recovery following market collapses. Bubble indicators also allow estimates of the severity of the correction which will follow the boom. Major bubbles emerge in periods of relatively low risk, for example, in the US prior to the 1929 Crash, in Japan prior to the 1990 Crash, and in Global Equity Markets prior to the 2008 Crash.

This combination of bubble warning with low downside risk is currently present in equity markets across the developed economies. I will describe the background to these indicators, the way in which they might be used in policy decisions and portfolio management and the levels to which they say major markets will correct.

Christian Gourieroux, Toronto
Bilateral Exposures and Systemic Solvency Risk (Slides)

By introducing a structure of the balance sheets of the banks, which takes into account their bilateral exposures in terms of stocks or lendings, we get a structural model for default analysis. This model allows to distinguish the exogenous and endogenous default dependence. We prove the existence and uniqueness of the liquidation equilibrium, we study the consequences of exogenous shocks on the banking system and we measure contagion phenom- ena. This approach is illustrated by an application to the French banking system.

Kartik Anand, Bank of Canada
The Macro-Financial Risk Assessment Framework (MFRAF): Model Features and Policy Use (Slides)

We present the top-down banking sector stress-testing framework used at the Bank of Canada and recent innovations in modeling information contagion, wherein news of one institution's health can modify market perceptions on the health of others. We discuss how we implement the model and use it in practice to assess the resilience of banks."