Macro-Dynamic Modeling of Systemic Risk

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This award funds a project that develops statistical models to measure systemic risk in the financial sector, taking into account changes in leverage and banckruptcies. The result of the project will be a new model of the capital that a financial firm would need to raise in order to function normally in a financial crisis. The measure can be used to assist regulators in monitoring systemic financial risk and how it evolves over time. As a result, the project advances science through providing a new method to measure a key variable. Because financial crises can have wide-ranging effects on the overall US economy, the project will also contribute to the national prosperity.It is well established that increasing the ration of assets to equity increases the volatility of equity prices. However, this structural theory of credit has not been integrated with volatility models. The project will consider a structural garch model that includes leverage as one determinant of volatility. The result will be a version of the existing SRISK measure that takes the risk of a leverage spiral into account. Understanding the deviations between risk measures with CDS and equities will possibly also allow measurement of implicit guarantees that were extended to some firms during the recent financial crisis.