An extreme value approach to CoVaR estimation

Abstract: The global financial crisis of 2007-2009 highlighted the crucial role systemic risk plays in ensuring stability of financial markets. Accurate assessment of systemic risk would enable regulators to introduce suitable policies to mitigate the risk as well as allow individual institutions to monitor their vulnerability to market movements. One popular measure of systemic risk is the conditional value-at-risk (CoVaR), proposed in Adrian and Brunnermeier (2011). We develop a methodology to estimate CoVaR semi-parametrically within the framework of multivariate extreme value theory. According to its definition, CoVaR can be viewed as a high quantile of the conditional distribution of one institution's (or the financial system) potential loss, where the conditioning event corresponds to having large losses in the financial system (or the given financial institution). We relate this conditional distribution to the tail dependence function between the system and the institution, then use parametric modelling of the tail dependence function to address data sparsity in the joint tail regions. We prove consistency of the proposed estimator, and illustrate its performance via simulation studies and a real data example.