Essays on applied financial econometrics and financial networks: reflections on systemic risk, financial stability & tail risk management
Student thesis: Doctoral Thesis
The global crisis of 2008 challenged the functioning of the financial markets. In the aftershock era numerous repercussions were felt throughout the world, resulting from a plethora of cross-border and cross-entity interdependencies. An initially systemic banking crunch – where cash strapped banks stopped lending, liquidity abruptly dried up, and credit conditions deteriorated – metastasized into a sovereign debt crisis in the euro area which devastated public finances and provoked higher sovereign default risk. Motivated by the intensity, the magnitude and the speed with which shocks propagate in the entire financial system, this thesis presents five essays on applied financial econometrics and financial networks which examine, model and investigate: i) systemic risk and the resilience of the banking industry via employing financial networks and entropy maximization; ii) the role of credit derivatives and the two-way feedback ramification, triggered by government interventions, on financial stability; iii) the symptoms of acute liquidity withdrawal in emerging markets; iv) a Bayesian three state switching regime approach to price financial assets; v) tail risk management with portfolio asymmetries and asset monotonic volatility. More precisely, in Chapter three the Maximum Entropy method is employed to capture systemic risk, the resilience of the banking system in Europe and the propagation of financial contagion in a dynamic financial network framework. As conditions deteriorate, three channels (interbank loan, sovereign, asset-backed loan) trigger severe direct and indirect losses and cascades of defaults, whilst the dominance of the sovereign credit risk channel amplifies, as the primary source of financial contagion in the banking network. Systemic risk within the northern euro area banking system is less apparent, while the southern euro area is more prone and susceptible to bank failures. By modelling the contagion path the results demonstrate that the euro area banking system insists to be markedly vulnerable and conducive to systemic risks, implying that there is a need for additional policies to increase the resilience of the sector. Moreover, the thesis develops a Markov-Switching Bayesian Vector Autoregression (MSBVAR) model in Chapter four to study the two-way feedback hypothesis between credit default swaps and the role of government interventions on financial stability. The results demonstrate that a rise in sovereign debt due to the countercyclical discretionary fiscal policy measures, is perceived by stock markets as a catastrophe on economic growth prospects. Interestingly, government interventions in the banking sector deteriorate the credit risk of sovereign debt, whilst higher risk premium required by investors for holding riskier government bonds depresses the sovereign debt market, and attenuates the collateral value of loans, leading to bank retrenchment. The ensuing two-way banking-fiscal feedback loop indicates that government interventions do not necessarily stabilize the banking sector. Furthermore, the thesis employs several copula functions and the Extreme Value theory in Chapter five, to estimate and quantify joint downside risks and the transmission of shocks in emerging currencies, evolving from domestic emerging stock markets, liquidity (banks’ credit default swaps), credit risk (Volatility Index) and growth (commodity prices) channels. The models measure the time-varying shock spillover intensities to ascertain a significant increase in cross-asset linkages during periods of high volatility which is over and above any expected economic fundamentals, providing strong evidence of asymmetric investor induced contagion, triggered by cross asset rebalancing. The critical role of the credit crisis is amplified, as the beginning of an important reassessment of emerging market currencies which lead to changes in the dependence structure, a revaluation and recalibration of their risk characteristics. Additionally, the thesis employs a Markov-switching vector autoregression (MSVAR) model to capture the transmission of shocks from stock, commodity and credit markets to four shipping indices in Chapter six. By estimating the impulse response functions (IRF), the model identifies the episodes and documents the existence of three regimes and directional spillovers between low, intermediate and high volatility regimes. The estimation results obtained using a Gibbs sampler indicate that the S&P 500, the S&P GSCI, Banks’ CDS and the VIX behave as channels which transform and spread the risk to the shipping market with the propagation of shocks. Interestingly, higher risk premium that is required by investors for holding financial assets depresses the shipping market substantially. Finally, several copula functions are employed to model tail dependence during periods of extreme, asset monotonic volatility and reverse portfolio asymmetry conditions between shipping, stock, commodity and credit markets in Chapter seven. The findings reveal that shocks in the shipping market coincide with dramatic changes in other markets and document the existence of extreme co-movements during severe financial conditions. Lower tail dependence exceeds conditional upper tail dependence, indicating that during periods of economic turbulence, dependence increases and the crisis spreads in a domino fashion, causing asymmetric contagion which advances during market downturns. In the post crisis period the level of dependence drops systematically and shipping assets become more pronouncedly heavy-tailed in downward moves. According to the estimated results accelerated decreases in commodities and prompt variations in volatility, provoke accelerated decreases and function as a barometer of shipping market fluctuations. The global financial crisis has profoundly shaped modern finance. This thesis examines the prominent role of the crisis in financial markets, provides important implications for understanding systemic and liquidity risk, for analysing policies designed to mitigate financial contagion, and for capturing the fluctuations of emerging currencies and financial assets during distress economic conditions.
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