Marking Systemic Portfolio Risk with Application to the Correlation Skew of Equity Baskets

TL;DR

This paper introduces a generalized model for systemic portfolio risk that accounts for jumps and correlations among assets, offering a new systematic approach to risk management especially during crises.

Contribution

It extends Merton's option formula to multiple assets with jumps, providing a novel framework for assessing and managing systemic risk in equity portfolios.

Findings

Common jumps across assets effectively describe systemic risk.

The methodology aligns with empirical data on asset correlations during crises.

Provides a practical tool for risk managers to evaluate systemic risk systematically.

Abstract

The downside risk of a portfolio of (equity)assets is generally substantially higher than the downside risk of its components. In particular in times of crises when assets tend to have high correlation, the understanding of this difference can be crucial in managing systemic risk of a portfolio. In this paper we generalize Merton's option formula in the presence jumps to the multi-asset case. It is shown how common jumps across assets provide an intuitive and powerful tool to describe systemic risk that is consistent with data. The methodology provides a new way to mark and risk-manage systemic risk of portfolios in a systematic way.