International Journal of Financial Engineering and Risk Management
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International Journal of Financial Engineering and Risk Management (2 papers in press)
An Equity-Credit Hybrid Model for Asset Correlations by Fabio Dias Abstract: Single factor Gaussian copula models are widely used to manage credit risk of loan portfolios, even driving how many large financial institutions are capitalised under Basel II / III. Under this formulation, the default correlation between two separate firms is directly explained by their asset correlation to a systematic factor, which can be estimated using either equity correlations or observed default rates, with the portfolio losses usually being simulated under a Gaussian copula model. Though it is widely accepted that the use of observed default rates or even equity returns to calibrate a single factor Gaussian copula model is likely to understate the tail risk, this paper proposes a Bayesian approach for a single factor Gaussian copula where the asset correlations are modelled using an inverse Wishart prior with the scale parameter calibrated to observed default rates and the degrees of freedom chosen using the in-sample continuous ranked probability score whilst the equity correlations are used to obtain the posterior distribution. The proposed hybrid model is shown to produce probabilistic forecasts of defaults with better out-of-sample performance than the standard single factor Gaussian copula even though it maintained low complexity and ease of implementation. Keywords: asset correlations; credit risk management; structural model of credit risk; factor copula models.
Financial markets, energy stock prices and energy political decisions: The case of Cyprus by Augustinos Dimitras Abstract: The impact of energy deals announcements on the stock markets is a topic that concerns not only academics but investors and funds too. This study examines the linkages between financial markets and energy firms' stock price returns after the decision of the Cypriot government to exploit its oil and natural gas deposits within its exclusive economic zone. This decision has several geopolitical aspects which affect a large number of interested parties. We employ a dynamic conditional correlation model to measure the effect on financial markets as well as energy firms' stock returns. Results provide evidence that there is no significant impact on either financial markets or energy firms stock prices. Moreover, we highlight the importance of similar political decisions and the reactions of Cyprus' neighbouring countries. Keywords: energy; financial markets; dynamic conditional correlation; geopolitics of energy.