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Measuring Systemic Risk: Common Factor Exposures and Tail Dependence Effects

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  • Wan†Chien Chiu
  • Juan Ignacio Peña
  • Chih†Wei Wang

Abstract

We model systemic risk using a common factor that accounts for market†wide shocks and a tail dependence factor that accounts for linkages among extreme stock returns. Specifically, our theoretical model allows for firm†specific impacts of infrequent and extreme events. Using data on the four sectors of the US financial industry from 1996 to 2011, we uncover two key empirical findings. First, disregarding the effect of the tail dependence factor leads to a downward bias in the measurement of systemic risk, especially during weak economic times. Second, when these measures serve as leading indicators of the St. Louis Fed Financial Stress Index, measures that include a tail dependence factor offer better forecasting ability than measures based on a common factor only.

Suggested Citation

  • Wan†Chien Chiu & Juan Ignacio Peña & Chih†Wei Wang, 2015. "Measuring Systemic Risk: Common Factor Exposures and Tail Dependence Effects," European Financial Management, European Financial Management Association, vol. 21(5), pages 833-866, November.
  • Handle: RePEc:bla:eufman:v:21:y:2015:i:5:p:833-866
    DOI: 10.1111/eufm.12040
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    4. Lee, Chien-Chiang & Wang, Chih-Wei & Hsieh, Hsin-Yi & Chen, Wen-Ling, 2023. "The impact of central bank digital currency variation on firm's implied volatility," Research in International Business and Finance, Elsevier, vol. 64(C).

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