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Worst-case higher moment risk measure: Addressing distributional shifts and procyclicality

Author

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  • Castro-Iragorri, Carlos
  • Gómez, Fabio
  • Quiceno, Nancy

Abstract

This paper addresses the inherent procyclicality in widely adopted financial risk measures, such as expected shortfall (ES). We propose an innovative approach utilizing the worst-case higher moment (HM) risk measure, which offers a robust solution to distributional shifts by incorporating adaptive features. Empirical results using historical S&P500 returns indicate that worst-case HM risk measures significantly reduce the underestimation of risk and provide more stable risk assessments throughout the financial cycle compared to traditional ES predictions. These results suggest that worst-case HM risk measures represent a viable alternative to regulatory add-ons for stress testing and procyclicality mitigation in financial risk management.

Suggested Citation

  • Castro-Iragorri, Carlos & Gómez, Fabio & Quiceno, Nancy, 2024. "Worst-case higher moment risk measure: Addressing distributional shifts and procyclicality," Finance Research Letters, Elsevier, vol. 65(C).
    • Handle: RePEc:eee:finlet:v:65:y:2024:i:c:s154461232400610x
    DOI: 10.1016/j.frl.2024.105580
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    More about this item

    Keywords

    Procyclicality; Higher moment risk; Stress testing; Expected shortfall;
    All these keywords.

    JEL classification:

    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics

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