The Impact of Asset Price Bubbles on Credit Risk Measures

Abstract

This study presents an analysis of the impact of asset price bubbles on standard credit risk measures, including Expected Loss ("EL") and Credit Value-at-Risk ("CVaR"). We present a styled model of asset price bubbles in continuous time, and perform a simulation experiment of a 2 dimensional Stochastic Differential Equation ("SDE") system for asset value determining Probability of Default ("PD") through a Constant Elasticity of Variance ("CEV") process, as well as a correlated a Loss-Given-Default ("LGD") through a mean reverting Cox-Ingersoll-Ross ("CIR") process having a longrun mean dependent upon the asset value. Comparing bubble to non-bubble economies, it is shown that asset price bubbles may cause an obligor's traditional credit risk measures, such as EL and CVaR to decline, due to a reduction in both the standard deviation and right skewness of the credit loss distribution. We propose a new risk measure in the credit risk literature to account for losses associated with a bubble bursting, the Expected Holding Period Credit Loss ("EHPCL"), a phenomenon that must be taken into consideration for the proper determination of economic capital for both credit risk management and measurement purposes.

The Detection of Asset Price Bubbles in the Cryptocurrency Markets with an Application to Risk Management and the Measurement of Model Risk

“…Protter (2011 and Jarrow et al (2007Jarrow et al ( , 2011Jarrow et al ( , 2014Jarrow et al ( , 2015 apply these new insights to determine the impact that asset price bubbles have on the common risk measures used in practice for the determination of equity capital. Jacobs (2015b) and Jacobs (2016) provide an extension of the latter literature the realms of credit and liquidity risk, respectively. Jacobs (2017) extend Jacobs (2016) with an addition of a sensitivity analysis as well as an empirical implementation with an application to the stress testing of credit risk.…”

“…Jacobs (2015aJacobs ( , 2017 applies a model for asset price bubbles in a credit risk context to stress testing ("ST"), a key supervisory tool for supplementing VaR measures such as VaR or economic capital. Jacobs (2013) surveys practices and supervisory expectations for stress testing ("ST"), in a credit risk framework for trading book exposures; including simple and practical ST examples, a ratings migration based approach and anther a top-down time series modeling approach. Combining these concepts, Jacobs et al (2015) presents an example of model risk quantification in the realm of ST, comparing alternative models in two different classes, Frequentist and Bayesian approaches to modeling stressed bank losses.…”

“…Note 2. In the wake of the financial crisis (Demirguc-Kunt et al, 2010;Acharya et al, 2009), international supervisors have recognized the importance of ST, especially in the realm of credit risk, as can be seen in the re-vised Basel framework (BCBS 2005(BCBS , 20062009 a,b;2010) and the Federal Reserve's Comprehensive Capital Analysis and Review ("CCAR") program (Jacobs, 2013;Jacobs et al, 2015). Note 3.…”