This paper deals with a copula-based stochastic dependence problem in the context of financial risks. We discuss the financial framework for assessing the theoretical up-front value of government guarantees on bank liabilities. EU States widely use these contracts to improve the financial system’s stability and manage the banking sector in crisis situations; in Italy, they have also been used to address the consequences of the Covid-19 emergency. From a market viewpoint, we deal with a defaultable guarantee contract where the State-guarantor and the bank-borrower are both subject to default risk, and their risks are interconnected. We show that the classical Gaussian copula is not satisfactory for modeling the dependence among the considered risks. Indeed, using the benchmark market model for credit risk portfolio management, we highlight some contradictory results observed for the up-front values of the guarantee when the default intensity of the guarantor is smaller than that of the borrower. Then, we introduce a new family of modified Gaussian copulas that overcomes the limitations of the standard approach, allowing to determine realistic results in terms of the guarantees “mark-to-model” value when the benchmark market model does not work. Numerical simulations validate the theoretical proposal.

Cerqueti, R., Cesarone, F., Heusch, M.C., Mottura, C.D. (2022). A new family of modified Gaussian copulas for market consistent valuation of government guarantees. REVIEW OF MANAGERIAL SCIENCE, 1-21 [10.1007/s11846-022-00600-1].

A new family of modified Gaussian copulas for market consistent valuation of government guarantees

Francesco Cesarone;Maria C. Heusch;Carlo D. Mottura
2022

Abstract

This paper deals with a copula-based stochastic dependence problem in the context of financial risks. We discuss the financial framework for assessing the theoretical up-front value of government guarantees on bank liabilities. EU States widely use these contracts to improve the financial system’s stability and manage the banking sector in crisis situations; in Italy, they have also been used to address the consequences of the Covid-19 emergency. From a market viewpoint, we deal with a defaultable guarantee contract where the State-guarantor and the bank-borrower are both subject to default risk, and their risks are interconnected. We show that the classical Gaussian copula is not satisfactory for modeling the dependence among the considered risks. Indeed, using the benchmark market model for credit risk portfolio management, we highlight some contradictory results observed for the up-front values of the guarantee when the default intensity of the guarantor is smaller than that of the borrower. Then, we introduce a new family of modified Gaussian copulas that overcomes the limitations of the standard approach, allowing to determine realistic results in terms of the guarantees “mark-to-model” value when the benchmark market model does not work. Numerical simulations validate the theoretical proposal.
Cerqueti, R., Cesarone, F., Heusch, M.C., Mottura, C.D. (2022). A new family of modified Gaussian copulas for market consistent valuation of government guarantees. REVIEW OF MANAGERIAL SCIENCE, 1-21 [10.1007/s11846-022-00600-1].
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Utilizza questo identificativo per citare o creare un link a questo documento: https://hdl.handle.net/11590/422810
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