Risk Aggregation with Dependence Uncertainty

Transcription

1 Risk Aggregation with Dependence Uncertainty Carole Bernard GEM and VUB Risk: Modelling, Optimization and Inference with Applications in Finance, Insurance and Superannuation Sydney December 7-8, 2017 Carole Bernard Risk Aggregation with Dependence Uncertainty 1

2 Motivation on VaR aggregation with dependence uncertainty Full information on marginal distributions: X j F j + Full Information on dependence: (known copula) VaR q (X 1 + X X d ) can be computed! Carole Bernard Risk Aggregation with Dependence Uncertainty 2

3 Motivation on VaR aggregation with dependence uncertainty Full information on marginal distributions: X j F j + Partial or no Information on dependence: (incomplete information on copula) VaR q (X 1 + X X d ) cannot be computed! Only a range of possible values for VaR q (X 1 + X X d ). Carole Bernard Risk Aggregation with Dependence Uncertainty 3

4 Acknowledgement of Collaboration with M. Denuit (UCL), X. Jiang (UW), L. Rüschendorf (Freiburg), S. Vanduffel (VUB), J. Yao (VUB), R. Wang (UW): Bernard, C., X. Jiang, R. Wang, (2013) Risk Aggregation with Dependence Uncertainty, Insurance: Mathematics and Economics. Bernard, C., Vanduffel, S. (2015). A new approach to assessing model risk in high dimensions. Journal of Banking and Finance. Bernard, C., Rüschendorf, L., Vanduffel, S., Yao, J. (2015). How robust is the Value-at-Risk of credit risk portfolios? European Journal of Finance. Bernard, C., Rüschendorf, L., Vanduffel, S. (2017). Value-at-Risk bounds with variance constraints. Journal of Risk and Insurance. Bernard, C., L. Rüschendorf, S. Vanduffel, R. Wang (2017) Risk bounds for factor models, 2017, Finance and Stochastics. Bernard, C., Denuit, M., Vanduffel, S. (2018). Measuring Portfolio Risk Under Partial Dependence Information. Journal of Risk and Insurance. Carole Bernard Risk Aggregation with Dependence Uncertainty 4

5 Model Risk 1 Goal: Assess the risk of a portfolio sum S = d i=1 X i. 2 Choose a risk measure ρ( ): variance, Value-at-Risk... 3 Fit a multivariate distribution for (X 1, X 2,..., X d ) and compute ρ(s) 4 How about model risk? How wrong can we be? Carole Bernard Risk Aggregation with Dependence Uncertainty 5

6 Model Risk 1 Goal: Assess the risk of a portfolio sum S = d i=1 X i. 2 Choose a risk measure ρ( ): variance, Value-at-Risk... 3 Fit a multivariate distribution for (X 1, X 2,..., X d ) and compute ρ(s) 4 How about model risk? How wrong can we be? Assume ρ(s) = var(s), ( d )} ( d )} ρ + F {var := sup X i, ρ F {var := inf X i i=1 where the bounds are taken over all other (joint distributions of) random vectors (X 1, X 2,..., X d ) that agree with the available information F Carole Bernard Risk Aggregation with Dependence Uncertainty 5 i=1

7 Aggregation with dependence uncertainty: Example - Credit Risk Marginals known Dependence fully unknown Consider a portfolio of 10,000 loans all having a default probability p = The default correlation is ρ = (for KMV). KMV VaR q Min VaR q Max VaR q q = % 0% 98% q = % 4.4% 100% Portfolio models are subject to significant model uncertainty (defaults are rare and correlated events). Using dependence information is crucial to try to get more reasonable bounds. Carole Bernard Risk Aggregation with Dependence Uncertainty 6

8 Aggregation with dependence uncertainty: Example - Credit Risk Marginals known Dependence fully unknown Consider a portfolio of 10,000 loans all having a default probability p = The default correlation is ρ = (for KMV). KMV VaR q Min VaR q Max VaR q q = % 0% 98% q = % 4.4% 100% Portfolio models are subject to significant model uncertainty (defaults are rare and correlated events). Using dependence information is crucial to try to get more reasonable bounds. Carole Bernard Risk Aggregation with Dependence Uncertainty 7

9 Objectives and Findings Model uncertainty on the risk assessment of an aggregate portfolio: the sum of d dependent risks. Given all information available in the market, what can we say about the maximum and minimum possible values of a given risk measure of a portfolio? Carole Bernard Risk Aggregation with Dependence Uncertainty 8

10 Objectives and Findings Model uncertainty on the risk assessment of an aggregate portfolio: the sum of d dependent risks. Given all information available in the market, what can we say about the maximum and minimum possible values of a given risk measure of a portfolio? Findings / Implications: Current VaR based regulation is subject to high model risk, even if one knows the multivariate distribution almost completely. Carole Bernard Risk Aggregation with Dependence Uncertainty 8

11 Outline of the Talk Part 1: The Rearrangement Algorithm Minimizing variance of a sum with full dependence uncertainty Variance bounds With partial dependence information on a subset Part 2: Application to Uncertainty on Value-at-Risk With 2 risks and full dependence uncertainty With d risks and full dependence uncertainty With partial dependence information on a subset Part 3: Other extensions: alternative information on dependence Carole Bernard Risk Aggregation with Dependence Uncertainty 9

12 Part I The Rearrangement Algorithm Portfolio with minimum variance Carole Bernard Risk Aggregation with Dependence Uncertainty 10

13 Risk Aggregation and full dependence uncertainty Marginals known: Dependence fully unknown In two dimensions d = 2, assessing model risk on variance is linked to the Fréchet-Hoeffding bounds var(f 1 1 (U)+F 1 2 (1 U)) var(x 1 +X 2 ) var(f 1 1 (U)+F 1 2 (U)) Maximum variance is obtained for the comonotonic scenario: var(x 1 +X X d ) var(f1 1 (U)+F2 1 (U)+...+F 1 (U)) Minimum variance: A challenging problem in d 3 dimensions Wang and Wang (2011, JMVA): concept of complete mixability Puccetti and Rüschendorf (2012): algorithm (RA) useful to approximate the minimum variance. Carole Bernard Risk Aggregation with Dependence Uncertainty 11 d

14 Rearrangement Algorithm N = 4 observations of d = 3 variables: X 1, X 2, X 3 M = iance sum Each column: marginal distribution. Interaction among columns: dependence among the risks. S N = Carole Bernard Risk Aggregation with Dependence Uncertainty 12

15 M = S N = Same marginals, different dependence Effect on the sum! ariance sum S N = S N = Aggregate Risk with Maximum Variance comonotonic scenario S c X 1 + X 2 + X X 1 + X 2 + X Carole Bernard Risk Aggregation with Dependence Uncertainty 13

16 Rearrangement Algorithm: Sum with Minimum Variance minimum variance with d = 2 risks X 1 and X 2 Antimonotonicity: var(x a 1 + X 2) var(x 1 + X 2 ). How about in d dimensions? Carole Bernard Risk Aggregation with Dependence Uncertainty 14

17 Rearrangement Algorithm: Sum with Minimum Variance minimum variance with d = 2 risks X 1 and X 2 Antimonotonicity: var(x a 1 + X 2) var(x 1 + X 2 ). How about in d dimensions? Use of the rearrangement algorithm on the original matrix M. Aggregate Risk with Minimum Variance Columns of M are rearranged such that they become anti-monotonic with the sum of all other columns: k {1, 2,..., d}, X a k antimonotonic with j k X j. ( After each step, var X a k + ) ( j k X j var X k + ) j k X j where X a k is antimonotonic with j k X j. Carole Bernard Risk Aggregation with Dependence Uncertainty 14

18 ard, Department Carole Bernard of Statistics and Actuarial RiskScience Aggregation with atdependence the University Uncertainty of 15 W S N = Aggregate risk with minimum variance Step 1: First column X 2 + X becomes

19 Aggregate risk with minimum variance X 2 + X X 1 + X X 1 + X becomes becomes becomes lumns are antimonotonic with the sum of the others: Carole Bernard Risk Aggregation with Dependence Uncertainty 16

20 Model Risk RA and variance bounds Dependence 7 becomes Info. Value-at-Risk bounds (5) Conclusions Dependence Info. umns are antimonotonic 4 1 with 1 the 5 sum of the 4 1others: Aggregate risk with minimum variance X 2 + X 3 All columns are antimonotonic X 1 + X 3 4 with the sum of the others: Each7column is antimonotonic 0 3 with 4 the sum4 of the others: X, 2 + X X 1 + X 3 1, X 1 + X , , um variance sum Minimum variance sum X 1 + X 1 + X 2 X X 3 X = (6) S N = The minimum variance of the sum is equal to 0! Ideal case of a constant sum (complete mixability, see Wang and Wang (2011)). Carole Bernard Risk Aggregation with Dependence Uncertainty 17

21 Bounds on variance Analytical Bounds on Standard Deviation Consider d risks X i with standard deviation σ i 0 std(x 1 + X X d ) σ 1 + σ σ d. Example with 20 normal N(0,1) 0 std(x 1 + X X 20 ) 20, in this case, both bounds are sharp and too wide for practical use! Our idea: Incorporate information on dependence. Carole Bernard Risk Aggregation with Dependence Uncertainty 18

22 Illustration with 2 risks with marginals N(0,1) X X 1 Carole Bernard Risk Aggregation with Dependence Uncertainty 19

23 Illustration with 2 risks with marginals N(0,1) X X 1 2 Assumption: Independence on F = {q β X k q 1 β }. k=1 Carole Bernard Risk Aggregation with Dependence Uncertainty 20

24 Our assumptions on the cdf of (X 1, X 2,..., X d ) F R d ( trusted or fixed area) U =R d \F ( untrusted ). We assume that we know: (i) the marginal distribution F i of X i on R for i = 1, 2,..., d, (ii) the distribution of (X 1, X 2,..., X d ) {(X 1, X 2,..., X d ) F}. (iii) P ((X 1, X 2,..., X d ) F). When only marginals are known: U = R d and F =. Our Goal: Find bounds on ρ(s) := ρ(x X d ) when (X 1,..., X d ) satisfy (i), (ii) and (iii). Carole Bernard Risk Aggregation with Dependence Uncertainty 21

25 r to illustrate each algorithm that we propose. Thi a realistic set of observations as in true applicatio ns (here N = 8) and possibly Example: a large number of va re given N = 8 observations, as follows d = with 3 dimensions 3 observations trusted (l f he matrix. and 3 observations trusted (p f = 3/8) S N = Carole Bernard Risk Aggregation with Dependence Uncertainty 22

26 Without loss Example: of generality N = we 8, can d = then 3 with consider 3 observations for further analysis trusted the following m and the vectors of sums S f N and Su N as follows. Maximum variance: re s is computed as in (22) e illustrate the upper and 2 4lower 2 bounds (21) and (23) for the variance deriv the matrix M of observations 0 2 1given in (19). M = , S f N = 8 We then use the 10 comonotonic s 7 the untrusted part of the matrix M and compute the 8, SN u vectors of sums S f N = 4 an ed above in (19). The average sum is s =5.5. The maximum variance is equa ( ) (s i s) 2 + ( s c i s) i=1 0 1 i=1 the lower Minimum bound, variance: we apply the RA on U N and we obtain Finally, with some abuse of notation (completing by 0 so that S f N and Su N take 8 va ne also has the following representation of S N, S N = IS f N +(1 I)Su N M = , S f N = 8 5 8, SN u = 5 5 here I =1 if if (x i1,x i2...x id ) F N (i =1, 2,..., N). In fact, S f N can be readily seen a ampled counterpart of the 3 T 1that 1 we used before (see Definition 4 5and Proposition hereas SN u is a comonotonic sum and corresponds to the sampled version of d i=1 Z his paper, we aim at finding worst case dependences allowing for a robust risk assess Carole Bernard Risk Aggregation with Dependence Uncertainty 23

27 Example d = 20 risks N(0,1) (X 1,..., X 20 ) independent N(0,1) on F := [q β, q 1 β ] d R d p f = P ((X 1,..., X 20 ) F) (for some β 50%) where q γ : γ-quantile of N(0,1). β = 0%: no uncertainty (20 independent N(0,1)). β = 50%: full uncertainty. U = p f 98% p f 82% U = R d F = [q β, q 1 β ] d β = 0% β = 0.05% β = 0.5% β = 50% ρ = (4.4, 5.65) (3.89, 10.6) (0, 20) Model risk on the volatility of a portfolio is reduced a lot by incorporating information on dependence! Carole Bernard Risk Aggregation with Dependence Uncertainty 24

28 Example d = 20 risks N(0,1) (X 1,..., X 20 ) independent N(0,1) on F := [q β, q 1 β ] d R d p f = P ((X 1,..., X 20 ) F) (for some β 50%) where q γ : γ-quantile of N(0,1) β = 0%: no uncertainty (20 independent N(0,1)) β = 50%: full uncertainty U = p f 98% p f 82% U = R d F = [q β, q 1 β ] d β = 0% β = 0.05% β = 0.5% β = 50% ρ = (4.4, 5.65) (3.89, 10.6) (0, 20) Model risk on the volatility of a portfolio is reduced a lot by incorporating information on dependence! Carole Bernard Risk Aggregation with Dependence Uncertainty 25

29 Information on the joint distribution Can come from a fitted model Can come from experts opinions Dependence known on specific scenarios Carole Bernard Risk Aggregation with Dependence Uncertainty 26

30 Illustration with marginals N(0,1) X 2 0 X X X 1 Carole Bernard Risk Aggregation with Dependence Uncertainty 27

31 Illustration with marginals N(0,1) X X 1 2 F 1 = {q β X k q 1 β } k=1 Carole Bernard Risk Aggregation with Dependence Uncertainty 28

32 Illustration with marginals N(0,1) 2 2 F 1 = {q β X k q 1 β } F = {X k > q p } F 1 k=1 k=1 Carole Bernard Risk Aggregation with Dependence Uncertainty 29

33 Illustration with marginals N(0,1) 2 F 1 =contour of MVN at β F = {X k > q p } F 1 k=1 Carole Bernard Risk Aggregation with Dependence Uncertainty 30

34 Conclusions of Part I Part 1: Assess model risk for variance of a portfolio of risks with given marginals but partially known dependence. Same method applies to TVaR (expected Shortfall) or any risk measure that satisfies convex order (but not for Value-at-Risk). Challenges: Choosing the trusted area F N too small: possible to improve the efficiency of the algorithm by re-discretizing using the fitted marginal ˆf i. Possible to amplify the tails of the marginals Carole Bernard Risk Aggregation with Dependence Uncertainty 31

35 Part II Another application of the Rearrangement Algorithm VaR aggregation with dependence uncertainty Maximum Value-at-Risk is not caused by the comonotonic scenario. Maximum Value-at-Risk is achieved when the variance is minimum in the tail. The RA is then used in the tails only. Bounds on Value-at-Risk at high confidence level stay wide even when the trusted area covers 98% of the space! Carole Bernard Risk Aggregation with Dependence Uncertainty 32

36 Risk Aggregation and full dependence uncertainty Literature review Marginals known Dependence fully unknown Explicit sharp (attainable) bounds n = 2 (Makarov (1981), Rüschendorf (1982)) Rüschendorf & Uckelmann (1991), Denuit, Genest & Marceau (1999), Embrechts & Puccetti (2006), A challenging problem in n 3 dimensions Approximate sharp bounds Puccetti and Rüschendorf (2012): algorithm (RA) useful to approximate the minimum variance. Embrechts, Puccetti, Rüschendorf (2013): algorithm (RA) to find bounds on VaR Carole Bernard Risk Aggregation with Dependence Uncertainty 33

37 Our Contributions Issues bounds on VaR are generally very wide ignore all information on dependence. Carole Bernard Risk Aggregation with Dependence Uncertainty 34

38 Our Contributions Issues bounds on VaR are generally very wide ignore all information on dependence. Our contributions: Incorporating in a natural way dependence information. Getting simple upper and lower bounds for VaR (not sharp in general) Extend the RA to deal with additional dependence information Carole Bernard Risk Aggregation with Dependence Uncertainty 34

39 VaR Bounds with full dependence uncertainty (Unconstrained VaR bounds) Carole Bernard Risk Aggregation with Dependence Uncertainty 35

40 Riskiest Dependence: maximum VaR q in 2 dims? If X 1 and X 2 are U(0,1) comonotonic, then VaR q (S c ) = VaR q (X 1 ) + VaR q (X 2 ) = 2q. q q Note that TVaR q (S c ) = 1 q 2pdp 1 q = 1 + q. Carole Bernard Risk Aggregation with Dependence Uncertainty 36

41 Riskiest Dependence: maximum VaR q in 2 dims? If X 1 and X 2 are U(0,1) comonotonic, then VaR q (S c ) = VaR q (X 1 ) + VaR q (X 2 ) = 2q. q q Note that TVaR q (S c ) = 1 q 2pdp 1 q = 1 + q. Carole Bernard Risk Aggregation with Dependence Uncertainty 37

42 Riskiest Dependence: maximum VaR q in 2 dims If X 1 and X 2 are U(0,1) and antimonotonic in the tail, then VaR q (S ) = 1 + q (which is maximum possible). q q VaR q (S ) = 1 + q > VaR q (S c ) = 2q to maximize VaR q, the idea is to change the comonotonic dependence such that the sum is constant in the tail Carole Bernard Risk Aggregation with Dependence Uncertainty 38

43 VaR at level q of the comonotonic sum w.r.t. q VaR q (S c ) q 1 p Carole Bernard Risk Aggregation with Dependence Uncertainty 39

44 VaR at level q of the comonotonic sum w.r.t. q TVaR q (S c ) VaR q (S c ) q 1 p where TVaR (Expected shortfall):tvar q (X ) = 1 1 q 1 q VaR u (X )du Carole Bernard Risk Aggregation with Dependence Uncertainty 40

45 Riskiest Dependence Structure VaR at level q S* => VaR q (S*) =TVaR q (S c )? VaR q (S c ) q 1 p Carole Bernard Risk Aggregation with Dependence Uncertainty 41

46 Analytic expressions (not sharp) Analytical Unconstrained Bounds with X j F j A = LTVaR q (S c ) VaR q [X 1 + X X n ] B = TVaR q (S c ) B:=TVaR q (S c ) A:=LTVaR q (S c ) q 1 p Carole Bernard Risk Aggregation with Dependence Uncertainty 42

47 VaR Bounds with full dependence uncertainty Approximate sharp bounds: Puccetti and Rüschendorf (2012): algorithm (RA) useful to approximate the minimum variance. Embrechts, Puccetti, Rüschendorf (2013): algorithm (RA) to find bounds on VaR Carole Bernard Risk Aggregation with Dependence Uncertainty 43

48 Illustration for the maximum VaR q (1/3) q 1-q Sum= 11 Sum= 15 Sum= 25 Sum= 29 Carole Bernard Risk Aggregation with Dependence Uncertainty 44

49 Illustration for the maximum VaR q (2/3) q Rearrange within columns..to make the sums as constant as possible B=( )/4=20 1-q Sum= 11 Sum= 15 Sum= 25 Sum= 29 Carole Bernard Risk Aggregation with Dependence Uncertainty 45

50 Illustration for the maximum VaR q (3/3) q Sum= 20 1-q Sum= 20 Sum= 20 =B! Sum= 20 Carole Bernard Risk Aggregation with Dependence Uncertainty 46

51 Adding information Information on a subset VaR bounds when the joint distribution of (X 1, X 2,..., X n ) is known on a subset of the sample space. Carole Bernard Risk Aggregation with Dependence Uncertainty 47

52 Numerical Results for VaR, 20 risks N(0, 1) When marginal distributions are given, What is the maximum Value-at-Risk? What is the minimum Value-at-Risk? A portfolio of 20 risks normally distributed N(0,1). Bounds on VaR q (by the rearrangement algorithm applied on each tail) q=95% ( -2.17, 41.3 ) q=99.95% ( , 71.1 ) More examples in Embrechts, Puccetti, and Rüschendorf (2013): Model uncertainty and VaR aggregation, Journal of Banking and Finance Very wide bounds All dependence information ignored Idea: add information on dependence from a fitted model or from experts opinions Carole Bernard Risk Aggregation with Dependence Uncertainty 48

53 Our assumptions on the cdf of (X 1, X 2,..., X n ) F R n ( trusted or fixed area) U =R n \F ( untrusted ). We assume that we know: (i) the marginal distribution F i of X i on R for i = 1, 2,..., n, (ii) the distribution of (X 1, X 2,..., X n ) {(X 1, X 2,..., X n ) F}. (iii) P ((X 1, X 2,..., X n ) F) Goal: Find bounds on VaR q (S) := VaR q (X X n ) when (X 1,..., X n ) satisfy (i), (ii) and (iii). Carole Bernard Risk Aggregation with Dependence Uncertainty 49

54 Numerical Results, 20 correlated N(0, 1) on F = [q β, q 1 β ] n U = p f 98% p f 82% U = R n F β = 0% β = 0.05% β = 0.5% β = 50% q=95% 12.5 ( 12.2, 13.3 ) ( 10.7, 27.7 ) ( -2.17, 41.3 ) q=99.5% 19.6 ( 19.1, 31.4 ) ( 16.9, 57.8 ) ( -0.29, 57.8 ) q=99.95% 25.1 ( , 71.1 ) U = : 20 correlated standard normal variables (ρ = 0.1). VaR 95% = 12.5 VaR 99.5% = 19.6 VaR 99.95% = 25.1 ff The risk for an underestimation of VaR is increasing in the probability level used to assess the VaR. ff For VaR at high probability levels (q = 99.95%), despite all the added information on dependence, the bounds are still wide! Carole Bernard Risk Aggregation with Dependence Uncertainty 50

55 Numerical Results, 20 correlated N(0, 1) on F = [q β, q 1 β ] n U = p f 98% p f 82% U = R n β = 0% β = 0.05% β = 0.5% β = 50% q=95% 12.5 ( 12.2, 13.3 ) ( 10.7, 27.7 ) ( -2.17, 41.3 ) q=99.5% 19.6 ( 19.1, 31.4 ) ( 16.9, 57.8 ) ( -0.29, 57.8 ) q=99.95% 25.1 ( 24.2, 71.1 ) ( 21.5, 71.1 ) ( , 71.1 ) U = : 20 correlated standard normal variables (ρ = 0.1). VaR 95% = 12.5 VaR 99.5% = 19.6 VaR 99.95% = 25.1 The risk for an underestimation of VaR is increasing in the probability level used to assess the VaR. For VaR at high probability levels (q = 99.95%), despite all the added information on dependence, the bounds are still wide! Carole Bernard Risk Aggregation with Dependence Uncertainty 51

56 We have shown that Conclusions Maximum Value-at-Risk is not caused by the comonotonic scenario. Maximum Value-at-Risk is achieved when the variance is minimum in the tail. The RA is then used in the tails only. Bounds on Value-at-Risk at high confidence level stay wide even if the multivariate dependence is known in 98% of the space! Assess model risk with partial information and given marginals Design algorithms for bounds on variance, TVaR and VaR and many more risk measures. A regulation challenge... Carole Bernard Risk Aggregation with Dependence Uncertainty 52

57 Regulation challenge The Basel Committee (2013) insists that a desired objective of a Solvency framework concerns comparability: Two banks with portfolios having identical risk profiles apply the framework s rules and arrive at the same amount of risk-weighted assets, and two banks with different risk profiles should produce risk numbers that are different proportionally to the differences in risk Carole Bernard Risk Aggregation with Dependence Uncertainty 53

58 Part III VaR Bounds with partial dependence uncertainty VaR Bounds with other types of Dependence Information... Carole Bernard Risk Aggregation with Dependence Uncertainty 54

59 Adding dependence information Finding minimum and maximum possible values for VaR of the credit portfolio loss, S = n i=1 X i, given that known marginal distributions of the risks X i. some dependence information. Example 1: Variance constraint - with Rüschendorf and Vanduffel M := sup VaR q [X 1 + X X n ], subject to X j F j, var(x 1 + X X n ) s 2 Example 2: Moments constraint - with Denuit, Rüschendorf, Vanduffel, Yao M := sup VaR q [X 1 + X X n ], subject to X j F j, E(X 1 + X X n ) k = c k Carole Bernard Risk Aggregation with Dependence Uncertainty 55

60 Adding dependence information Example 3: with Rüschendorf, Vanduffel and Wang where Z is a factor. M := sup VaR q [X 1 + X X n ], subject to (X j, Z) H j, Carole Bernard Risk Aggregation with Dependence Uncertainty 56

61 Examples Example 1: variance constraint M := sup VaR q [X 1 + X X n ], subject to X j F j, var(x 1 + X X n ) s 2 Example 2: Moments constraint M := sup VaR q [X 1 + X X n ], subject to X j F j, E(X 1 + X X n ) k c k for all k in 2,...,K Carole Bernard Risk Aggregation with Dependence Uncertainty 57

62 VaR bounds with moment constraints Without moment constraints, VaR bounds are attained if there exists a dependence among risks X i such that { A probability q S = B probability 1 q a.s. If the distance between A and B is too wide then improved bounds are obtained with { S a with probability q = b with probability 1 q such that { a k q + b k (1 q) c k aq + b(1 q) = E[S] in which a and b are as distant as possible while satisfying all constraints (for all k) Carole Bernard Risk Aggregation with Dependence Uncertainty 58

63 Analytical result for variance constraint A and B: unconstrained bounds on Value-at-Risk, µ = E[S]. Constrained Bounds with X j F j and variance s 2 a = max ( A, µ s ) 1 q VaR q [X 1 + X X n ] q ( b = min B, µ + s q 1 q If the variance s 2 is not too large (i.e. when s 2 q(a µ) 2 + (1 q)(b µ) 2 ), then b < B. The target distribution for the sum: a two-point cdf that takes two values a and b. We can write and apply the standard RA. X 1 + X X n S = 0 Carole Bernard Risk Aggregation with Dependence Uncertainty 59 )

64 Extended RA q 1-q -a -a -a -a b b b b Rearrange now within all columns such that all sums becomes close to zero Carole Bernard Risk Aggregation with Dependence Uncertainty 60

65 Corporate portfolio a corporate portfolio of a major European Bank loans mainly to medium sized and large corporate clients total exposure (EAD) is (million Euros), and the top 10% of the portfolio (in terms of EAD) accounts for 70.1% of it. portfolio exhibits some heterogeneity. Summary statistics of a corporate portfolio Minimum Maximum Average Default probability EAD LGD Carole Bernard Risk Aggregation with Dependence Uncertainty 61

66 Comparison of Industry Models VaRs of the corporate portfolio under different industry models q = Comon. KMV Credit Risk + Beta 95% ρ = % % Carole Bernard Risk Aggregation with Dependence Uncertainty 62

67 VaR bounds Model risk assessment of the VaR of the corporate portfolio (we use ρ = 0.1 to construct moments constraints) q = KMV Comon. Unconstrained K = 2 K = 3 95% (34.0 ; ) (97.3 ; 614.8) (100.9 ; 562.8) 99% (56.5 ; ) (111.8 ; 1245) (115.0 ; 941.2) 99.5% (89.4 ; 10120) (114.9 ; 1709) (117.6 ; ) Obs 1: Comparison with analytical bounds Obs 2: Significant bounds reduction with moments information Obs 3: Significant model risk Carole Bernard Risk Aggregation with Dependence Uncertainty 63

68 Acknowledgments BNP Paribas Fortis Chair in Banking PRMIA Award for New Frontiers in Risk Management Research project on Risk Aggregation and Diversification with Steven Vanduffel for the Canadian Institute of Actuaries: Humboldt Research Foundation: Project on Systemic Risk funded by the Global Risk Institute in Financial Services: Society of Actuaries Center of Actuarial Excellence Research Grant at Waterloo. Natural Sciences and Engineering Research Council of Canada Carole Bernard Risk Aggregation with Dependence Uncertainty 64