Research

Articles

Exchange rates and the global transmission of equity market shocks (2022)

With the capacity to amplify or buffer the effect of shocks between equity markets in different countries, exchange rates play a crucial role in the transmission of shocks. By modelling the dependence structure between exchange rates and equity markets, we quantify the impact of an equity market shock on other equity markets through the cross-expected shortfall and assess the contribution of exchange rates to shock transmission. For emerging Latin American countries (Argentina, Brazil, Chile and Mexico) and two developed markets (the EU and USA), we document (a) that the contribution of exchange rates to shock transmission is time-varying and differs across countries; and (b) that exchange rates diversify (echo) shocks from abroad for investors based in emerging (developed) economies. Our results suggest that investors need to accurately measure the diversification role of their currency when making international portfolio and risk management decisions.

Do green bonds de-risk investment in low-carbon stocks? (2022)

Published in Economic Modelling

De-risking green investments is crucial to unlocking climate finance and to spurring investors’ interest in allocating resources to activities consistent with a resilient low-carbon economy. We explore the extent to which green bonds could de-risk investments in low-carbon assets by considering different market circumstances. We characterize joint dependence between green bonds and low-carbon assets and consider a de-risking metric based on expected shortfall. Our analysis for the Chinese, European and US markets for 2016 to 2020 indicates that green-bond and low-carbon stock returns move in opposite directions or independently, and a fall in green-bond returns below the 5% quantile increases the expected value of low-carbon stocks by 8.6% and 15.1% in the Chinese and European markets, respectively, but has a negligible effect on the US market. We also document that green bonds have sizeable diversification benefits when they are included in low-carbon investment portfolios.

Disentangling the role of the exchange rate in oil-related scenarios for the European stock market (2020)

Published in Energy Economics and ECB WPS

Slides link here

Poster link here

To date, most of the analyses on spillovers from oil to stock market have been performed considering prices in domestic currency. This assumption implies merging the commodity risk with the exchange rate risk when oil and stocks are traded in different currencies. This article proposes incorporating the exchange rate in the international shock analysis by using the convolution concept. I apply this framework to study the low quantile response of the European stock market under an oil stress scenario, without overlooking the role of the exchange rate.

I capture the dependence structure between these three variables using a vine copula approach, while a Switching Markov technique allows for structural changes in this relationship. The empirical exercise shows that the same stress scenario could generate an opposite impact depending on the source of risk. This framework can improve our understanding of how the exchange rate interacts in global markets. Also, It contributes to reduce the uncertainty about the impact of foreign shocks where the exchange rate plays a role.

Structural change in the link between oil and the European stock market: implications for risk management (2019)

Published on Dependence Modeling

Slides link here

The relationship between the European stock market and the crude oil depends on the significance of the different industries in the European economy. The literature points to a structural change after the 2008 crisis without getting into details of which sectors lead this regime switch. The co-movement between oil prices and stock market is known to exhibit (1) non-linearity, (2) asymmetric tail dependence and (3) variation over time. I combine a copula approach with Switching Markov models to capture this complex linkage while the CoVaR measure translates the consequences of the tail dependence into potential losses. The results indicate a change in the lower tail dependence from negative to positive association between oil and Eurostoxx, meaning a shift in the exposure of our stock portfolio to commodity risk. There is a structural change in dependence after the 2008 financial crisis led by energy-intensive sector, e.g. basic materials and consumer goods. The economic cycle and its implications for profit margin and oil demand might explain this switch. Healthcare sector responds to oil shocks in an opposite way than Eurostoxx, displaying useful features to reduce the exposure of the stock portfolio to oil spillovers.

Working papers

The macroprudential challenge of climate change (2022)

Published in ESRB Working Papers

The report identifies several amplifiers of climate risk across the financial system. Transition risks may be magnified because of economic and financial linkages between and across banks and companies. For example, a surge in carbon prices could increase the likelihood that the default of one company leads to the default of another. While this particularly applies to high-carbon companies, it could also affect their less carbon-intensive counterparties.

Meanwhile, interdependent natural hazards – such as water stress, heat stress and wildfires – can amplify physical climate risk, as they can cluster together and exacerbate each other. Market dynamics can also magnify the financial impact of physical risks. For example, a climate shock could lead to a sudden reassessment of climate risk pricing, thereby causing fire sales, where financial institutions – especially those with overlapping portfolios – quickly sell a large number of exposed assets at the same time at distressed prices.

Scenario analysis suggests that climate risks might take shape in the financial system in a specific order. First, unforeseen climate shocks could have an abrupt impact on market prices, initially hitting the portfolios of investment funds, pension funds and insurance companies. Second, this sudden repricing could cause companies to default, resulting in losses for exposed banks. In a disorderly transition scenario, marked by an immediate and substantial increase in carbon prices, respective market losses of insurers and investment funds could potentially amount to 3% and 25% on stress-tested assets in the near term. An orderly transition towards net zero by 2050 could soften such shocks and alleviate the fallout for companies and banks, reducing the probability of corporate defaults by around 13-20% in 2050 compared with today’s policies. It would also lessen credit losses for banks.

The impact of climate transition risks on financial stability. A systemic risk approach (2022)

Published in JRC Working Papers in Economics and Finance

Poster here

Slides here

LSE post here

Best Conference Paper Award of the Annual Event Of Finance Research Letters 2022 CEMLA Conference: New Advances In International Finance

FEF Antonio Dionis Soler 2022 accessit research prize

Transitioning to a low-carbon economy involves risks for the value of financial assets, with potential ramifications for financial stability. We quantify the systemic impact on financial firms arising from changes in the value of financial assets under three climate transition scenarios that reflect different levels of vulnerability to the transition to a low-carbon economy, namely, orderly transition, disorderly transition, and no transition (hot house world). We describe three systemic risk metrics computed from a copula-based model of dependence between financial firm returns and financial asset market returns: climate transition expected returns, climate transition value-at-risk, and climate transition expected shortfall. Empirical evidence for European financial firms over the period 2013-2020 indicates that the climate transition risk varies across sectors and countries, with banks and real estate firms experiencing the highest and lowest systemic impacts from a disorderly transition, respectively. We find that default premium, yield slope and inflation are the main drivers of climate transition risk, and that, in terms of capital shortfall, the cost of rescuing more risk-exposed financial firms from climate transition losses is relatively manageable. Simulation of climate risks over a five-year period shows that disorderly transition can be expected to imply significant costs for banks, while financial services and real estate firms remain more sheltered.

The Hedging Cost of Forgetting the Exchange Rate (2021)

Published in ICAE WPS

The safe-haven property of gold has been widely studied, although little attention has been paid to how exchange rate movements could affect hedging strategies. We analyse the exchange rate role in stock portfolios hedged with gold in several regions from the point of view of non-US and US investors, using vine copulas to model the relation between gold, stock and exchange rates.

We find a leading role played by exchange rate hedging stock losses, which outstrips the position of gold (index) in non-US (US) portfolios. The inclusion of the exchange rate can reduce the ES between 107 and 162 bps. An out-of-sample exercise supports our results. The implications of this study go beyond risk management decisions. Regulatory and supervisory authorities might find tools to assess the performance of financial assets under market distress scenarios.

Exchange rates and the global transmission of equity market shocks (2021)

Published in JRC Working Papers in Economics and Finance

We assess the role played by exchange rates in buffering or amplifying the propagation of shocks across international equity markets. Using copula functions we model the joint dependence between exchange rates and two global equity markets and, from a copula framework, we obtain the conditional expectation and measure the exchange rate contribution to shock propagation between those equity markets. Our estimates for emerging Latin American economies (Argentina, Brazil, Chile and Mexico) and two developed markets (Europe and the USA) document the following: (a) the contribution of exchange rates to the transmission of equity shocks is time varying and asymmetric and differs across countries; and (b) exchange rates diversify shocks from abroad for investors based in emerging economies (particularly Brazil, Chile and Mexico) and echo the effect of shocks from abroad for investors based in developed markets. This evidence has implications for international investors in terms of portfolio and risk management decisions.

Deconstructing systemic risk: A reverse stress testing approach (2020)

Published in CNMV WPS

The financial sector faces different systemic events. The early recognition of these events is a key step to monitor and track possible financial crises. Three main questions arise related to systemic risk, and they deal with their quantification, their probability of occurrence and the role of main contributors. This paper proposes a methodology based on a reverse stress test exercise to shed light on these questions. Time series and cross-section information regarding systemic risk are obtained. Further, we explore how these results of systemic assessment could change depending on key parameters in a Gaussian framework and, finally, a small empirical exercise is performed.

Cuantificación de la incertidumbre sobre los escenarios adversos de liquidez para los fondos de inversión (Quantifying uncertainty in adverse liquidity scenarios for investment funds) (2020)

Published in CNMV bulletin (ESP) (ENG). Press release. Extended version .

Featured in: Cinco días (1) (2) (3), El Español, El Economista, Funds People, Funds Society (1) (2).

This study introduces a statistical approach to generate a severe but plausible redemption scenario for investment funds, which is the main trigger in liquidity stress tests. Copula methodology allows us to create coherent scenarios across funds with different business models, whilst conditional quantile tunes the severity of the scenario. To perform the case study, a novel database on investment funds is built by combining supervisory data and different credit rating databases. A simulation exercise compares the distribution of the risk measures employed to define redemption scenarios using different statistical approaches. Results show that our methodology generates narrower confidence intervals for distribution of the shock than current regulatory approach. Finally, we analyse the response of Spanish investment funds to distress redemption scenarios in terms of their Redemption Coverage Ratio (RCR). Findings show that considering not only a point estimate but a range of potential redemption scenarios allows us to recognise vulnerable investment funds which might not be identified looking at the point estimate. Spanish investment funds respond resiliently to redemption shocks with the exception of few funds that hold important shares of illiquid asset class, i.e. high yield corporate bonds.

A proposal for the design of energy-related scenario for stock stress testing (2019)

Published in CNMV WPS

This article proposes a flexible methodology that captures the asymmetry in the relationship between the stock market and the oil market jointly with potential structural changes. It deals with the challenge of modelling the sharp increase in dependence across markets in stress situations. The study analyses the response of the European stock market to an extreme energy-related scenario. This exercise is of particular significance given the growing interest in the consequences of energy prices for the real economy and the risks of a disruptive transition to a low-carbon economy.

Contagion spillovers between sovereign and financial European sector from a Delta

CoVaR approach (2018)

Published in ICAE WPS

Slides link here

I examine the evolution of contagion indexes between the European financial sector and the sovereign sector (Austria, Belgium, France, Germany, Italy, Netherlands and Spain) during the European sovereign credit crisis. Contagion indexes, Delta CoVaR and Delta CoES, reflect events associated with extreme left tail returns and interdependencies between defaults different than those observed in tranquil times. These measures reveal very useful information concerning risk management.

I use a copula approach with time-varying parameters to capture changes in the tail dependence between returns in the financial and the sovereign sectors. I employ a Switching Markov model to identify the most stressful moments of the contagion indicators.

The results point out the emergence of Greek debt crisis on March 2010 and the vulnerable situation of Spain and Italy in summer 2011 as the main periods where the contagion from the sovereign to the financial sector was stronger. The decrease in contagion was gradual since the speech made by the ECB on July 26th,2012. The statistical significance of the change in the contagion indicators is checked using bootstrap tests.