Probabilistic Approach to Measuring Early-Warning Signals of Systemic Contagion Risk

This paper proposes a model based on probability density functions associated with dynamics of underlying asset prices to measure contagion-induced systemic risk in the market. The two new risk measures with closed-form formulas derived from the model are:(1) the rate of change of the probability of triggering a shock determined by the joint dynamics of prices of systemically important assets/entities and less important ones; and (2) the distress correlation between the two types of assets/entities, which can provide forward-looking signals of such risk. The model is applied to the euro-area sovereign debt crisis and demonstrates how systemic liquidity shocks can build up in the sovereign debt market due to contagion between sovereign risk of small countries (i.e., Portugal) and systemically important countries (i.e., Italy and Spain). A signal of the rate of change of the joint probability appeared in April 2011 before the systemic liquidity shock occurred in November 2011. There exist endogenous critical levels of sovereign spreads, above which the signal materializes