Practical Applications of Principal Components as a Measure of Systemic Risk

Abstract

Monitoring systemic risk has become a top priority for regulators and investors, and this Practical Applications report explores research about the use of asset prices to judge the level of implied systemic risk in the marketplace.

In Principal Components as a Measure of Systemic Risk , which was published in the Summer 2011 issue of The Journal of Portfolio Management , the authors introduce an asset price-centric metric called the absorption ratio.

In Toward Determining Systemic Importance , which was published in the Summer 2012 issue of JPM, the authors explore the practical applications of the absorption ratio by applying the methodology to a sample of industry returns for the U.S. stock market and for company returns within the U.S. and global financial sectors.

Mark Kritzman, President and CEO of Windham Capital Management in Boston and a co-author of the two articles, tells us how to use the absorption ratio as a signal.