Model provides more insight into extreme results on the financial markets

Erasmus School of Economics

The global corona outbreak is increasingly emerging as a tail risk that can undermine the financial markets. Casper de Vries holds the Witteveen chair of Monetary Economics at Erasmus School of Economics and is an expert on tail risks in financial markets. He helped to develop a model that provides better insights into the risk of extreme events and systemic risk.

The model informs pension funds and life insurers how frequently financial disasters strike and how deep the fall can be. This helps pension funds and insurers to be prepared for such events and keep steady while the storm is raging. In a recent video call, we asked Professor Casper de Vries to explain his risk model. The video can be found below. 

Black Swan events

De Vries has been working on calculating the chances of large losses in the market for a very long time. On Monday 19 October 1987, also known as Black Monday, the stock market fell by approximately 20 percent. De Vries says he was very grateful for this day, as he had already made the first calculations of how often such an event occurs. De Vries also remembers the credit crisis from 2008 very well and now we are, once again, in a crisis. Nevertheless, it is very difficult to predict when a crisis will occur. What you can predict is how often such a crisis will occur. The methods developed by de Vries allow us to predict how often so-called ‘Black Swan’ events, which are events that turn the financial market upside down, will occur.

Doctor of the financial world 

De Vries advices pension funds not to try to cover themselves against the blows of the crisis, as this is far too costly. After all, pensions are focused on the long term and crises will blow over again. Knowing that they will occur helps enormously already. De Vries was also asked whether he would not call himself a doomsayer, given his field of expertise. But de Vries prefers to call himself a doctor of the financial world. ‘Doctors are also crisis managers, but of our bodies. I think it's in everyone's interest, and certainly in the interest of pension funds, to know what the chances are of major outliers on the financial market. From a scientific point of view, this remains challenging due to the very limited amount of data.’

Crises come and blow over

De Vries has three messages for directors and supervisors. First of all, use all the data you can find. ‘Crises are rare and the larger the dataset, the better you can estimate the probability of a crisis.’ He also advises directors not to overreact and to keep control. ‘Crises come and blow over. Pension funds are there for the long term and you have to focus on that.’ His third message is that as a society, and as an administrator, we just have to accept that there are risks. According to de Vries, we should not try to suggest that this risk does not exist. ‘In the new pension system, it is important that we no longer ensure this certain level of security with which we are currently working.’

Model provides more insight into extreme results on the financial markets