Financial Econometrics and Empirical Market Microstructure

Global Risk Factor Theory and Risk Scenario Generation Based on the Rogov-Causality Test of Time Series Time-Warped Longest Common Subsequence

Mikhail Rogov

Abstract The paper is concerned with the global risk factor theory and the Rogov - causality test of time-warped longest common subsequence for risk management purposes, including the prospects of hedging and portfolio diversification of oper­ational risks. The author discusses the interaction of all types of risk, the role of human error and the effect of space weather (geomagnetic activity taking into account the interplanetary magnetic field (IMF) polarity). The RogovIndex© family of global risk factor indices is described as part of the risk indicator time series database. The paper discusses the apparatus of time series data, mining including hierarchical clustering based on time-warped longest common subsequence simi­larity (T-WLCSS). The Rogov-causality test is offered for risk scenario generation. The test involves analyzing the time-lag cumulative distribution function for the longest common subsequence of time series.

Keywords Default rate • Financial risk • Geomagnetic activity • Global risk factor • Human error • Key risk indicator • Longest common subsequence • Operational risk • Risk management • Rogov-causality • Space weather • Time series • Time warp • Volatility

JEL Classification C22, C32, C53, C81, C82, D81, G32

M. Rogov (H)

Dubna International University, Dubna, Moscow Oblast, Russia e-mail: rogovm@hotmail. com

© Springer International Publishing Switzerland 2015

A. K. Bera et al. (eds.), Financial Econometrics and Empirical Market

Microstructure, DOI 10.1007/978-3-319-09946-0_____ 18

1 Introduction

Modern risk management is currently experiencing an ideological crisis, showing the following symptoms:

• Failure to understand the nature of the majority of financial risks

• Eclecticism of methods and concepts, in both technologies and standards of risk management

• Disregard of the interaction between operational risk, credit risk and market risk, lack of continuity in management processes, and lack of common rating scales for the assessment of various risks

• Inadequate tools for operational risk assessment

• Virtual absence of portfolio approach to operational risk management

• Difficulties with forecasting stress and crisis scenarios generation

• Difficulties explaining the nature of chaotic market processes

• Problem of the recently increased relevance of some previously uncommon factors, of which the following ones are thought by the author to be most important:

- cyber-terrorism and industrial terrorism

- influence of social networks

- High Frequency Trading (HFT)

- threat of antibiotic resistance

The author believes that the next decades will see the development of the following branches of risk management (Rogov 2011):

• human error

• transfer of operational risks including hedging and portfolio diversification

• prediction markets

• new concepts of key risk indicator (KRI)

• risk management of small and medium enterprises (SMEs) and households

• crowdsourcing, including platforms like Ushahidi, Wiki

• new generations of publicly available risk indices

• emergence of new asset classes

The basis for the development of the global risk factor theory

• Jevons (1878), Chizhevsky (1936)

• Advent of modern heliobiology and its findings

• Findings of the sciences of human factors, human errors

• Findings of the sciences of risk management and financial mathematics

• Accumulation of statistical data (statistics of disasters, volatility, defaults other events and indices)

The following postulates can be confirmed or refuted by explaining the causal relationships and by statistical analysis.

Postulate 1. Risks Are Interrelated There are relationships between financial risks of all types (market, credit, operational).