General CoVaR Based on Entropy Pooling

Abstract: We propose a general CoVaR framework that extends the traditional CoVaR by incorporating diverse expert views and information, such as asset moment characteristics, quantile insights, and perspectives on the relative loss distribution between two assets. To integrate these expert views effectively while minimizing deviations from the prior distribution, we employ the entropy pooling method to derive the posterior distribution, which in turn enables us to compute the general CoVaR. Assuming bivariate normal distributions, we derive its analytical expressions under various perspectives. Sensitivity analysis reveals that CoVaR exhibits a linear relationship with both the expectations of the variables in the views and the differences in expectations between them. In contrast, CoVaR shows nonlinear dependencies with respect to the variance, quantiles, and correlation within these views. Empirical analysis of the US banking system during the Federal Reserve's interest rate hikes demonstrates the effectiveness of the general CoVaR when expert views are appropriately specified. Furthermore, we extend this framework to the general $\Delta$CoVaR, which allows for the assessment of risk spillover effects from various perspectives.