nep-fmk New Economics Papers
on Financial Markets
Issue of 2011‒03‒26
three papers chosen by
Kwang Soo Cheong
Johns Hopkins University

  1. Constrained Mixture Models for Asset Returns Modelling By Iead Rezek
  2. Dynamic hedging of portfolio credit derivatives By Rama Cont; Yu Hang Kan
  3. Risk Management of Risk under the Basel Accord: Forecasting Value-at-Risk of VIX Futures By Chia-Lin Chang; Juan-Ángel Jiménez-Martín; Michael McAleer; Teodosio Pérez-Amaral

  1. By: Iead Rezek
    Abstract: The estimation of asset return distributions is crucial for determining optimal trading strategies. In this paper we describe the constrained mixture model, based on a mixture of Gamma and Gaussian distributions, to provide an accurate description of price trends as being clearly positive, negative or ranging while accounting for heavy tails and high kurtosis. The model is estimated in the Expectation Maximisation framework and model order estimation also respects the model's constraints.
    Date: 2011–03
    URL: http://d.repec.org/n?u=RePEc:arx:papers:1103.2670&r=fmk
  2. By: Rama Cont (PMA - Laboratoire de Probabilités et Modèles Aléatoires - CNRS : UMR7599 - Université Pierre et Marie Curie - Paris VI - Université Paris-Diderot - Paris VII); Yu Hang Kan (Center for Financial Engineering, Columbia University - Columbia University)
    Abstract: We compare the performance of various hedging strategies for index collateralized debt obligation (CDO) tranches across a variety of models and hedging methods during the recent credit crisis. Our empirical analysis shows evidence for market incompleteness: a large proportion of risk in the CDO tranches appears to be unhedgeable. We also show that, unlike what is commonly assumed, dynamic models do not necessarily perform better than static models, nor do high-dimensional bottom-up models perform better than simpler top-down models. When it comes to hedging, top-down and regression-based hedging with the index provide significantly better results during the credit crisis than bottom-up hedging with single-name credit default swap (CDS) contracts. Our empirical study also reveals that while significantly large moves—“jumps”—do occur in CDS, index, and tranche spreads, these jumps do not necessarily occur on the default dates of index constituents, an observation which shows the insufficiency of some recently proposed portfolio credit risk models.
    Keywords: hedging, credit default swaps, portfolio credit derivatives, index default swaps, collateralized debt obligations, portfolio credit risk models, default contagion, spread risk, sensitivity-based hedging, variance minimization
    Date: 2011–02–01
    URL: http://d.repec.org/n?u=RePEc:hal:journl:hal-00578008&r=fmk
  3. By: Chia-Lin Chang (Department of Applied Economics, Department of Finance, National Chung Hsing University); Juan-Ángel Jiménez-Martín (Department of Quantitative Economics, Complutense University of Madrid); Michael McAleer (Erasmus University Rotterdam, Tinbergen Institute, The Netherlands, and Institute of Economic Research, Kyoto University); Teodosio Pérez-Amaral (Department of Quantitative Economics, Complutense University of Madrid)
    Abstract: The Basel II Accord requires that banks and other Authorized Deposit-taking Institutions (ADIs) communicate their daily risk forecasts to the appropriate monetary authorities at the beginning of each trading day, using one or more risk models to measure Value-at-Risk (VaR). The risk estimates of these models are used to determine capital requirements and associated capital costs of ADIs, depending in part on the number of previous violations, whereby realised losses exceed the estimated VaR. McAleer, Jimenez-Martin and Perez- Amaral (2009) proposed a new approach to model selection for predicting VaR, consisting of combining alternative risk models, and comparing conservative and aggressive strategies for choosing between VaR models. This paper addresses the question of risk management of risk, namely VaR of VIX futures prices. We examine how different risk management strategies performed during the 2008-09 global financial crisis (GFC). We find that an aggressive strategy of choosing the Supremum of the single model forecasts is preferred to the other alternatives, and is robust during the GFC. However, this strategy implies relatively high numbers of violations and accumulated losses, though these are admissible under the Basel II Accord.
    Keywords: Median strategy, Value-at-Risk (VaR), daily capital charges, violation penalties, optimizing strategy, aggressive risk management, conservative risk management, Basel II Accord, VIX futures, global financial crisis (GFC).
    JEL: G32 G11 C53 C22
    Date: 2011–03
    URL: http://d.repec.org/n?u=RePEc:kyo:wpaper:761&r=fmk

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