New Economics Papers
on Risk Management
Issue of 2004‒12‒12
twenty papers chosen by

  1. Can Tests Based on Option Hedging Errors Correctly Identify Volatility Risk Premia? By Nicole Branger; Christian Schlag
  2. Modern Portfolio Theory and Control Risk By Kirby Adam J.R. Faciane
  3. Why VAR Fails: Long Memory and Extreme Events in Financial Markets By Cornelis A. Los
  4. Price and Wealth Asymptotic Dynamics with CRRA Technical Trading Strategies By Mikhail Anoufriev, Giulio Bottazzi, Francesca Pancotto
  5. Is Jump Risk Priced? - What We Can (and Cannot) Learn From Option Hedging Errors By Nicole Branger; Christian Schlag
  6. Rational Investors' Performance Versus Momentum Traders By Kirby Adam J.R. Faciane
  7. Style, Fees and Performance of Italian Equity Funds By Riccardo Cesari; Fabio Panetta
  8. Risk Properties of AMU denominated Asian Bonds By Junko Shimizu; Eiji Ogawa
  9. Continuous Cumulative Prospect Theory and Individual Asset Allocation By Greg B. Davies; Stephen E. Satchell
  10. Cofinancing to Manage Risk in the Motion Picture Industry By Ronald Goettler; Phillip Leslie
  11. Is bank capital procyclical? A cross-country analysis By Jaap Bikker; Paul Metzemakers
  12. Basel and Procyclicality: A comparison of the Standardised and IRB Approaches to an Improved Credit Risk Method By Miguel Segoviano; Charles Goodhart
  13. A Two-State Capital Asset Pricing Model with Unobservable States By Nilsson, Birger; Hansson, Björn
  14. Some theory of bivariate risk attitude By Marta_Cardin; Paola_Ferretti
  15. Asset Prices in an Overlapping Generations Model with Case-Based Decision Makers with Short Memory By Guerdjikova, Ani
  16. Evolution of Wealth and Asset Prices in Markets with Case-Based Investors By Guerdjikova, Ani
  17. Macroeconomic Sources of Risk in the Term Structure By Chiona Balfoussia; Michael Wickens
  18. When in Peril, Retrench: Testing the Portfolio Channel of Contagion By Fernando A. Broner; R. Gaston Gelos; Carmen Reinhart
  19. A market model for inflation By Nabyl Belgrade; Eric Benhamou; Etienne Koehler
  20. Liquidity Discovery and Asset Pricing By Michael Gallmeyer; Burton Hollifield; Duane Seppi

  1. By: Nicole Branger; Christian Schlag
    Date: 2003
  2. By: Kirby Adam J.R. Faciane (Kirby Faciane / KAJR Faciane)
    Abstract: Modern portfolio theory has played an important role in concentrating the attention of professional investors on the need to control risk. Since professionals invest on behalf of a great variety of institutions and individuals, they would ideally like to be able to discuss risk in a systematic and quantifiable way. Although the pressure for change in the United Kingdom has not been so great as within the United States, where the introduction of ERISA has provided legal impetus for investment managers to adopt an acceptable method of risk measurement, there has nevertheless been a gradual transition towards accountability and risk- adjusted performance in the U.K. Yet there remains a wide divergence between the theoretical principles and the practical methodology of portfolio investment. One of the most important ways in which this divergence manifests itself lies in the contrast between the recommended market approach of theory and the concentration by practitioners on sectors and individual share selection.
    Keywords: portfolio theory; risk
    JEL: G G0 F1 F2
    Date: 2004–11–29
  3. By: Cornelis A. Los
    Abstract: The Value-at-Risk (VAR) measure is based on only the second moment of a rates of return distribution. It is an insufficient risk performance measure, since it ignores both the higher moments of the pricing distributions, like skewness and kurtosis, and all the fractional moments resulting from the long - term dependencies (long memory) of dynamic market pricing. Not coincidentally, the VaR methodology also devotes insufficient attention to the truly extreme financial events, i.e., those events that are catastrophic and that are clustering because of this long memory. Since the usual stationarity and i.i.d. assumptions of classical asset returns theory are not satisfied in reality, more attention should be paid to the measurement of the degree of dependence to determine the true risks to which any investment portfolio is exposed: the return distributions are time-varying and skewness and kurtosis occur and change over time. Conventional mean-variance diversification does not apply when the tails of the return distributions ate too fat, i.e., when many more than normal extreme events occur. Regrettably, also, Extreme Value Theory is empirically not valid, because it is based on the uncorroborated i.i.d. assumption.
    Keywords: Long memory, Value at Risk, Extreme Value Theory, Portfolio Management, Degrees of Persistence
    JEL: C33 G13 G14 G18 G19 G24
    Date: 2004–12–08
  4. By: Mikhail Anoufriev, Giulio Bottazzi, Francesca Pancotto
    Abstract: In this paper we study the dynamics of a simple asset pricing model describing the trading activity of heterogeneous agents in a "stylized" market. The economy in the model contains two assets: a bond with risk-less return and a dividend paying stock. The price of the stock is determined through market clearing condition. Traders are speculators described as expected utility maximizers with heterogeneous beliefs about future stock price and with heterogeneous estimation of risk. In particular, we consider traders who base their investment decision on different time horizons and we analyze the effect of these differences on the price dynamics. Under suitable parameterization, the stock no-arbitrage "fundamental" price can emerge as a stable fixed point of the model dynamics. For different parameterizations, however, the market shows cyclical or chaotic price dynamics with speculative bubbles and crashes. We find that the sole heterogeneity of agents with respect to their time horizons is not enough to guarantee the instability of the fundamental price and the emergence of non-trivial price dynamics. However, if different groups of agents are characterized by different trading behaviors, the introduction of heterogeneous investment horizons can help to decrease the stability region of the "fundamental" fixed point. The role of time horizons turns out to be different for different trade behaviors and, in general, depends on the whole ecology of agents' beliefs. We demonstrate this effect discussing a case in which the increase of fundamentalists time horizons can lead to cyclical or chaotic price behavior, while the same increase for the chartists helps to stabilize the fundamental price.
    Keywords: Asset pricing, Price and wealth dynamics, Large market limit, Optimal selection principle.
  5. By: Nicole Branger; Christian Schlag
    Date: 2004–05
  6. By: Kirby Adam J.R. Faciane (Kirby Faciane / KAJR Faciane)
    Abstract: Through a formalization of the intuition of De Long, Shieifer, Summers & Waldmann (1990a), this paper first shows that the presence of irrational investors of any type who behave differently from rational investors always drives a wedge between the equity premium and the covariance of aggregate consumption growth and stock returns because only rational investors satisfy the Euler equations. By analyzing the case where the stock positions of rational investors and irrational investors sum to 0, I demonstrate that the extra equity premium of 2% ~ 4% that positive feedback traders generate in the simulation can come about without any increase in the covariance of aggregate consumption growth and stock returns. I show that in this case irrational investors change the equity premium from the efficient market level through the effect from market inefficiency while they do not change the covariance of aggregate consumption growth and stock returns from the efficient market level because the stock positions of different agents always sum to the fixed supply of stocks and the covariance of aggregate consumption growth and stock returns is determined only by the aggregate stock position. This paper then demonstrates that in the situation where the conditional variance of rate of returns is constant along the fundamentals path, any transitory component in prices increases the conditional variance when prices fall below fundamentals and decreases it when prices rise above fundamentals. Moreover, the persistence of return volatility is actually identical to the persistence of the transitory component. As positive feedback traders with extended knowledge make prices deviate widely and persistently from fundamentals, the increase of volatility when stock prices fall can be dramatic and the volatility shows an extreme persistence. This paper further determines that the deviation follows approximately another MA process of a very high order when the memory horizon is very long. This extreme persistence of the deviation is the source of the extreme persistence of volatility. Positive feedback traders with extended knowledge make the stock market a seemingly paradoxical place where their infinitesimal forecast error causes prices to deviate widely from fundamentals. However, although positive feedback traders are not rational, they hardly lose to rational investors.
    Keywords: inventory; stock trades; prices; informed traders; positive feedback traders; market makers; irrational traders; momentum traders
    JEL: G G0
    Date: 2004–11–29
  7. By: Riccardo Cesari (University of Bologna, Department of Economics); Fabio Panetta (Bank of Italy, Economic Research Department)
    Abstract: Using a clustering procedure,we classify Italian funds ex-post on the basis of the composition of their portfolios and find that the optimal number of clusters is equal to 4. The four groups which result from the statistical classification closely match the 4-level aggregation of the 20 ex-ante categories used by the Italian mutual funds association. We then estimate the risk-adjusted performance of Italian equity funds, using both net and gross returns and employing both one-factor CAPM benchmarks and multi-factor benchmarks. In addition to the standard Jensen's a, we measure risk-adjusted performance using the Positive Period Weighting measure (PPW), which is not influenced by managers' market-timing strategy.Using net returns (calculated after management fees and taxes but before load fees) the Italian equity funds' performance is not significantly different from zero. However, when the funds'performance is evaluated on the basis of gross returns (i.e.returns computed adding back management fees paid each year by the funds), the performance of the Italian equity funds is always positive. In particular, when both a 2-index benchmark that takes account of the funds' investments in government bonds and a 5-factor APT benchmark are considered, performance is positive and significant using both Jensen's a and the PPW. This result supports Grossman and Stiglitz's (1980) view of market efficiency, suggesting that informed investors (investment funds) are compensated for their information gathering.
    Keywords: mutual funds; performance measures; investment style; management fees; market timing
    JEL: G23 G14
    Date: 1998–01
  8. By: Junko Shimizu; Eiji Ogawa
    Abstract: This paper is to investigate risk properties of AMU (Asian Monetary Unit) denominated Asian bonds by comparing them with those of local currency denominated bonds issued in East Asian countries. We suppose the AMU as an Asian currency unit which is formed as a currency basket of East Asian currencies. In this paper, we simulate a currency basket composed by ASEAN5 countries, Japan, China, Korea, and Hong Kong. Our results indicate that the AMU denominated bonds can lower the risks for both US and Japanese investor. It is because the portfolio effects should reduce the foreign exchange risk. These results depend on the currency system in the East Asian countries.
    Keywords: Asian bond, a currency basket, AMU(Asian Monetary Unit), foreign exchange risk
    JEL: F31 F33 G15
    Date: 2004–11
  9. By: Greg B. Davies; Stephen E. Satchell
    Abstract: We implement the Cumulative Prospect Theory (CPT) framework (Tversky and Kahneman 1992) into a model of individual asset allocation, building on earlier work by Hwang and Satchell (2003) where they derive explicit formulae for the asset allocation decision using a loss aversion utility function. We apply Prelec’s probability weighting function (1998) to continuous distributions and derive the formulae for the optimal asset allocation between risky and safe assets. US equity returns data are used to examine the feasible parameter space. The earlier results of Hwang and Satchell are confirmed and the more complex model is compatible with observed equity proportions. The parameters are highly interconnected, but feasible combinations indicate that more inverse-S shaped deviations from linear probability weightings are associated with lower risk taking behaviour.
    Keywords: Cumulative Prospect Theory, asset allocation, non-linear decisions weights
    JEL: G11 D81
    Date: 2004–11
  10. By: Ronald Goettler; Phillip Leslie
    Date: 2003–10
  11. By: Jaap Bikker; Paul Metzemakers
    Abstract: This paper investigates the determinants of commercial banks' own internal capital targets and potential sensitivity of these levels to the business cycle . World-wide results make clear that banks' own risk is only slightly dependent on the business cycle. Banks tend to hold substantial capital buffers on top of minimum requirements, reflecting that they hold capital for other reasons than strictly meeting the capital requirements. These results suggest that actual capital levels may not become substantially more procyclical under the new risk-sensitive Basel II regime. However, a number of banks, especially smaller ones, combine a relatively risky portfolio with limited buffer capital. A more risk-sensitive capital regulation regime could force these banks to obtain higher capital levels, which would make them more procyclical.
    JEL: E32 G21 G28 G31
    Date: 2004–09
  12. By: Miguel Segoviano; Charles Goodhart
    Abstract: The regulation of bank capital in the form of capital adequacy requirements is itself inherently procyclical; it bites in downturns, but fails to restrain in booms. The more ¶risk-sensitive¶ the regulation, the greater the scope for pro-cyclicality to become a problem, particularly in view of the changing nature of macroeconomic cycles. The simulation exercises performed in this paper suggest that the new Basel II accord, which deliberately aimed at significantly increasing the risk sensitiveness of capital requirements, may in fact considerably accentuate the procyclicality of the regulatory system. Since the experience in the past, also discussed in this paper, suggests that a required hoisting of capital ratios in downturns may be brought about by cutting back lending rather than raising capital, the new capital accord may therefore lead to an amplification of business cycle fluctuations, especially in downturns.
    Date: 2004–11
  13. By: Nilsson, Birger (Department of Economics, Lund University); Hansson, Björn (Department of Economics, Lund University)
    Abstract: We derive theoretical discrete time asset pricing restrictions on the within state conditional mean equations for the market portfolio and for individual assets under the assumptions: (1) the conditional CAPM holds; (2) asset returns are driven by an underlying unobserved two-state discrete Markov process. We show that the market risk-premiums in the two states can be decomposed into a standard CAPM volatility-level premium plus an additional volatility-uncertainty premium. The latter premium is increasing in the market price of risk, the uncertainty about the next period's state and the difference in volatility between the two states. In an empirical application the model is estimated for the U.S. stock market 1836-2003. We apply a discrete mixture of two Normal Inverse Gaussian (NIG) distributions to represent the return characteristics in the unobservable states. Our results show that the high-risk regime has a volatility of 36.28 % on an annual basis while the low-risk regime has just 14.42%, and the latter is much more frequent. Stock returns display characteristics that support our specification of within state NIG distributions as an alternative to Normal distributions. The risk premiums for the two regimes are 2.79% and 17.86% on an annual basis, but the volatility-uncertainty premium for the two states are shown to give an unimportant contribution to the estimated risk premium. The most striking result, from a practical point of view, is that the average sample risk premium of 4% belongs to the highest quintiles of the estimated conditional risk premiums.
    Keywords: asset pricing; state dependent risk premium; discrete mixture distribution
    JEL: C22 G12
    Date: 2004–12–06
  14. By: Marta_Cardin (University of Venice); Paola_Ferretti (University of Venice)
    Abstract: In past years the study of the impact of risk attitude among risks has become a major topic, in particular in Decision Sciences. Subsequently the attention was devoted to the more general case of bivariate random variables. The first approach to multivariate risk aversion was proposed by de Finetti (1952) and Richard (1975) and it is related to the bivariate case. More recently, multivariate risk aversion has been studied by Scarsini (1985, 1988, 1999). Nevertheless even if decision problems with consequences described by more than two attributes have become increasingly important, some questions appear not completely solved. This paper concerns with a definition of bivariate risk aversion which is related to a particular type of concordance: a bivariate risk averse Decision Maker is a Decision Maker who always prefers the independent version of a bivariate random variable to the random variable itself.
    Keywords: Bivariate risk aversion; concordance aversion; submodular functions; bivariate association; concordance; dependence; diversification.
    JEL: C7 D8
    Date: 2004–11–29
  15. By: Guerdjikova, Ani (Cornell University)
    Abstract: I consider an economy, populated by case-based decision makers with one-period memory. Consumption can be transferred between the periods by the means of a riskless storage technology or a risky asset with iid dividend payments. I analyze the dynamics of asset holdings and asset prices. Whereas an economy in which the investors have low aspiration levels exhibits constant prices and asset holdings, investors with high aspiration levels create cycles, which may be stochastic or deterministic. Arbitrage possibilities, deviation of the price from the fundamental value, predictability of returns and excessive volatility are shown to obtain in a market with case-based investors.
    Date: 2004–11–24
  16. By: Guerdjikova, Ani (Cornell University)
    Abstract: I analyze whether case-based decision makers (CBDM) can survive in an assetmarket in the presence of expected utilitymaximizers. Conditions are identified, under which the CBDM retain a positive mass with probability one. CBDM can cause predictability of asset returns, high volatility and bubbles. It is found that the expected utility maximizers can disappear from the market for a finite period of time, if the mispricing of the risky asset caused by the case-based decision-makers aggravates too much. Only in the case of logarithmic expected utility maximizers do the case-based decision makers disappear from the market for all parameter values.
    Date: 2004–11–24
  17. By: Chiona Balfoussia; Michael Wickens
    Abstract: In this paper we develop a new way of modelling time variation in term premia. This is based on the stochastic discount factor model of asset pricing with observable macroeconomic factors. The joint distribution of excess holding period US bond returns of different maturity and the fundamental macroeconomic factors is modelled using multivariate GARCH with conditional covariances in the mean to capture the term premia. We show how by testing the assumption of no arbitrage we can derive a specification test of our model. We estimate the contribution made to the term premia at different maturities by real and nominal macroeconomic sources of risk. From the estimated term premia we recover the term structure of interest rates and examine how it varies through time. Finally, we examine whether the large number of reported failures of the rational expectations hypothesis of the term structure can be attributed to an omitted time-varying term premium.
    Keywords: term structure, the stochastic discount factor model, term premia, GARCH
    JEL: C50 E40 G10
    Date: 2004
  18. By: Fernando A. Broner; R. Gaston Gelos; Carmen Reinhart
    Abstract: One plausible mechanism through which financial market shocks may propagate across countries is through the effect of past gains and losses on investors' risk aversion. The paper first presents a simple model examining how heterogeneous changes in investors' risk aversion affects portfolio decisions and stock prices. Second, the paper shows empirically that, when funds' returns are below average, they adjust their holdings toward the average (or benchmark) portfolio. In other words, they tend to sell the assets of countries in which they were "overweight", increasing their exposure to countries in which they were "underweight." Based on this insight, the paper discusses a matrix of financial interdependence reflecting the extent to which countries share overexposed funds. Comparing this measure to indices of trade or bank linkages indicates that our index can improve predictions about which countries are likely to be affected by contagion from crisis centers.
    JEL: F02 F30 F32 F36
    Date: 2004–12
  19. By: Nabyl Belgrade (CERMSEM et CDC IXIS-CM,R&D); Eric Benhamou (CDC IXIS-CM,R&D); Etienne Koehler (CERMSEM et CDC IXIS Risk)
    Abstract: The various macro econometrics model for inflation are helpless when it comes to the pricing of inflation derivatives. The only article targeting inflation option pricing, the Jarrow Yildirim model (2000), relies on non observable data. This makes the estimation of the model parameters a non trivial problem. In addition, their framework does not examine any relationship between the most liquid inflation derivatives instruments : the year to year and zero coupon swap. To fill this gap, we see how to derive a model on inflation, based on traded and liquid market instrument. Applying the same strategy as the one for a market model on interest rates, we derive no-arbitrage relationship between zero coupon and year to year swaps. We explain how to compute the convexity adjustment and what relationship the volatility surface should satisfy. Within this framework, it becomes much easier to estimate model parameters and to price inflation derivatives in a consistent way.
    Keywords: Inflation index, forward, zero-coupon, year-on-year, volatility cube, convexity adjustment
    JEL: C59
    Date: 2004–10
  20. By: Michael Gallmeyer; Burton Hollifield; Duane Seppi
    Abstract: Asset prices are risky, in part, because of uncertainty about the preferences of potential counterparties and the terms-of-trade at which they will be willing to provide liquidity in the future. We call such randomness liquidity risk. We argue that liquidity risk is an important source of asymmetric information in addition to private information about future cash flows. We model the endogenous dynamics of liquidity risk, the risk premisum for bearing liquidity risk, and the role of market trading in the liquidity discovery process through which investors learn about their counterparties' preferences and their future demands for securities. We show that market liquidity is a forward-looking predictor of future risk and, as such, is prices. Our model also provides rational explanations for "prices support levels" and "flights to quality."

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