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on Risk Management |
| By: | Gianluca Cassesse; Massimo Guidolin |
| Abstract: | We analyze the volatility surface vs. moneyness and time to expiration implied by MIBO options written on the MIB30, the most important Italian stock index. We specify and fit a number of models of the implied volatility surface and find that it has a rich and interesting structure that strongly departs from a constant volatility, Black-Scholes benchmark. This result is robust to alternative econometric approaches, including generalized least squares approaches that take into account both the panel structure of the data and the likely presence of heteroskedasticity and serial correlation in the random disturbances. Finally we show that the degree of pricing efficiency of this options market can strongly condition the results of the econometric analysis and therefore our understanding of the pricing mechanism underlying observed MIBO option prices. Applications to value-at-risk and portfolio choice calculations illustrate the importance of using arbitrage-free data only. |
| Keywords: | Assets (Accounting) ; Prices |
| Date: | 2005 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedlwp:2005-008&r=rmg |
| By: | Silvia Goncalves; Massimo Guidolin |
| Abstract: | One key stylized fact in the empirical option pricing literature is the existence of an implied volatility surface (IVS). The usual approach consists of fitting a linear model linking the implied volatility to the time to maturity and the moneyness, for each cross section of options data. However, recent empirical evidence suggests that the parameters characterizing the IVS change over time. In this paper we study whether the resulting predictability patterns in the IVS coefficients may be exploited in practice. We propose a two-stage approach to modeling and forecasting the S&P 500 index options IVS. In the first stage we model the surface along the cross-sectional moneyness and time-to-maturity dimensions, similarly to Dumas et al. (1998). In the second-stage we model the dynamics of the cross-sectional first-stage implied volatility surface coefficients by means of vector autoregression models. We find that not only the S&P 500 implied volatility surface can be successfully modeled, but also that its movements over time are highly predictable in a statistical sense. We then examine the economic significance of this statistical predictability with mixed findings. Whereas profitable delta-hedged positions can be set up that exploit the dynamics captured by the model under moderate transaction costs and when trading rules are selective in terms of expected gains from the trades, most of this profitability disappears when we increase the level of transaction costs and trade multiple contracts off wide segments of the IVS. This suggests that predictability of the time-varying S&P 500 implied volatility surface may be not inconsistent with market efficiency. |
| Keywords: | Assets (Accounting) ; Prices |
| Date: | 2005 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedlwp:2005-010&r=rmg |
| By: | Hui Guo; Christopher J. Neely |
| Abstract: | If there is no priced risk - including volatility risk - associated with hedging an option, then expected delta hedging errors should be zero. This paper finds that delta hedging errors of a synthetic at-the-money call option on foreign exchange futures are significantly positive and cannot be explained by standard asset pricing models. However, we cannot rule out the hypothesis that delta hedging errors reflect rational pricing; foreign exchange volatility and stock market volatility predict them. Moreover, foreign exchange volatility also predicts excess stock market returns, indicating that foreign exchange volatility risk might be priced because of its relation to foreign exchange level risk. |
| Keywords: | Foreign exchange ; Assets (Accounting) ; Prices |
| Date: | 2004 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedlwp:2004-029&r=rmg |
| By: | Patrick de Fontnouvelle; Victoria Garrity; Scott Chu; Eric Rosengren |
| Abstract: | Basel II replaces Basel I’s implicit capital charge on operational risk with an explicit charge. Certain U.S. banks concentrated in processing-related business lines – which have significant operational risk – could thus face an increase in overall minimum regulatory capital requirements. Some have argued that, as a result, these so-called “processing banks” would be disadvantaged vis-à-vis competitors not subject to regulatory capital requirements for operational risk. This paper evaluates these concerns. |
| Keywords: | Bank capital ; Risk management ; Basel capital accord |
| Date: | 2005 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedgwp:5&r=rmg |
| By: | João Fernandes (Banco BPI) |
| Abstract: | The literature on corporate credit risk modeling for privately-held firms is scarce. Although firms with unlisted equity or debt represent a significant fraction of the corporate sector worldwide, research in this area has been hampered by the unavailability of public data. This study is an empirical application of credit scoring and rating techniques applied to the corporate historical database of one of the major Portuguese banks. Several alternative scoring methodologies are presented, thoroughly validated and statistically compared. In addition, two distinct strategies for grouping the individual scores into rating classes are developed. Finally, the regulatory capital requirements under the New Basel Capital Accord are calculated for a simulated portfolio, and compared to the capital requirements under the current capital accord. |
| Keywords: | Credit Scoring, Credit Rating, Private Firms, Discriminatory Power, Basel Capital Accord, Capital Requirements |
| JEL: | C13 C14 G21 G28 |
| Date: | 2005–05–13 |
| URL: | http://d.repec.org/n?u=RePEc:wpa:wuwpfi:0505013&r=rmg |
| By: | Massimo Guidolin; Allan Timmerman |
| Abstract: | This paper characterizes the term structure of risk measures such as Value at Risk (VaR) and expected shortfall under different econometric approaches including multivariate regime switching, GARCH-in-mean models with student-t errors, two-component GARCH models and a non-parametric bootstrap. We show how to derive the risk measures for each of these models and document large variations in term structures across econometric specifications. An out-of-sample forecasting experiment applied to stock, bond and cash portfolios suggests that the best model is asset- and horizon specific but that the bootstrap and regime switching model are best overall for VaR levels of 5% and 1%, respectively. |
| Keywords: | Time-series analysis ; Econometric models |
| Date: | 2005 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedlwp:2005-001&r=rmg |
| By: | Massimo Guidolin; Allan Timmerman |
| Abstract: | This paper proposes a new tractable approach to solving multi-period asset allocation problems. We assume that investor preferences are defined over moments of the terminal wealth distribution such as its skew and kurtosis. Time-variations in investment opportunities are driven by a regime switching process that can capture bull and bear states. We develop analytical methods that only require solving a small set of difference equations and thus are very convenient to use. These methods are applied to a simple portfolio selection problem involving choosing between a stock index and a risk-free asset in the presence of bull and bear states in the return distribution. If the market is in a bear state, investors increase allocations to stocks the longer their time horizon. Conversely, in bull markets it is optimal for investors to decrease allocations to stocks the longer their investment horizon. |
| Keywords: | Assets (Accounting) |
| Date: | 2005 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedlwp:2005-006&r=rmg |
| By: | Massimo Guidolin; Allan Timmerman |
| Abstract: | This paper finds strong evidence of time-variations in the joint distribution of returns on a stock market portfolio and portfolios tracking size- and value effects. Mean returns, volatilities and correlations between these equity portfolios are found to be driven by underlying regimes that introduce short-run market timing opportunities for investors. The magnitude of the premia on the size and value portfolios and their hedging properties are found to vary significantly across regimes. Regimes are also found to have a large impact on the optimal asset allocation - especially under rebalancing - and on investors' welfare. |
| Keywords: | Assets (Accounting) |
| Date: | 2005 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedlwp:2005-007&r=rmg |
| By: | Pierluigi Balduzzi; Cesare Robotti |
| Abstract: | This paper considers two alternative formulations of the linear factor model (LFM) with nontraded factors. The first formulation is the traditional LFM, where the estimation of risk premia and alphas is performed by means of a cross-sectional regression of average returns on betas. The second formulation (LFM*) replaces the factors with their projections on the span of excess returns. This formulation requires only time-series regressions for the estimation of risk premia and alphas. We compare the theoretical properties of the two approaches and study the small-sample properties of estimates and test statistics. Our results show that when estimating risk premia and testing multi-beta models, the LFM* formulation should be considered in addition to, or even instead of, the more traditional LFM formulation. |
| Date: | 2005 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedawp:2005-04&r=rmg |
| By: | Chen-Miao Lin; Stephen D. Smith |
| Abstract: | The purpose of this paper is to empirically investigate the interaction between hedging, financing, and investment decisions. This work is relevant in that theoretical predictions are not necessarily identical to those in the case where only two decisions are being made. We argue that the way in which hedging affects the firms’ financing and investing decisions differs for firms with different growth opportunities. We empirically find that high-growth firms increase their investment, but not their leverage, by hedging. However, we also find that firms with few investment opportunities use derivatives to increase their leverage. |
| Date: | 2005 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedawp:2005-05&r=rmg |
| By: | Patrick de Fontnouvelle; Eric Rosengren; John Jordan |
| Abstract: | Quantification of operational risk has received increased attention with the inclusion of an explicit capital charge for operational risk under the new Basle proposal. The proposal provides significant flexibility for banks to use internal models to estimate their operational risk, and the associated capital needed for unexpected losses. Most banks have used variants of value at risk models that estimate frequency, severity, and loss distributions. This paper examines the empirical regularities in operational loss data. Using loss data from six large internationally active banking institutions, we find that loss data by event types are quite similar across institutions. Furthermore, our results are consistent with economic capital numbers disclosed by some large banks, and also with the results of studies modeling losses using publicly available “external” loss data. |
| Keywords: | Bank capital ; Risk management ; Basel capital accord |
| Date: | 2004 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedbwp:1&r=rmg |
| By: | Simon H. Kwan |
| Abstract: | Under the strong-form of market discipline, publicly traded banks that have constantly available public market signals from their stock (and bond) prices would take less risk than non-publicly traded banks because counterparties, borrowers, and regulators could react to adverse public market signals against publicly traded banks. In comparing the credit risk, earnings risk, capitalization, and failure risk between publicly traded and non-publicly traded banks, the evidence in this paper rejects the strong-form of market discipline. In fact, the findings indicate that banking organizations tend to take more risk when they were publicly traded than when they were privately owned. |
| Keywords: | Stock market ; Risk ; Banks and banking |
| Date: | 2004 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedfap:2004-19&r=rmg |
| By: | Glenn D. Rudebusch; Tao Wu |
| Abstract: | This paper examines a recent shift in the dynamics of the term structure and interest rate risk. We first use standard yield-spread regressions to document such a shift in the U.S. in the mid-1980s. Over the pre- and post-shift subsamples, we then estimate dynamic, affine, no-arbitrage models, which exhibit a significant difference in behavior that can be largely attributed to changes over time in the pricing of risk associated with a “level” factor. Finally, we suggest a link between the shift in term structure behavior and changes in the risk and dynamics of the inflation target as perceived by investors. |
| Keywords: | Interest rates ; Monetary policy ; Econometric models |
| Date: | 2004 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedfap:2004-25&r=rmg |
| By: | Mark L . J. Wright |
| Abstract: | What has been the effect of the shift in emerging market capital flows toward private sector borrowers? Are emerging market capital flows more efficient? If not, can controls on capital flows improve welfare? This paper shows that the answers depend on the form of default risk. When private loans are enforceable, but there is the risk that the government will default on behalf of all residents, private lending is inefficient and capital controls are potentially Pareto-improving. However, when private agents may individually default, capital flow subsidies are potentially Pareto-improving. |
| Keywords: | Capital market ; Risk |
| Date: | 2004 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedfpb:2004-34&r=rmg |
| By: | Tim Bollerslev; Michael Gibson; Hao Zhou |
| Abstract: | This paper proposes a method for constructing a volatility risk premium, or investor risk aversion, index. The method is intuitive and simple to implement, relying on the sample moments of the recently popularized model-free realized and option-implied volatility measures. A small-scale Monte Carlo experiment suggests that the procedure works well in practice. Implementing the procedure with actual S&P 500 option-implied volatilities and high-frequency five-minute-based realized volatilities results in significant temporal dependencies in the estimated stochastic volatility risk premium, which we in turn relate to a set of underlying macro-finance state variables. We also find that the extracted volatility risk premium helps predict future stock market returns. |
| Keywords: | Stochastic analysis ; Risk ; Uncertainty |
| Date: | 2004 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedgfe:2004-56&r=rmg |
| By: | Sean D. Campbell; Canlin Li |
| Abstract: | Since the early 1980s much research, including the most recent contribution of Santa-Clara and Valkanov (2003), has concluded that there is a stable, robust and significant relationship between Democratic presidential administrations and robust stock returns. Moreover, the difference in returns does not appear to be accompanied by any significant differences in risk across the presidential cycle. These conclusions are largely based on OLS estimates of the difference in returns across the presidential cycle. We re-examine this issue using more efficient estimators of the presidential premium. Specifically, we exploit the considerable and persistent heteroskedasticity in stock returns to construct more efficient weighted least squares (WLS) and generalized autoregressive conditional heteroskedasticity (GARCH) estimators of the difference in expected excess stock returns across the presidential cycle. Our findings provide considerable contrast to the findings of previous research. Across the different WLS and GARCH estimates we find that the point estimates are considerably smaller than the OLS estimates and fluctuate considerably across different sub samples. We show that the large difference between the WLS, GARCH and OLS estimates is driven by differing stock market performance during very volatile market environments. During periods of elevated market volatility, excess stock returns have been markedly higher under Democratic than Republican administrations. Accordingly, the WLS and GARCH estimators are less sensitive to these episodes than the OLS estimator. Ultimately, these results are consistent with the conclusion that neither risk nor return varies significantly across the presidential cycle. |
| Keywords: | Stock market ; Rate of return |
| Date: | 2004 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedgfe:2004-69&r=rmg |
| By: | Daniel Covitz; Song Han |
| Abstract: | A frictionless, structural view of default has the unrealistic implication that recovery rates on bonds, measured at default, should be close to 100 percent. This suggests that standard "frictions" such as default delays, corporate-valuation jumps, and bankruptcy costs may be important drivers of recovery rates. A structural view also suggests the existence of nonlinearities in the empirical relationship between recovery rates and their determinants. We explore these implications empirically and find direct evidence of jumps, and also evidence of the predicted nonlinearities. In particular, recovery rates increase as economic conditions improve from low levels, but decrease as economic conditions become robust. This suggests that improving economic conditions tend to boost firm values, but firms may tend to default during particularly robust times only when they have experienced large, negative shocks. |
| Keywords: | Bonds ; Default (Finance) ; Risk management |
| Date: | 2004 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedgfe:2005-10&r=rmg |
| By: | Ryoichi Ikeda (Graduate School of Economics, University of Tokyo); Takao Kobayashi (Faculty of Economics, University of Tokyo); Akihiko Takahashi (Faculty of Economics, University of Tokyo) |
| Abstract: | This paper proposes a structural model to price credit risk of firms with short-term and long-term debts. This enables one to distinguish between default probabilities in the short run and in the long run, and to identify how the composition of debts affects credit risk. We endogenize the banks' decision to bankrupt or save firms in insolvency, and analyze the influence of the governance structure on credit risk valuation. |
| Date: | 2005–05 |
| URL: | http://d.repec.org/n?u=RePEc:tky:jseres:2005cj131&r=rmg |
| By: | Eichberger, Jürgen (Sonderforschungsbereich 504); Summer, Martin (Oesterreichische Nationalbank) |
| Abstract: | We analyze the impact of capital adequacy regulation on bank insolvency and aggregate investment. We develop a model of the banking system that is characterized by the interaction of many heterogeneous banks with the real sector, interbank credit relations as a consequence of bank liquidity management and an insolvency mechanism. This allows us to study the impact of capital adequacy regulation on systemic risk. In particular we can analyze the impact of regulation on contagious defaults arising from mutual credit relations. We show that the impact of capital adequacy on systemic stability is ambiguous and that systemic risk might actually increase as a consequence of imposing capital constraints on banks. Furthermore we analyze the indirect consequences of capital adequacy regulation that are transmitted to the real economy by their impact on equilibrium interbank rates and thus the opportunity costs of liquidity within the banking system. |
| Date: | 2004–11–24 |
| URL: | http://d.repec.org/n?u=RePEc:xrs:sfbmaa:04-45&r=rmg |