nep-rmg New Economics Papers
on Risk Management
Issue of 2005‒05‒29
five papers chosen by
Stan Miles
York University

  1. Dynamic Hedging of Financial Instruments When the Underlying Follows a Non-Gaussian Process By Alvaro Cartea
  2. Is systematic downside beta risk really priced? Evidence in emerging market data By Don U.A. Galagedera; Robert D. Brooks
  3. Is Bank Portfolio Riskiness Procyclical? Evidence from Italy using a Vector Autoregression By Juri Marcucci; Mario Quagliariello
  4. Anomalous Price Behavior Following Earnings Surprises: Does Representativeness Cause Overreaction? By Michael Kaestner
  5. Illusionary Finance and Trading Behavior By Malika, HAMADI; Erick, RENGIFO; Diego SALZMAN

  1. By: Alvaro Cartea (School of Economics, Mathematics & Statistics, Birkbeck College)
    Abstract: Traditional dynamic hedging strategies are based on local information (ie Delta and Gamma) of the financial instruments to be hedged. We propose a new dynamic hedging strategy that employs non-local information and compare the profit and loss (P&L) resulting from hedging vanilla options when the classical approach of Delta- and Gammaneutrality is employed, to the results delivered by what we label Delta- and Fractional-Gamma-hedging. For specific cases, such as the FMLS of Carr and Wu (2003a) and Merton’s Jump-Diffusion model, the volatility of the P&L is considerably lower (in some cases only 25%) than that resulting from Delta- and Gamma-neutrality.
    Date: 2005–05
  2. By: Don U.A. Galagedera; Robert D. Brooks
    Abstract: Several studies advocating safety first as a major concern to investors propose downside beta risk as an alternative to the traditional systematic risk-beta. Downside measures are concerned with a subset of the data and therefore the results in the studies that consider the downside beta only may be biased. This study addresses this issue by including downside co-skewness risk in addition to the downside beta risk in the pricing model. In a sample of 27 emerging markets two-stage rolling regression analysis fails to support pricing models with downside risk measures. In a cross-sectional analysis inclusion of downside co-skewness improves model fit. When considered together, downside beta is potential and downside co-skewness is a risk to the rational investor. Even though our results are inconclusive the evidence strongly suggests a need for further investigation of co-skewness risk in pricing models that adopt a downside risk framework.
    Keywords: Beta, Downside risk, Emerging markets
    JEL: G12 G15
    Date: 2005–05
  3. By: Juri Marcucci; Mario Quagliariello
    Abstract: This study analyzes the cyclical behaviour of the default rates of Italian bank borrowers over the last two decades. A vector autoregression (VAR) modelling technique is employed to assess the extent to which macroeconomic shocks affect the banking sector (first round effect). The VAR also helps to disentangle the feedback effects from the financial system to the real side of the economy. We find evidence of the first round effect and some support for the feedback effect which operates via the bank capital channel.
    Keywords: First-round effect; procyclicality; feedback effects; VAR; banks; default rate
    JEL: C32 E30 E32 E44 G28
  4. By: Michael Kaestner (GESEM, Center for Research in Finance, Montpellier University, France)
    Abstract: Behavioral Finance aims to provide a theoretical background to uncovered empirical anomalies by introducing investor psychology as a determinant of asset prices. Our work provides evidence in favor of representativeness as a potential explanation of anomalous price behavior following earnings announcements. We rely on one assumption made by Barberis, Shleifer, and Vishny (1998), which is that the overreaction phenomenon, uncovered by De Bondt and Thaler (1985), is due to a representativeness bias. We examine current and past earnings surprises and subsequent market reaction for listed US companies over the period 1983-1999. Our empirical results suggest that investors overreact to past earnings surprises. As, on average, extreme past surprises are not confirmed by actual earnings figures, they are generally followed by stock market reactions of the opposite sign. Moreover, the longer the similar earnings surprise series, the higher the subsequent reversal.
    Keywords: Behavioral finance, overreaction, representativeness bias, earnings announcements
    JEL: G14 D84
    Date: 2005–05–22
  5. By: Malika, HAMADI; Erick, RENGIFO; Diego SALZMAN
    Abstract: One important aspect of financial market is that there might be some traders that intentionally mislead other market participants by creating illusions in order to obtain a profit. We call this new concept illusionary finance. We present an analysis of how illusions can be created and disseminated in financial markets based on certain psychological principles that explain agents’ decisions under time pressure and polysemous signals. We develop a simple model that incorporates the illusions in the price formation process. Furthermore, using powerful simulations, we show how illusions can be incorporated, directly or indirectly, in the expected prices of the traders.
    Keywords: Illusionary Finance; Behavioral Finance; Evolutionary Finance; Neuroeconomics
    JEL: C32 C35 G10
    Date: 2004–09–15

This nep-rmg issue is ©2005 by Stan Miles. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.