nep-rmg New Economics Papers
on Risk Management
Issue of 2005‒06‒05
ten papers chosen by
Stan Miles
York University

  1. A Test of the Strategic Effect of Basel II Operational Risk Requirements on Banks By Carolyn Currie
  2. Extending the Merton Model: A Hybrid Approach to Assessing Credit Quality By Alexxandros Benos; George Papanastasopoulos
  3. Growth or Glamour? Fundamentals and Systematic Risk in Stock Returns By John Y. Campbell; Christopher Polk; Tuomo Vuolteenaho
  4. Rare Events and the Equity Premium By Robert J. Barro
  5. Calibrating risk-neutral default correlation. By Elisa Luciano
  6. The Role of Industry, Geography and Firm Heterogeneity in Credit Risk Diversification By M. Hashem Pesaran; Til Schuermann; Björn-Jakob Treutler
  7. Mixed Tactical Asset Allocation By Alejandro Corvalán
  8. The Rise in Firm-Level Volatility: Causes and Consequences By Diego Comin; Thomas Philippon
  9. Risk management for the poor and vulnerable By Ari A. Perdana
  10. Dependent Background Risks and Asset Prices By Yusuke Osaki

  1. By: Carolyn Currie (School of Finance and Economics, University of Technology, Sydney)
    Abstract: Most problematic of the Basel II capital adequacy requirements is the subset of Pillar I, requiring provision for operational risk (OR) as distinct from credit and market risk. Previous tests of the strategic effect of this new regulation from three prior Quality Impact Studies (QIS) conducted in G10 countries under the guidance of the Bank for International Settlements, have concluded that OR requirements poses difficulties of definition, implementation, and strategic planning. Anticipated strategic effects include dramatic changes to product development, investment and asset mix, as well as the necessity to rapidly develop new risk rating models and techniques, together with vastly expanded internal and external audit compliance routines. Unlike QIS1, 2 and 3, QIS4 focuses on operational risk, but still has drawbacks. This paper discusses its approach, in view of the ongoing difficulties that banks are experiencing with operational risk, particularly in the construction of a database. It concludes by listing the unanswered questions that have not even been addressed in four studies of the strategic impact of Basel II?s OR requirements. It also suggests that many smaller banks and emerging nations may not be able to use the sophisticated approaches and hence will suffer a competitive disadvantage. Hence in view of drawbacks in the simpler approaches such as lack of correlation of operational risk and revenue, other indicators such as the standard deviation of efficiency measures are suggested.
    Keywords: operational risk; Basel II
    JEL: E42 E44 E58
    Date: 2005–05–01
  2. By: Alexxandros Benos (University of Piraeus); George Papanastasopoulos (University of Peloponnese)
    Abstract: In this paper we have combined fundamental analysis and contingent claim analysis into a hybrid model of credit risk measurement. We have extended the standard Merton approach to estimate a new risk-neutral distance to default metric, assuming a more complex capital structure, adjusting for dividend payments, introducing randomness to the default point and allowing a fractional recovery when default occurs. Then, using financial ratios, other accounting based measures and the risk- neutral distance metric from our structural model as explanatory variables we calibrate the hybrid model with an ordered – probit regression method. Using the same econometric method, we calibrate a model using financial ratios and accounting variables as explanatory variables and a model using our risk-neutral distance to default metric as unique explanatory variable. Then, using cumulative accuracy plots we have test the classification power of those models to predict defaults out of sample. We have found that by enriching the risk-neutral distance to default metric with financial ratios and accounting variables into the hybrid model, we can improve both in of-sample fit of credit ratings and out-of-sample predictability of defaults. Our main conclusion is that financial ratios and accounting variables contain significant and incremental information, thus the risk-neutral distance to default metric does not reflect all available information regarding the credit quality of a firm.
    Keywords: credit risk, distance to default, financial ratios, accounting variables
    JEL: G
    Date: 2005–05–27
  3. By: John Y. Campbell; Christopher Polk; Tuomo Vuolteenaho
    Abstract: The cash flows of growth stocks are particularly sensitive to temporary movements in aggregate stock prices (driven by movements in the equity risk premium), while the cash flows of value stocks are particularly sensitive to permanent movements in aggregate stock prices (driven by market-wide shocks to cash flows.) Thus the high betas of growth stocks with the market's discount-rate shocks, and of value stocks with the market's cash-flow shocks, are determined by the cash-flow fundamentals of growth and value companies. Growth stocks are not merely "glamour stocks" whose systematic risks are purely driven by investor sentiment. More generally, accounting measures of firm-level risk have predictive power for firms' betas with market-wide cash flows, and this predictive power arises from the behavior of firms' cash flows. The systematic risks of stocks with similar accounting characteristics are primarily driven by the systematic risks of their fundamentals.
    JEL: G12 G14 N22
    Date: 2005–06
  4. By: Robert J. Barro
    Abstract: The allowance for low-probability disasters, suggested by Rietz (1988), explains a lot of puzzles related to asset returns and consumption. These puzzles include the high equity premium, the low risk-free rate, the volatility of stock returns, and the low values of typical macro-econometric estimates of the intertemporal elasticity of substitution for consumption. Another mystery that may be resolved is why expected real interest rates were low in the United States during major wars, such as World War II. This resolution works even though price-earnings ratios tended also to be low during the wars. This approach achieves these explanations while maintaining the tractable framework of a representative agent, time-additive and iso-elastic preferences, complete markets, and i.i.d. shocks to productivity growth. Perhaps just as puzzling as the high equity premium is why Rietz's framework has not been taken more seriously by researchers in macroeconomics and finance.
    Date: 2005–05
  5. By: Elisa Luciano
    Abstract: The implementation of credit risk models has largely relied on the use of historical default dependence, as proxied by the correlation of equity returns. However, as is well known, credit derivative pricing requires risk-neutral dependence. Using the copula methodology, we infer risk neutral dependence from CDS data. We also provide a market application and explore its impact on the fees of some credit derivatives.
    JEL: G12
    Date: 2005–05
  6. By: M. Hashem Pesaran; Til Schuermann; Björn-Jakob Treutler
    Abstract: In theory the potential for credit risk diversification for banks could be substantial. Portfolio diversification is driven broadly by two characteristics: the degree to which systematic risk factors are correlated with each other and the degree of dependence individual firms have to the different types of risk factors. We propose a model for exploring these dimensions of credit risk diversification: across industry sectors and across different countries or regions. We find that full firm-level parameter heterogeneity matters a great deal for capturing differences in simulated credit loss distributions. Imposing homogeneity results in overly skewed and fat-tailed loss distributions. These differences become more pronounced in the presence of systematic risk factor shocks: increased parameter heterogeneity greatly reduces shock sensitivity. Allowing for regional parameter heterogeneity seems to better approximate the loss distributions generated by the fully heterogeneous model than allowing just for industry heterogeneity. The regional model also exhibits less shock sensitivity.
    Keywords: Risk management, default dependence, economic interlinkages, portfolio choice
    JEL: C32 E17 G20
    Date: 2005–05
  7. By: Alejandro Corvalán
    Abstract: In a typical tactical asset allocation set up a manager receives compensation for his excess of return given a tracking error target. Critics of this framework cite its lack of control over the total portfolio risk. Current approaches recommend what we call a mixed allocation, derived from concerns about relative and absolute return and risk. This work provides an analytical framework for mixed tactical asset allocation, based on the premise that after the investor sets a tracking error target, a fundamental trade off remains unsolved: the one between excess of return and total risk. The article derives a separation theorem for tactical allocation, wherein the portfolio is a linear combination of an alpha portfolio providing excess returns and a beta portfolio providing overall risk hedge. The author shows how the formal expression summarizes all previous works. Moreover, it also includes the simplest Black-Litterman allocation.
    Date: 2005–05
  8. By: Diego Comin; Thomas Philippon
    Abstract: We document that the recent decline in aggregate volatility has been accompanied by a large increase in firm level risk. The negative relationship between firm and aggregate risk seems to be present across industries in the US, and across OECD countries. Firm volatility increases after deregulation. Firm volatility is linked to research and development spending as well as access to external financing. Further, R&D intensity is also associated with lower correlation of sectoral growth with the rest of the economy.
    JEL: E3 O3 D4
    Date: 2005–05
  9. By: Ari A. Perdana (Centre for Strategic and International Studies, Jakarta, Indonesia)
    Abstract: This paper reviews some literatures on the mechanisms available for the poor in managing risk. Lacking access to formal mechanisms of risk management, the poor rely on informal mechanisms, which are built based on the existing social networks and trust. But when the shocks are big or affecting the entire community, these informal mechanisms may not be adequate. Some policy interventions are then required to help improving the ability of poor people in managing risk. Policy intervention should aim to provide access for the poor on saving, credit and insurance. Microfinance schemes have been applauded as a successful `best practice' in providing access to saving and credit. However, microfinance institutions still have some room for improvement by expanding their role in providing insurance schemes.
    Keywords: poverty, vulnerability, risk management, microfinance.
    JEL: I3
    Date: 2005–05
  10. By: Yusuke Osaki (Graduate School of Economics, Osaka University)
    Abstract: Dependent background risks which have functional forms are introduced into Lucas economies. This paper determines the conditions on preferences to guarantee the monotonicity of asset prices, when dependent background risks satisfy the monotonicity and the single crossing conditions.
    Keywords: Asset Price, Dependent Background Risk, Monotonicity, Single Crossing Condition.
    JEL: D51 D81 G12
    Date: 2005–05

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.