New Economics Papers
on Risk Management
Issue of 2005‒06‒14
seventeen papers chosen by

  1. The Term Structure of the Risk-Return Tradeoff By Campbell, John Y; Viceira, Luis M
  2. How do Venture Capitalists Handle Risk in High-Technology Ventures? - some preliminary results By Gavin C. Reid; Julia A. Smith
  3. Investor and Investee Conduct in the Risk Appraisal of High Technology New Ventures in the UK By Gavin C. Reid; Julia A. Smith
  4. A Fast Algorithm for Computing Expected Loan Portfolio Tranche Loss in the Gaussian Factor Model. By Pavel Okunev
  5. The Role of Industry, Geography and Firm Heterogeneity in Credit Risk Diversification By M. Hashem Pesaran; Til Schuermann; Björn-Jakob Treutler
  6. Quantiles and medians By Chambers, Christopher P.
  7. Dispersion of Opinion and Stock Returns By Goetzmann, William; Massa, Massimo
  8. Monetary Policy Uncertainty and the Stock Market By Locarno, Alberto; Massa, Massimo
  9. Liquidity Risk, Leverage and Long-Run IPO Returns By Eckbo, B Espen; Norli, Øyvind
  10. Is Cash Negative Debt? A Hedging Perspective on Corporate Financial Policies By Acharya, Viral V; Almeida, Heitor; Campello, Murillo
  11. Why is Long-Horizon Equity Less Risky? A Duration-based Explanation of the Value Premium By Lettau, Martin; Wachter, Jessica
  12. Loss Functions in Option Valuation: A Framework for Model Selection By Bams, Dennis; Lehnert, Thorsten; Wolff, Christian C
  13. Offsetting the Incentives: Rise Shifting and Benefits of Benchmarking in Money Management By Basak, Suleyman; Pavlova, Anna; Shapiro, Alex
  14. A review of backtesting and backtesting procedures By Sean D. Campbell
  15. Pessimistic portfolio allocation and Choquet expected utility By Gilbert W. Bassett Jr; Roger Koenker; Gregory Kordas
  16. Risk Management and Corporate Governance: the Importance of Independence and Financial Knowledge for the Board and the Audit Committee By Georges Dionne; Thouraya Triki
  17. Investor Conduct Towards New High Technology Firms: UK Evidence on How Risk is Managed By Gavin C. Reid

  1. By: Campbell, John Y; Viceira, Luis M
    Abstract: Recent research in empirical finance has documented that expected excess returns on bonds and stocks, real interest rates, and risk shift over time in predictable ways. Furthermore, these shifts tend to persist over long periods of time. In this paper we propose an empirical model that is able to capture these complex dynamics, yet is simple to apply in practice, and we explore its implications for asset allocation. Changes in investment opportunities can alter the risk-return tradeoff of bonds, stocks, and cash across investment horizons, thus creating a ‘term structure of the risk-return tradeoff’. We show how to extract this term structure from our parsimonious model of return dynamics, and illustrate our approach using data from the US stock and bond markets. We find that asset return predictability has important effects on the variance and correlation structure of returns on stocks, bonds and T-bills across investment horizons.
    Keywords: long-horizon investing; mean-variance analysis; risk-return tradeoff; vector autoregression
    JEL: G12
    Date: 2005–02
  2. By: Gavin C. Reid; Julia A. Smith
    Abstract: This paper presents new empirical evidence, obtained by fieldwork methods, on investor risk-handling practice in the UK venture capital industry. Its focus is on high-technology firms and the techniques their venture capital backers use for risk management. The active areas of risk management are explored under the headings of risk premia, investment time horizons, and sensitivity analysis. As an organising framework, risk is divided into ‘agency risk’, ‘business risk’ and ‘innovation risk’. Data were gathered by working through a semi-structured interview agenda in face-to-face meetings with the top venture capital deal-makers in the UK. They were questioned specifically on how they handled risks in high-technology ventures. The interview agenda covered: risk premia, investment time horizon, sensitivity analysis, expected values, cash flow prediction, financial objectives, decision making, and qualitative appraisal. The paper draws on evidence from all eight agenda items, but focuses on the first three. This paper finds that the three categories of risk identified as important, innovation, agency and business risk, have pervasive influences on investor conduct in the UK. Their form of influence was traced under the agenda headings of risk premia, investment time horizon, and sensitivity analysis. It was found that the riskiness of investment types (e.g. seed, MBO etc) could be clearly ranked by investors. These rankings were found to be generally consistent with principles of financial economics. Investors were also asked what factors were most important to their risk appraisals, for given high technology investments. Of a wide range of factors, it was found that the most important to risk appraisal could be directly related to our categories of ‘agency risk’ and ‘business risk’. It was found too that the time profiles of investments and their sensitivity to changed assumptions could be approached using our three risk categories. Of these, ‘innovation risk’ was thought to be particularly high, implying various forms of adaptation by investors, including setting very high hurdle rates of return and deploying radical stress tests of investment models.
    Keywords: Venture Capital, Risk Management, High-Technology, Fieldwork
    JEL: G24 D81 L84 M21 L21
  3. By: Gavin C. Reid; Julia A. Smith
    Abstract: This paper examines, in a high technology context, how investor and investee behave, and interact, in the face of risk. The evidence on which it is based was obtained by fieldwork methods, over the period 2000-2, examining a sample of UK investors and investees active in high technology areas. The paper focuses on four questions: how risky are investments; what affects risk most; what aspects of innovation affect risk; what non-financial factors affect risk most? It finds that there was general agreement between investors and investees about which investments were relatively more or less risky. However, investees were shown to be relatively more risk averse than investors, right across the spectrum of investee types. When it came to factors affecting risk most, there was a clear difference between investors and investees. Agency risk was largely the concern of the investor. Business risk was the investee’s first priority, and agency risk did not figure large in the investee’s mind. This suggests that this component of risk had successfully been shifted on to the investor. Business risk was also a clear concern of investors, but they placed more emphasis on matters like market opportunities and sales, than did investees. The paper concludes that investors and investees generally see risk in the same light, but, that when views differ, this is explicable either by function (producer/ funder) or by relative risk aversion.
    Keywords: Venture Capital, Risk Management, High-Technology, Fieldwork
    JEL: G24 D81 L84 M21 L21
  4. By: Pavel Okunev (LBNL & UC Berkeley)
    Abstract: We propose a fast algorithm for computing the expected tranche loss in the Gaussian factor model. We test it on a 125 name portfolio with a single factor Gaussian model and show that the algorithm gives accurate results. We choose a 125 name portfolio for our tests because this is the size of the standard DJCDX.NA.HY portfolio. The algorithm proposed here is intended as an alternative to the much slower Moody's FT method.
    Keywords: Moody's Fourier Transform method, portfolio loss distribution, DJCDX, CDS portfolio, CDS, expected tranche loss
    Date: 2005–06–07
  5. By: M. Hashem Pesaran; Til Schuermann; Björn-Jakob Treutler
    Abstract: In theory the potential for credit risk diversifcation for banks could be substantial. Portfolios are large enough that idiosyncratic risk is diversifed away leaving exposure to systematic risk. The potential for portfolio diversifcation 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 diversifcation: across industry sectors and across di¤erent 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
  6. By: Chambers, Christopher P.
    Abstract: We provide a list of functional equations that characterize quantile functions for collections of bounded and measurable functions. Our central axiom is ordinal covariance. When a probability measure is exogeneously given, we characterize quantiles with respect to that measure through monotonicity with respect to stochastic dominance. When none is given, we characterize those functions which are simply ordinally covariant and monotonic as quantiles with respect to capacities; and we also find an additional condition for finite probability spaces that allows us to represent the capacity as a probability measure. Additionally requiring that a function be covariant under its negation results in a generalized notion of median. Finally, we show that all of our theorems continue to hold under the weaker notion of covariance under increasing, concave transformations. Applications to the theory of ranking infinite utility streams and to the theory of risk measurement are provided.
    Keywords: Ordinal, quantile, median, axiom, risk measure, value at risk, intergenerational equity
    Date: 2005–04
  7. By: Goetzmann, William; Massa, Massimo
    Abstract: We use a panel of more than 100,000 investor accounts in US stocks over the period 1991-95 to construct an investor-based measure of dispersion of opinion, unlike the analyst based measure used in the literature. We use this measure to test two competing hypotheses: the sidelined investors hypothesis and the uncertainty/asymmetric information hypothesis. We find evidence that supports the sidelined-investors hypothesis. We show that the dispersion of opinion of the investors in a stock is positively related to the contemporaneous returns and trading volume of the stock and negatively related to its future returns. Moreover, dispersion of opinion aggregates across many stocks and generates factors that have a market-wide effect, affecting the stock equilibrium rate of return and providing additional explanatory power in a standard asset-pricing model. This supports the interpretation of dispersion of opinion as a risk factor. We also show that dispersion of opinion among retail investors Granger causes dispersion of opinion among analysts.
    Keywords: asset prices; dispersion of opinion; volatility
    JEL: D10 G10
    Date: 2004–12
  8. By: Locarno, Alberto; Massa, Massimo
    Abstract: We study the relationship between inflation and stock returns focusing on the signalling content of inflation. Investors use inflation to learn about the stance of the monetary policy. Depending on investors’ beliefs, a change in consumption prices has different effects on the risk premium. A change in consumption prices that confirms investors' beliefs reduces stock risk premia, while a change that contradicts them increases risk premia. This may generate a negative correlation between returns and inflation that explains the Fisher puzzle. We model this intuition and test its implication on US data. We construct a market-based proxy of monetary policy uncertainty, we show that it is priced and that, by conditioning on it, the Fisher puzzle disappears.
    Keywords: asset pricing; learning risk; monetary policy uncertainty; risk factors
    JEL: G11 G12 G14
    Date: 2005–01
  9. By: Eckbo, B Espen; Norli, Øyvind
    Abstract: We examine the risk-return characteristics of a rolling portfolio investment strategy where more than six thousand Nasdaq initial public offering (IPO) stocks are bought and held for up to five years. The average long-run portfolio return is low, but IPO stocks appear as ‘longshots’, as five-year buy-and-hold returns of 1000% or more are somewhat more frequent than for non-issuing Nasdaq firms matched on size and book-to-market ratio. The typical IPO firm is of average Nasdaq market capitalization but has relatively low book-to-market ratio. We also show that IPO firms exhibit relatively high stock turnover and low leverage, which may lower systematic risk exposures. To examine this possibility, we launch an easily constructed ‘low minus high’ (LMH) stock turnover portfolio as a liquidity risk factor. The LMH factor produces significant betas for broad-based stock portfolios, as well as for our IPO portfolio and a comparison portfolio of seasoned equity offerings. The factor-model estimation also includes standard characteristics-based risk factors, and we explore mimicking portfolios for leverage-related macroeconomic risks. Because they track macroeconomic aggregates, these mimicking portfolios are relatively immune to market sentiment effects. Overall, we cannot reject the hypothesis that the realized return on the IPO portfolio is commensurable with the portfolio’s risk exposures, as defined here.
    Keywords: asset pricing; capital structure; Initial Public Offering (IPO); liquidity; market efficiency; risk and return
    JEL: G10 G11 G12 G20 G24
    Date: 2005–01
  10. By: Acharya, Viral V; Almeida, Heitor; Campello, Murillo
    Abstract: We model the interplay between cash and debt policies in the presence of financial constraints. While saving cash allows constrained firms to hedge against future cash flow shortfalls, reducing current debt – ‘saving borrowing capacity’ – is a more effective way of securing investment in high cash flow states. This trade-off implies that constrained firms will allocate cash flows into cash holdings if their hedging needs are high (i.e., if the correlation between operating cash flows and investment opportunities is low). Those same firms, however, will use free cash flows to reduce current debt if their hedging needs are low. The empirical examination of debt and cash policies of a large sample of firms reveals evidence that is consistent with our theory. In particular, our evidence shows that financially constrained firms with high hedging needs have a strong propensity to save cash out of cash flows while leaving their debt positions unchanged. In contrast, constrained firms with low hedging needs direct most of their free cash flows towards debt reduction, as opposed to cash savings. Our analysis points to an important hedging motive behind standard financial policies such as cash and debt management. It suggests that cash should not be viewed as negative debt.
    Keywords: cash holdings; debt policies; financing constraints; hedging; risk management
    JEL: G31
    Date: 2005–02
  11. By: Lettau, Martin; Wachter, Jessica
    Abstract: This paper proposes a dynamic risk-based model that captures the high expected returns on value stocks relative to growth stocks, and the failure of the capital asset pricing model to explain these expected returns. To model the difference between value and growth stocks, we introduce a cross-section of long-lived firms distinguished by the timing of their cash flows. Firms with cash flows weighted more to the future have high price ratios, while firms with cash flows weighted more to the present have low price ratios. We model how investors perceive the risks of these cash flows by specifying a stochastic discount factor for the economy. The stochastic discount factor implies that shocks to aggregate dividends are priced, but that shocks to the time-varying price of risk are not. As long-horizon equity, growth stocks co-vary more with this time-varying price of risk than value stocks, which co-vary more with shocks to cash flows. When the model is calibrated to explain aggregate stock market behaviour, we find that it can also account for the observed value premium, the high Sharpe ratios on value stocks relative to growth stocks, and the out-performance of value (and underperformance of growth) relative to the CAPM.
    Keywords: duration; growth; habit formation; value
    JEL: G10 G12
    Date: 2005–02
  12. By: Bams, Dennis; Lehnert, Thorsten; Wolff, Christian C
    Abstract: In this paper, we investigate the importance of different loss functions when estimating and evaluating option pricing models. Our analysis shows that it is important to take into account parameter uncertainty, since this leads to uncertainty in the predicted option price. We illustrate the effect on the out-of-sample pricing errors in an application of the ad hoc Black-Scholes model to DAX index options. Our empirical results suggest that different loss functions lead to uncertainty about the pricing error itself. At the same time, it provides a first yardstick to evaluate the adequacy of the loss function. This is accomplished through a data-driven method to deliver not just a point estimate of the pricing error, but a confidence interval.
    Keywords: estimation risk; GARCH; implied volatility; loss functions; option pricing
    JEL: G12
    Date: 2005–03
  13. By: Basak, Suleyman; Pavlova, Anna; Shapiro, Alex
    Abstract: Money managers are rewarded for increasing the value of assets under management, and predominantly so in the mutual fund industry. This gives the manager an implicit incentive to exploit the well-documented positive fund-flows to relative-performance relationship by manipulating her risk exposure. In a dynamic portfolio choice framework, we show that as the year-end approaches, the ensuing convexities in the manager's objective induce her to closely mimic the index, relative to which her performance is evaluated, when the fund's year-to-date return is sufficiently high. As her relative performance falls behind, she chooses to deviate from the index by either increasing or decreasing the volatility of her portfolio. The maximum deviation is achieved at a critical level of underperformance. It may be optimal for the manager to reach such deviation via selling the risky asset despite its positive risk premium. Under multiple sources of risk, with both systematic and idiosyncratic risks present, we show that optimal managerial risk shifting may not necessarily involve taking on any idiosyncratic risk. Costs of misaligned incentives to investors resulting from the manager's policy are economically significant. We then demonstrate how a simple risk management practice that accounts for benchmarking can ameliorate the adverse effects of managerial incentives.
    Keywords: benchmarking; fund flows; implicit incentives; portfolio choice; risk management; risk taking
    JEL: D60 D81 G11 G20
    Date: 2005–04
  14. By: Sean D. Campbell
    Abstract: This paper reviews a variety of backtests that examine the adequacy of Value-at-Risk (VaR) measures. These backtesting procedures are reviewed from both a statistical and risk management perspective. The properties of unconditional coverage and independence are defined and their relation to backtesting procedures is discussed. Backtests are then classified by whether they examine the unconditional coverage property, independence property, or both properties of a VaR measure. Backtests that examine the accuracy of a VaR model at several quantiles, rather than a single quantile, are also outlined and discussed. The statistical power properties of these tests are examined in a simulation experiment. Finally, backtests that are specified in terms of a pre-specified loss function are reviewed and their use in VaR validation is discussed.
    Keywords: Risk management ; Bank investments
    Date: 2005
  15. By: Gilbert W. Bassett Jr; Roger Koenker (Institute for Fiscal Studies and University of Illinois); Gregory Kordas
    Abstract: Recent developments in the theory of choice under uncertainty and risk yield a pessimistic decision theory that replaces the classical expected utility criterion with a Choquet expectation that accentuates the likelihood of the least favorable outcomes. A parallel theory has recently emerged in the literature on risk assessment. It is shown that a general form of pessimistic portfolio optimization based on the Choquet approach may be formulated as a problem of linear quantile regression.
    Date: 2004–06
  16. By: Georges Dionne; Thouraya Triki
    Abstract: The new NYSE rules for corporate governance require the audit committee to discuss and review the firm's risk assessment and hedging strategies. They also put additional requirements for the composition and the financial knowledge of the directors sitting on the board and on the audit committee. In this paper, we investigate whether these new rules as well as those set by the Sarbanes Oxley act lead to hedging decisions that are of more benefit to shareholders. We construct a novel hand collected dataset that allows us to explore multiple definitions for the financially knowledgeable term present in this new regulation. We find that the requirements on the audit committee size and independence are beneficial to shareholders, although maintaining a majority of unrelated directors in the board and a director with an accounting background on the audit committee may not be necessary. Interestingly, financially educated directors seem to encourage corporate hedging while financially active directors and those with an accounting background play no active role in such policy. This evidence combined with the positive relation we report between hedging and the firm's performance suggests that shareholders are better off with financially educated directors on their boards and audit committees. Our empirical findings also show that having directors with a university education on the board is an important determinant of the hedging level. Indeed, our measure of risk management is found to be an increasing function of the percentage of directors holding a diploma superior to a bachelor degree. This result is the first direct evidence concerning the importance of university education for the board of directors.
    Keywords: Corporate governance, risk management, corporate hedging, financial knowledge, board independence, audit committee independence, board of directors, university education, empirical test, unrelated directors, NYSE rules, Sarbanes Oxley act, audit committee size, financially educated directors, financially active directors, firm performance
    JEL: G18 G30
    Date: 2005
  17. By: Gavin C. Reid
    Abstract: This paper uses statistical analysis to characterise ‘industry practice’, in terms of concordance of investors concerning appropriate practice. The evidence was gathered by field work methods in 2000-01, and refers to the practices of twenty UK venture capital investors, who accounted for the bulk of funds allocated to high technology investments in the UK. This paper has two parts: general and detailed statistical analysis. 1) In the first part, the main finding is of a coherent (and generally statistically significant picture) of investor conduct towards high-technology companies. Thus it is found that investors assign risk premia and expected values, and use risk classes. They adopt relatively short time horizons, but follow quite sophisticated procedures in investment appraisal. For example, they use sensitivity analysis, cash flow prediction, financial modelling, and decision trees. However, they miss out in some sophisticated areas of technical analysis, including Value at Risk (VaR), and simulation methods (including Monte Carlo methods). 2) The second part of the paper focuses on risk, factors influencing it, and innovation. Its aim is to discover if there is a kind of ‘industry standard’ or consensus about what is most important to investors in the high technology area. Largely, that turned out to be the case. The UK venture capitalists are agreed on what are high-risk and low-risk investments. They also agree on what are the key commercial factors affecting risk. However, when it comes to non-commercial factors, this consensus starts to crumble. Finally, so far as features of innovation are concerned, industry consensus starts to break down entirely. Thus, there do remain important areas in which investor practice is opaque. Therefore, there remains a need for further research into investor practice in the UK.
    Keywords: Venture Capital, Risk Management, High-Technology, Fieldwork
    JEL: G24 D81 L84 M21 L21

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