nep-rmg New Economics Papers
on Risk Management
Issue of 2005‒08‒13
seven papers chosen by
Stan Miles
York University

  1. Can Mergers in Europe Help Banks Hedge Against Macroeconomic Risk? By Pierre-Guillaume Méon; Laurent Weill
  2. Factors Driving Risk Premia By Mike Kennedy; Torsten Sløk
  3. Liquidity Risk in Securities Settlement By Devriese, Johan; Mitchell, Janet
  4. Risk Premia in Forward Foreign Exchange Markets: A Comparison of Signal Extraction and Regression Methods By Prasad V. Bidarkota
  5. Multivariate Partial Distribution: A New Method of Pricing Group Assets and Analyzing the Risk for Hedging By Feng Dai; Hui Liu; Ying Wang
  6. A simple derivation of Prelec’s probability weighting function By Ali al-Nowaihi; Sanjit Dhami
  7. Asymmetric Risk and International Portfolio Choice By Susan Thorp; George Milunovich

  1. By: Pierre-Guillaume Méon (DULBEA, Université libre de Bruxelles, Brussels); Laurent Weill (LARGE, Université Robert Schuman, Strasbourg)
    Abstract: This paper investigates the motive of geographic risk diversification in the lending activity for bank mergers in the EU on a sample of large banking groups. Geographic diversification should allow banks to reduce their risk. We observe that the loan portfolios of European banks are home-biased. We apply the portfolio approach to explore the risk-return efficiency of the locations of banks’ activities. We also study mergers between pairs of banks. We provide evidence of the sub-optimality of the loan portfolios of European banks in terms of geographic risk diversification, and of the existence of potential gains from inter-country pair mergers.
    Keywords: bank mergers, risk diversification, European integration
    JEL: F15 G11 G21 G34
    Date: 2005–02
  2. By: Mike Kennedy; Torsten Sløk
    Abstract: <P>This paper assesses the extent to which the fall in risk premia of a number of financial assets, which occurred throughout 2003, was due to improvements in factors specific to individual markets at that time or to general economic fundamentals coupled with OECD-wide abundant liquidity. Regarding the latter two factors, principal component analysis was used here to identify a common trend in risk premia in equity, corporate bond and emerging markets since early 1998. The analysis finds that both economic fundamentals and liquidity have played a statistically significant role in driving the common factor. It also finds that liquidity (measured as the GDP weighted average of M3 of the three major economies less its trend) performs better than similarly weighted short-term interest rates. By spring 2004, the common factor in different risk premia had fallen below what could be explained by economic fundamentals and liquidity ...</P> <P>Les déterminants des primes de risque <P>Ce document examine dans quelle mesure la chute des primes de risque de certains placements financiers au cours de 2003 peut être attribuée à l’amélioration de facteurs spécifiques à certains marchés durant cette période, ou aux fondamentaux associés à l’abondante liquidité dans les pays de l’OCDE. En ce qui concerne ces deux derniers facteurs, une analyse en composantes principales est appliquée afin d’identifier une tendance commune aux primes de risque dans les marchés boursiers, obligataires et les marches émergents depuis le début de 1998. Cette analyse montre qu’aussi bien les fondamentaux que la liquidité ont joué un rôle statistiquement significatif concernant le facteur commun. De plus, la liquidité (évaluée comme la moyenne du M3 dans les trois principales économies pondérée par le PIB, moins la tendance) s’avère comporter un meilleur pouvoir explicatif que les taux d’intérêts à court terme (pondérés de manière similaire). Au printemps 2004, le facteur commun aux ...</P>
    Keywords: Risk premia, factor analysis, principal components, fundamentals, liquidity, Primes de risqué, analyse factorielle, analyse en composantes principales, fondamentaux, liquidité
    JEL: C22 E44 G15
    Date: 2004–04–29
  3. By: Devriese, Johan; Mitchell, Janet
    Abstract: This paper studies the potential impact on securities settlement systems (SSSs) of a major market disruption, caused by the default of the largest player. A multi-period, multi-security model with intraday credit is used to simulate direct and second round settlement failures triggered by the default, as well as the dynamics of settlement failures, arising from a lag in settlement relative to the date of trades. The effects of the defaulter's net trade position, the numbers of securities and participants in the market, and participants' trading behaviour are also analysed. We show that in SSSs – contrary to payment systems – large and persistent settlement failures are possible even when ample liquidity is provided. Central bank liquidity support to SSSs thus cannot eliminate settlement failures due to major market disruptions. This is due to the fact that securities transactions involve a cash leg and a securities leg, and liquidity can affect only the cash side of a transaction. Whereas a broad program of securities borrowing and lending might help, it is precisely during periods of market disruption that participants will be least willing to lend securities. Interestingly, settlement failures continue to occur beyond the period corresponding to the lag in settlement. This is due to the fact that, upon observation of a default, market participants must form expectations about the impact of the default, and these expectations affect current trading behaviour. If, ex post, fewer of the previous trades settle than expected, new settlement failures will occur. This result has interesting implications for financial stability. On the one hand, conservative reactions by market participants to a default - for example by limiting the volume of trades – can result in a more rapid return of the settlement system to a normal level of efficiency. On the other hand, limitation of trading by market participants can reduce market liquidity, which may have a negative impact on financial stability.
    Keywords: contagion; liquidity risk; securities clearing and settlement; systemic risk
    JEL: C60 D80 G20
    Date: 2005–07
  4. By: Prasad V. Bidarkota (Department of Economics, Florida International University)
    Abstract: We investigate time varying risk premia in forward dollar/pound monthly exchange rates over the last two decades. We study this issue using a signal plus noise model and separately using regression techniques. Our models account for time varying volatility and non-normalities in the observed series. Our signal plus noise model fails to isolate a statistically significant risk premium component whereas our regression model does. We attribute the discrepancy in the results from the two methods to the low power of the signal plus noise model in discriminating between a time varying risk premium component and a serially uncorrelated spot exchange rate expectational error. An important reason for the low power of the signal plus noise model is its failure to use information on current period forward rates in extracting the risk premium.
    Keywords: spot foreign exchange rates; forward foreign exchange rates; timevarying risk premium; signal extraction; non-normality; volatility persistence
    JEL: F31 C5 G12
    Date: 2005–01
  5. By: Feng Dai (Zhengzhou Information Engineering University); Hui Liu (Zhengzhou Information Engineering University); Ying Wang (Zhengzhou Information Engineering University)
    Abstract: Based on the Partial Distribution (Feng Dai, 2001), a new model to price an asset (MPA) is given. Going a step further, this paper puts forward the Multivariate Partial Distribution (MPD) for the first time. By use of MPD, we could gain a new kind of model for pricing the group assets (MPGA), in which the competition and cooperation are considered. Based on MPGA, the integrated risk of group assets can be divided to hedging risk and independent risk, and the corresponding models are given. So we could analyze the price risk of group assets in more particular way. The conclusions show that assets are hedged in simple way of one to one can not eliminates completely their market risk in many cases. So there should be an optimal ratio between underlying asset and its derivative in hedging. The approach to determine the optimal ratio in hedging is offered in this paper. By the MPA and MPGA, we also could interpret five of interesting economic propositions in analytic way.
    Keywords: multivariate Partial Distribution; pricing assets; group assets; risk analysis; optimal hedging
    JEL: C1 C2 C3 C4 C5 C8
    Date: 2005–07–24
  6. By: Ali al-Nowaihi; Sanjit Dhami
    Abstract: Since Kahneman and Tversky (1979), it has been generally recognized that decision makers overweight low probabilities and underweight high probabilities. Of the several weighting functions that have been proposed, that of Prelec (1998) has the attractions that it is parsimonious, consistent with much of the available empirical evidence and has an axiomatic foundation. Luce (2001) provided a simpler derivation based on reduction invariance, rather than compound invariance of Prelec (1998). This note gives a simpler form of reduction invariance, which we call power invariance. A more direct derivation of Prelec’s function is given, achieving a further simplification.
    Keywords: Decision making under risk; Prelec’s probability weighting function; Compound invariance; Reduction invariance; Power invariance; Prospect theory; Algebraic functional equations
    JEL: C60 D81
    Date: 2005–07
  7. By: Susan Thorp (School of Finance and Economics, University of Technology, Sydney); George Milunovich (Division of Economic and Financial Studies, Macquarie University)
    Abstract: Empirical research shows that stock volatilities and correlations between markets rise more after negative shocks than after positive returns shocks of the same size. We measure the importance of these asymmetric e¤ects for mean-variance investors holding portfolios of international equities who use dynamic conditional covariance forecasts to reweight their portfolios. Portfolio weights are computed using ex ante predictions from symmetric GARCH DCC and asymmetric GJR ADCC models, and a spectrum of expected returns. Data are weekly returns to equity price indices for the USA, Japan, UK and Australia. We ?nd that the majority of realised portfolio standard deviations are less when we reweight using the asymmetric covariance model. Reductions in portfolio risk are signi?cant according to Diebold-Mariano tests. Investors who are moderately risk averse and have longer rebalancing horizons bene?t more from the asymmetric model than less risk averse, shorter-horizon investors, and would be prepared to pay up to 107 basis points annually to use it instead of the symmetric model. Bene?ts are greater for investors holding US equities.
    Date: 2005–07–01

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