nep-rmg New Economics Papers
on Risk Management
Issue of 2005‒09‒29
eight papers chosen by
Stan Miles
York University

  1. Risk Management with Benchmarking By Basak, Suleyman; Shapiro, Alex; Teplá, Lucie
  2. Stock Returns and Expected Business Conditions: Half a Century of Direct Evidence By Sean D. Campbell; Francis X. Diebold
  3. A Comparison of Single Factor Markov-Functional and Multi Factor Market Models By Pietersz, R.; Pelsser, A.A.J.
  4. Generic Market Models By Pietersz, R.; Regenmortel, M. van
  5. Testing for mean-coherent regular risk spanning By Melenberg,Bertrand; Polbennikov,Simon
  6. Mean-coherent risk and mean-variance approaches in portfolio selection : an empirical comparison By Polbennikov,Simon; Melenberg,Bertrand
  7. Are the dynamic linkages between the macroeconomy and asset prices time-varying? By Massimo Guidolin; Sadayuki Ono
  8. Estimating Bank Trading Risk: A Factor Model Approach By James O'Brien; Jeremy Berkowitz

  1. By: Basak, Suleyman; Shapiro, Alex; Teplá, Lucie
    Abstract: Portfolio theory must address the fact that, in reality, portfolio managers are evaluated relative to a benchmark, and therefore adopt risk management practices to account for the benchmark performance. We capture this risk management consideration by allowing a prespecified shortfall from a target benchmark-linked return, consistent with growing interest in such practice. In a dynamic setting, we demonstrate how a risk averse portfolio manager optimally under- or overperforms a target benchmark under different economic conditions, depending on his attitude towards risk and choice of the benchmark. The analysis therefore illustrates how investors can achieve their desired performance profile for funds under management through an appropriate combined choice of the benchmark and money manager. We consider a variety of extensions, and also highlight the ability of our setting to shed some light on documented return patterns across segments of the money management industry.
    Keywords: benchmarking; investments; shortfall risk; tracking error; value-at-risk
    JEL: D81 G11 G23
    Date: 2005–08
  2. By: Sean D. Campbell (Risk Analysis Section, Division of Research and Statistics, Federal Reserve Board); Francis X. Diebold (Department of Economics, University of Pennsylvania)
    Abstract: We explore the macro/finance interface in the context of equity markets. In particular, using half a century of Livingston expected business conditions data we characterize directly the impact of expected business conditions on expected excess stock returns. Expected business conditions consistently affect expected excess returns in a statistically and economically significant counter-cyclical fashion: depressed expected business conditions are associated with high expected excess returns. Moreover, inclusion of expected business conditions in otherwise standard predictive return regressions substantially reduces the explanatory power of the conventional financial predictors, including the dividend yield, default premium, and term premium, while simultaneously increasing. Expected business conditions retain predictive power even after controlling for an important and recently introduced non-financial predictor, the generalized consumption/wealth ratio, which accords with the view that expected business conditions play a role in asset pricing different from and complementary to that of the consumption/wealth ratio. We argue that time-varying expected business conditions likely capture time-varying risk, while time-varying consumption/wealth may capture time-varying risk aversion.
    Keywords: Business cycle, expected equity returns, prediction, Livingston survey, risk aversion, equity premium, risk premium
    JEL: G12
    Date: 2005–05–01
  3. By: Pietersz, R.; Pelsser, A.A.J. (Erasmus Research Institute of Management (ERIM), RSM Erasmus University)
    Abstract: We compare single factor Markov-functional and multi factor market models for hedging performance of Bermudan swaptions. We show that hedging performance of both models is comparable, thereby supporting the claim that Bermudan swaptions can be adequately riskmanaged with single factor models. Moreover, we show that the impact of smile can be much larger than the impact of correlation. We propose a new method for calculating risk sensitivities of callable products in market models, which is a modification of the least-squares Monte Carlo method. The hedge results show that this new method enables proper functioning of market models as risk-management tools.
    Keywords: Markov-functional model;market model;Bermudan swaption;terminal correlation;hedging;Greeks for callable products;smile;
    Date: 2005–04–03
  4. By: Pietersz, R.; Regenmortel, M. van (Erasmus Research Institute of Management (ERIM), RSM Erasmus University)
    Abstract: Currently, there are two market models for valuation and risk management of interest rate derivatives, the LIBOR and swap market models. In this paper, we introduce arbitrage-free constant maturity swap (CMS) market models and generic market models featuring forward rates that span periods other than the classical LIBOR and swap periods. We develop generic expressions for the drift terms occurring in the stochastic differential equation driving the forward rates under a single pricing measure. The generic market model is particularly apt for pricing of Bermudan CMS swaptions, fixed-maturity Bermudan swaptions, and callable hybrid coupon swaps.
    Keywords: market model;generic market models;generic drift terms;hybrid products;BGM model;
    Date: 2005–03–08
  5. By: Melenberg,Bertrand; Polbennikov,Simon (Tilburg University, Center for Economic Research)
    Abstract: Coherent risk measures have received considerable attention in the recent literature. Coherent regular risk measures form an important subclass: they are empirically identifiable, and, when combined with mean return, they are consistent with second order stochastic dominance. As a consequence, these risk measures are natural candidates in a mean-risk trade-off portfolio choice. In this paper we develop a mean-coherent regular risk spanning test and related performance measure. The test and the performance measure can be implemented by means of a simple semi-parametric instrumental variable regression, where instruments have a direct link with the stochastic discount factor. We illustrate applications of the spanning test and the performance measure for several coherent regular risk measures, including the well known expected shortfall.
    Keywords: portfolio choice;coherent risk;spanning test
    JEL: G11 D81
    Date: 2005
  6. By: Polbennikov,Simon; Melenberg,Bertrand (Tilburg University, Center for Economic Research)
    Abstract: We empirically analyze the implementation of coherent risk measures in portfolio selection. First, we compare optimal portfolios obtained through mean-coherent risk optimization with corresponding mean-variance portfolios. We find that, even for a typical portfolio of equities, the outcomes can be statistically and economically different. Furthermore, we apply spanning tests for the mean-coherent risk efficient frontiers, which we compare to their equivalents in the meanvariance framework. For portfolios of common stocks the outcomes of the spanning tests seem to be statistically the same.
    Keywords: portfolio choice;mean variance;mean coherent risk;comparison
    JEL: G11
    Date: 2005
  7. By: Massimo Guidolin; Sadayuki Ono
    Abstract: We estimate a number of multivariate regime switching VAR models on a long monthly data set for eight variables that include excess stock and bond returns, the real T-bill yield, predictors used in the finance literature (default spread and the dividend yield), and three macroeconomic variables (inflation, real industrial production growth, and a measure of real money growth). Heteroskedasticity may be accounted for by making the covariance matrix a function of the regime. We find evidence of four regimes and of time-varying covariances. We provide evidence that the best in-sample fit is provided by a four state model in which the VAR(1) component fails to be regime-dependent. We interpret this as evidence that the dynamic linkages between financial markets and the macroeconomy have been stable over time. We show that the four-state model can be helpful in forecasting applications and to provide one-step ahead predicted Sharpe ratios.
    Keywords: Macroeconomics ; Assets (Accounting) - Prices
    Date: 2005
  8. By: James O'Brien; Jeremy Berkowitz
    Abstract: Risk in bank trading portfolios and its management are potentially important to the banks’ soundness and to the functioning of securities and derivatives markets. In this paper, proprietary daily trading revenues of 6 large dealer banks are used to study the bank dealers’ market risks using a market factor model approach. Dealers’ exposures to exchange rate, interest rate, equity, and credit market factors are estimated. A factor model framework for variable exposures is presented and two modeling approaches are used: a random coefficient model and rolling factor regressions. The results indicate small average market exposures with significant but relatively moderate variation in exposures over time. Except for interest rates, there is heterogeneity in market exposures across the dealers. For interest rates, the dealers have small average long exposures and exposures vary inversely with the level of rates. Implications for aggregate bank dealer risk and market stability issues are discussed.
    JEL: G21
    Date: 2005–09

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