nep-rmg New Economics Papers
on Risk Management
Issue of 2005‒12‒01
eleven papers chosen by
Stan Miles
York University

  1. Methodology of measuring performance in alternative investment. By Alexis Bonnet; Isabelle Nagot
  2. Sharpe Ratio Maximization and Expected Utility when Asset Prices have Jumps By Morten Christensen; Eckhard Platen
  3. Using Credit Derivatives to Compute Market-Wide Default Probability Term Structures By Byström, Hans
  4. Risk-adjusted performance measures at bank holding companies with section 20 subsidiaries By Victoria Geyfman
  5. Analysing banking sector conditions - how to use macro-prudential indicators By Leena Mörttinen; Paolo Poloni; Patrick Sandars; Jukka Vesala
  6. Currency Hedging for a Dutch Investor: The Case of Pension Funds and Insurers By Luis Berggrun
  7. A portfolio view of consumer credit By David K. Musto; Nicholas Souleles
  8. Predicting Bankruptcy with Support Vector Machines By Wolfgang Härdle; Rouslan A. Moro; Dorothea Schäfer
  9. Hedge funds and their implications for financial stability By Tomas Garbaravicius; Frank Dierick
  10. Business failure prediction: simple-intuitive models versus statistical models By H. OOGHE; C. SPAENJERS; P. VANDERMOERE
  11. Structural versus Temporary Drivers of Country and Industry Risk By Lieven Baele; Koen Inghelbrecht

  1. By: Alexis Bonnet (Methodology Group, London et CERMSEM); Isabelle Nagot (Methodology Group, London et CERMSEM)
    Abstract: The development of alternative investment has highlighted the limitations of standard performance measures like the Sharpe ratio, primarily because alternative strategies yield returns distributions which can be far from gaussian. In this paper, we propose a new framework in which trades, portfolios or strategies of various types can be analysed regardless of assumptions on payoff. The proposed class of measures is derived from natural and simple properties of the asset allocation. We establish representation results which allow us to describe our set of measures and involve the log-Laplace transform of the asset distribution. These measures include as particular cases the squared Sharpe ratio, Stutzer's rank ordering index and Hodges' Generalised Sharpe Ratio. Any measure is shown to be proportional to the squared Sharpe ratio for gaussian distributions. For non gaussian distributions, asymmetry and fat tails are taken into account. More precisely, the risk preferences are separated into gaussian and non-gaussian risk aversions.
    Keywords: Alternative investment, performance measure, additive independence condition, generalised Sharpe ratio, portfolio optimization.
    JEL: G11 C65
    Date: 2005–10
  2. By: Morten Christensen (University of Southern Denmark); Eckhard Platen (School of Finance and Economics, University of Technology, Sydney)
    Abstract: We analyze portfolio strategies which are locally optimal, meaning that they maximize the Sharpe ratio in a general continuous time jump-di®usion framework. These portfolios are characterized explicitly and compared to utility based strategies. In the presence of jumps, maximizing the Sharpe ratio is shown to be generally inconsistent with maximizing expected utility, but this is shown to depend strongly on market completeness and whether event risk is priced.
    Date: 2005–11–01
  3. By: Byström, Hans (Department of Economics, Lund University)
    Abstract: In this paper we suggest a simple way of backing out market-wide risk-neutral default probability (and default density) distributions from quoted credit default swap (CDS) index spreads. We apply the approach to two market-wide European portfolios represented by two frequently traded iTraxx Europe CDS indexes, and the resulting analytical default probability term structures are updated on a daily basis. We believe such instantaneous default probability term structures to be useful not only for risk managers in commercial banks but also for hedge funds and others involved in speculation and arbitrage as well as for supervisory authorities like central banks in their quest for financial stability.
    Keywords: iTraxx; credit default swap index; default probability; term structure
    JEL: C20 G33
    Date: 2005–10–25
  4. By: Victoria Geyfman
    Abstract: This paper examines risk-adjusted performance measures in banking, which are used as a guide for efficient asset allocation, performance evaluation, and capital structure decisions in complex, multidivisional financial institutions. Traditional measures of performance are contrasted with the portfolio-based risk-adjusted measures using a unique detailed micro data set for a sample of domestic bank holding companies (BHCs) that engaged in both commercial banking and investment banking activities between 1990 and 1999. This paper finds evidence that traditional stand-alone performance measures can lead to results substantially different from those of the portfolio models. This study also examines BHCs’ optimal portfolios consisting of traditional and nontraditional banking activities derived from the efficient frontiers. These results show that there are gains from diversification as indicated by the composition of optimal portfolios.
    Keywords: Bank holding companies ; Risk management
    Date: 2005
  5. By: Leena Mörttinen; Paolo Poloni (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Patrick Sandars (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Jukka Vesala
    Abstract: This paper presents the methodological and statistical framework for macro-prudential analysis of the financial condition of the EU banking sector that has been adopted by the European System of Central Banks (ESCB). The framework is also a central component of broader financial stability assessments carried out by the ECB in co-operation with national authorities. The framework has three main building blocks, which draw on a large number of macro-prudential indicators. The first block is designed for assessing the financial condition of the banking sector. The second building block provides a framework for analysing potential sources of risk and vulnerability to which banks are exposed and an assessment of the importance of related exposures. The final part of the analysis deals with the resilience of banks vis-à-vis these different sources of risk and vulnerability. Analysing the impact of the identified risks on banks’ financial condition is the ultimate objective of the ESCB banking sector stability analysis.
    Keywords: Financial stability, Banking sector, Macro-prudential analysis and indicators, Financial sector statistics.
    JEL: C82 E44 E58 G21
    Date: 2005–04
  6. By: Luis Berggrun
    Abstract: This paper analyzes the risk reduction effectiveness of currency hedging international portfolios from the perspective of an average Dutch pension fund and insurer during the period 1999-2004. Several portfolios and approaches to hedging are analyzed. Passive hedging seems to be efficient in reducing the volatility of a foreign bond portfolio whereas the risk reduction achieved for a foreign equity portfolio is not significant. The case of mixed (bonds and equities) portfolios and hedging is also analyzed. No significant risk reduction (at the same level of returns as that of an unhedged portfolio) was attained using a static hedging approach and portfolio optimization under short sale constraints. Using a selective (dynamic) hedging approach based on the forward premium, showed similar results; the volatility of an unhedged and hedged portfolio was virtually the same. Nevertheless, this selective hedging strategy had a positive impact improving the hedged portfolio returns.
    JEL: F31
    Date: 2005–10
  7. By: David K. Musto; Nicholas Souleles
    Abstract: This paper takes a portfolio view of consumer credit. Default models (credit-risk scores) estimate the probability of default of individual loans. But to compute risk-adjusted returns, lenders also need to know the covariances of the returns on their loans with aggregate returns. Covariances are independently relevant for lenders who care directly about the volatility of their portfolios, e.g., because of Value-at-Risk considerations or the structure of the securitization market. Cross-sectional differences in these covariances also provide insight into the nature of the shocks hitting different types of consumers. ; The authors use a unique panel dataset of credit bureau records to measure the ‘covariance risk’ of individual consumers, i.e., the covariance of their default risk with aggregate consumer default rates, and more generally to analyze the cross-sectional distribution of credit, including the effects of credit scores. They obtain two key sets of results. First, there is significant systematic heterogeneity in covariance risk across consumers with different characteristics. Consumers with high covariance risk tend to also have low credit scores (high default probabilities). Second, the amount of credit obtained by consumers significantly increases with their credit scores, and significantly decreases with their covariance risk (especially revolving credit), though the effect of covariance risk is smaller in magnitude. It appears that some lenders take covariance risk into account, at least in part, in determining the amount of credit they provide.
    Keywords: Consumer credit ; Credit scoring systems
    Date: 2005
  8. By: Wolfgang Härdle; Rouslan A. Moro; Dorothea Schäfer
    Abstract: The purpose of this work is to introduce one of the most promising among recently developed statistical techniques – the support vector machine (SVM) – to corporate bankruptcy analysis. An SVM is implemented for analysing such predictors as financial ratios. A method of adapting it to default probability estimation is proposed. A survey of practically applied methods is given. This work shows that support vector machines are capable of extracting useful information from financial data, although extensive data sets are required in order to fully utilize their classification power.
    Keywords: support vector machine, classification method, statistical learning theory, electric load prediction, optical character recognition, predicting bankruptcy, risk classification
    JEL: C40 G10
    Date: 2005–03
  9. By: Tomas Garbaravicius (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Frank Dierick (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: The paper provides an overview of the hedge fund industry, mainly from a financial stability and European angle. It is primarily based on an extensive analysis of information from the TASS database. On the positive side of the financial stability assessment, hedge funds have a role as providers of diversification and liquidity, and they contribute to the integration and completeness of financial markets. Possible negative effects occur through their impact on financial markets (e.g. via crowded trades) and financial institutions (e.g. via prime brokerage). Several initiatives have been launched to address these concerns and most of them follow indirect regulation via banks. If any direct regulation were to be considered, it would probably have to be implemented in a coordinated manner at the international level. At the EU level there is currently no common regulatory regime, although some Member States have adopted national legislation.
    Keywords: Asset management, crowded trades, financial regulation, financial stability, hedgefunds, prime brokerage, risk management.
    JEL: G15 G18 G21 G23 G24
    Date: 2005–08
    Abstract: We give an overview of the shortcomings of the most frequently used statistical techniques in failure prediction modelling. The statistical procedures that underpin the selection of variables and the determination of coefficients often lead to ‘overfitting’. We also see that the ‘expected signs’ of variables are sometimes neglected and that an underlying theoretical framework mostly does not exist. Based on the current knowledge of failing firms, we construct a new type of failure prediction models, namely ‘simple-intuitive models’. In these models, eight variables are first logit-transformed and then equally weighted. These models are tested on two broad validation samples (1 year prior to failure and 3 years prior to failure) of Belgian companies. The performance results of the best simple-intuitive model are comparable to those of less transparent and more complex statistical models.
    Date: 2005–10
  11. By: Lieven Baele (Tilburg University, CentER, Netspar); Koen Inghelbrecht (Ghent University)
    Abstract: This paper analyzes the dynamics and determinants of the relative benefits of geographical and industry diversification over the last 30 years. First, we develop a new structural regime-switching volatility spillover model to decompose total risk into a systematic and a country (industry) specific component. Contrary to most other studies, we explicitly allow market betas and asset-specific risks to vary with both structural and temporary changes in the economic and financial environment. In a second step, we investigate the relative benefits of geographical and industry diversification by comparing average asset- specific volatilities and model-implied correlations across countries and industries. We find a large positive (negative) effect of the structural factors on country betas (country-specific volatility), especially in Europe, while industry betas are mainly determined by temporary factors. Not taking into account the time variation in betas leads to biases in measures of industry and country-specific risk of up to 33 percent. After correcting for this bias, we find that under the influence of globalization and regionial integration, the traditional dominance geographical over industry diversification has been eroded, and that over the last years geographical and industry diversification roughly yield the same diversification benefits. Finally, our results indicate that the surge in industry risk at the end of the 1990s was partly (but not fully) related to the TMT bubble.
    Keywords: International portfolio diversification, Country versus Industry Effects, Financial integration, Idiosyncratic risk, Time- Varying Correlations, Regime-switching models
    JEL: G11 G12 G15 C32
    Date: 2005–11–21

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