New Economics Papers
on Risk Management
Issue of 2006‒04‒08
six papers chosen by

  1. Stock Returns and Expected Business Conditions: Half a Century of Direct Evidence By Sean D. Campbell; Francis X. Diebold
  2. Optimal Asset Allocation and Risk Shifting in Money Management By Basak, Suleyman; Pavlova, Anna; Shapiro, Alex
  3. Hedge Funds: Performance, Risk and Capital Formation By Fung, William; Hsieh, David A; Naik, Narayan; Ramadorai, Tarun
  4. Credit Risk Transfer and Contagion By Franklin Allen; Elena Carletti
  5. Five Open Questions About Prediction Markets By Wolfers, Justin; Zitzewitz, Eric
  6. The Volatility of Realized Volatility By Fulvio Corsi; Uta Kretschmer; Stefan Mittnik; Christian Pigorsch

  1. By: Sean D. Campbell (Federal Reserve Board); Francis X. Diebold (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 R2. 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: 2005–01–22
  2. 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 the ensuing convexities in the manager's objective give rise to a finite risk-shifting range over which she gambles to finish ahead of her benchmark. Such gambling entails either an increase or a decrease in the volatility of the manager's portfolio, depending on her risk tolerance. In the latter case, the manager reduces her holdings of the risky asset despite its positive risk premium. Our empirical analysis lends support to the novel predictions of the model. 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 demonstrated to be economically significant.
    Keywords: fund flows; implicit incentives; portfolio choice; relative performance; risk management; risk taking
    JEL: D60 D81 G11 G20
    Date: 2006–03
  3. By: Fung, William; Hsieh, David A; Naik, Narayan; Ramadorai, Tarun
    Abstract: We use a comprehensive dataset of Funds-of-Hedge-Funds (FoFs) to investigate performance, risk and capital formation in the hedge fund industry over the past ten years. We confirm the finding of high systematic risk exposures in FoF returns. We divide up the past ten years into three distinct subperiods and demonstrate that the average FoF has only delivered alpha in the short second period from October 1998 to March 2000. In the cross section of FoFs, however, we are able to identify FoFs capable of delivering persistent alpha. We find that these more successful hedge funds experience far greater (and steadier) capital inflows than their less fortunate counterparts. Berk and Green's (2004) rational model of active portfolio management implies that diminishing returns to scale combined with the inflow of new capital leads to the erosion of superior performance over time. In keeping with this implication, we provide evidence that even successful hedge funds have experienced a recent, dramatic decline in risk-adjusted performance.
    Keywords: alpha; factor models; flow; funds-of-hedge funds; hedge funds; performance
    JEL: G11 G12 G23
    Date: 2006–03
  4. By: Franklin Allen (The Wharton School, University of Pennsylvania); Elena Carletti (Center for Financial Studies)
    Abstract: Some have argued that recent increases in credit risk transfer are desirable because they improve the diversification of risk. Others have suggested that they may be undesirable if they increase the risk of financial crises. Using a model with banking and insurance sectors, we show that credit risk transfer can be beneficial when banks face uniform demand for liquidity. However, when they face idiosyncratic liquidity risk and hedge this risk in an interbank market, credit risk transfer can be detrimental to welfare. It can lead to contagion between the two sectors and increase the risk of crises.
    Keywords: Financial Innovation, Pareto Inferior, Banking, Insurance
    JEL: G21 G22
    Date: 2005–10–09
  5. By: Wolfers, Justin; Zitzewitz, Eric
    Abstract: Interest in prediction markets has increased in the last decade, driven in part by the hope that these markets will prove to be valuable tools in forecasting, decision-making and risk management - in both the public and private sectors. This paper outlines five open questions in the literature, and we argue that resolving these questions is crucial to determining whether current optimism about prediction markets will be realized.
    Keywords: event futures; information markets; instrumental variables; market manipulation; prediction IV; prediction markets
    JEL: C9 D7 D8 G1 M2
    Date: 2006–03
  6. By: Fulvio Corsi (University of Lugano); Uta Kretschmer (University of Bonn, Germany); Stefan Mittnik (University of Munich); Christian Pigorsch (University of Munich)
    Abstract: Using unobservable conditional variance as measure, latent–variable approaches, such as GARCH and stochastic–volatility models, have traditionally been dominating the empirical finance literature. In recent years, with the availability of high–frequency financial market data modeling realized volatility has become a new and innovative research direction. By constructing “observable” or realized volatility series from intraday transaction data, the use of standard time series models, such as ARFIMA models, have become a promising strategy for modeling and predicting (daily) volatility. In this paper, we show that the residuals of the commonly used time–series models for realized volatility exhibit non–Gaussianity and volatility clustering. We propose extensions to explicitly account for these properties and assess their relevance when modeling and forecasting realized volatility. In an empirical application for S&P500 index futures we show that allowing for time–varying volatility of realized volatility leads to a substantial improvement of the model’s fit as well as predictive performance. Furthermore, the distributional assumption for residuals plays a crucial role in density forecasting.
    Keywords: Finance, Realized Volatility, Realized Quarticity, GARCH, Normal Inverse Gaussian Distribution, Density Forecasting
    JEL: C22 C51 C52 C53
    Date: 2005–11–28

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