nep-rmg New Economics Papers
on Risk Management
Issue of 2006‒04‒22
six papers chosen by
Stan Miles
York University

  1. Execution Risk By Robert Engle; Robert Ferstenberg
  2. Nonparametric Estimation for Non-Homogeneous Semi-Markov Processes: An Application to Credit Risk By Andre Monteiro; Georgi V. Smirnov; Andre Lucas
  4. Optimal Asset Allocation Based on Utility Maximization in the Presence of Market Frictions By Alessandro Bucciol; Raffaele Miniaci
  5. Business Cycle and Stock Market Volatility: A Particle Filter Approach By Roberto Casarin; Carmine Trecroci
  6. CLOSED-END FUND BETAS By Michael Bleaney; R. Todd Smith

  1. By: Robert Engle; Robert Ferstenberg
    Abstract: Transaction costs in trading involve both risk and return. The return is associated with the cost of immediate execution and the risk is a result of price movements during a more gradual trading. The paper shows that the trade-off between risk and return in optimal execution should reflect the same risk preferences as in ordinary investment. The paper develops models of the joint optimization of positions and trades, and shows conditions under which optimal execution does not depend upon the other holdings in the portfolio. Optimal execution however may involve trades in assets other than those listed in the order; these can hedge the trading risks. The implications of the model for trading with reversals and continuations are developed. The model implies a natural measure of liquidity risk
    JEL: G2
    Date: 2006–04
  2. By: Andre Monteiro (Vrije Universiteit Amsterdam); Georgi V. Smirnov (University of Porto); Andre Lucas (Vrije Universiteit Amsterdam)
    Abstract: We propose procedures for estimating the time-dependent transition matrices for the general class of finite nonhomogeneous continuous-time semi-Markov processes. We prove the existence and uniqueness of solutions for the system of Volterra integral equations defining the transition matrices, therefore showing that these empirical transition probabilities can be estimated from window censored event-history data. An implementation of the method is presented based on nonparametric estimators of the hazard rate functions in the general and separable cases. A Monte Carlo study is performed to assess the small sample behavior of the resulting estimators. We use these new estimators for dealing with a central issue in credit risk. We consider the problem of obtaining estimates of the historical corporate default and rating migration probabilities using a dataset on credit ratings from Standard & Poor's.
    Keywords: Nonhomogeneous semi-Markov processes; transition matrix; Volterra integral equations; separability; credit risk
    JEL: C13 C14 C33 C41 G11
    Date: 2006–03–08
  3. By: Dairo Estrada; Daniel Osorio
    Abstract: According to traditional literature, liquidity risk in individual banks can turn into a system-wide ¯nancial crisis when either interbank credit exposures or bank runs are present. This paper shows that this phenomenon can also arise when individual liquidity risk trans- forms into system-wide market risk (even in the absence of bank runs and interbank credit networks). This happens when banks try to sell some portion of its assets in order to overcome a liquidity shortage (individual liquidity risk). These sales depress the market price of assets if demand is not perfectly elastic. Given the fact that banks mark to market the asset book, the fall of market price reduces the value of assets of every bank in the system (system-wide market risk), leaving them less suited for future liquidity shortages and therefore more prone to bankruptcies. The paper rationalizes this idea through the simulation of a model that tries to capture the behavior of a liq- uidity manager that faces shocks on bank deposits and loans. The main results suggest that the extent of ¯nancial contagion depends crucially on the size of the market for assets.
    Date: 2006–03–01
  4. By: Alessandro Bucciol; Raffaele Miniaci
    Abstract: We develop a model of optimal asset allocation based on a utility framework. This applies to a more general context than the classical mean-variance paradigm since it can also account for the presence of constraints in the portfolio composition. Using this approach, we study the distribution of a measure of wealth compensative variation, we propose a benchmark and portfolio efficiency test and a procedure to estimate the implicit risk aversion parameter of a power utility function. Our empirical analysis makes use of the S&P 500 and industry portfolios time series to show that although the market index cannot be considered an efficient investment in the mean-variance metric, the wealth loss associated with such an investment is statistically different from zero but rather small (lower than 0.5%). The wealth loss is at its minimum for a representative agent with a constant risk aversion index not higher than 5. Furthermore we show that, for reasonable levels of risk aversion, the use of an equally weighted portfolio is surprisingly consistent with an expected utility maximizing behavior.
  5. By: Roberto Casarin; Carmine Trecroci
    Abstract: The recent observed decline of business cycle variability suggests that broad macroeconomic risk may have fallen as well. This may in turn have some impact on equity risk premia. We investigate the latent structures in the volatilities of the business cycle and stock market valuations by estimating a Markov switching stochastic volatility model. We propose a sequential Monte Carlo technique for the Bayesian inference on both the unknown parameters and the latent variables of the hidden Markov model. Sequential importance sampling is used for filtering the latent variables and kernel estimator with a multiple-bandwidth is employed to reconstruct the parameter posterior distribution. We find that the switch to lower variability has occurred in both business cycle and stock market variables along similar patterns.
  6. By: Michael Bleaney; R. Todd Smith
    Abstract: The CAPM can explain closed-end fund (CEF) discounts as a consequence of the higher betas on CEF shares than on their underlying portfolios. The difference in betas is much greater for international funds and for bond funds than for domestic equity funds. CEF shares carry both more idiosyncratic risk (usually) and more systematic risk than their portfolios, and also exhibit excess volatility. The difference in betas reflects the sensitivity of CEF price returns to market returns, after controlling for portfolio returns. The influence of home market returns on international fund prices is particularly marked in UK funds.

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