nep-rmg New Economics Papers
on Risk Management
Issue of 2006‒05‒20
eleven papers chosen by
Stan Miles
York University

  1. The International CAPM and a Wavelet-Based Decomposition of Value at Risk By Viviana Fernandez
  2. An Empirical Analysis of the Pricing of Collateralized Debt Obligations By Francis A. Longstaff; Arvind Rajan
  3. Managing Bank Liquidity Risk: How Deposit-Loan Synergies Vary with Market Conditions By Evan Gatev; Til Schuermann; Philip E. Strahan
  4. Backtesting VaR Accuracy: A New Simple Test By Christophe Hurlin; Sessi Tokpavi
  5. Assessing Credit with Equity: A CEV Model with Jump to Default By Luciano Campi; Simon Polbennikov; Sbuelz
  6. RISK PREMIUM: INSIGHTS OVER THE THRESHOLD By Jose L. B. Fernandes; Augusto Hasman; Juan Ignacio Peña
  7. A multi-factor model for the valuation and risk managment of demand deposits By Hans Dewachter; Marco Lyrio; Konstantijn Maes
  8. Efficiency of Insurance Firms with Endogenous Risk Management and Financial Intermediation Activities By J. David Cummins; Georges Dionne; Robert Gagné; Abdelhakim Nouira
  9. A Prospect-Theoretical Interpretation of Momentum Returns By Menkhoff, Lukas; Schmeling, Maik
  10. Institutional and Individual Sentiment: Smart Money and Noise Trader Risk By Schmeling, Maik
  11. Currency hedging of global portfolios - a closer examination of some of the ingredients By D. Johannes Juttner; Wayne Leung

  1. By: Viviana Fernandez
    Abstract: In this article, we formulate a time-scale decomposition of an international version of the CAPM that accounts for both market and exchange-rate risk. In addition, we derive an analytical formula for time-scale value at risk and marginal value at risk (VaR) of a portfolio. We apply our methodology to stock indices of seven emerging economies belonging to Latin America and Asia, for the sample period 1990-2004. Our main conclusions are the following. First, the estimation results hinge upon the choice of the world market portfolio. In particular, the stock markets of the sampled countries appear to be more integrated with other emerging countries than with developed ones. Second, value at risk depends on the investor’s time horizon. In the short run, potential losses are greater than in the long run. Third, additional exposure to some specific stock indices will increase value at risk to a greater extent, depending on the investment horizon. Our results go in line with recent research in asset pricing that stresses the importance of heterogeneous investors.
    JEL: C22 G15
    Date: 2006–05
  2. By: Francis A. Longstaff; Arvind Rajan
    Abstract: We study the pricing of collateralized debt obligations (CDOs) using an extensive new data set for the actively-traded CDX credit index and its tranches. We find that a three-factor portfolio credit model allowing for firm-specific, industry, and economywide default events explains virtually all of the time-series and crosssectional variation in CDX index tranche prices. These tranches are priced as if losses of 0.4, 6, and 35 percent of the portfolio occur with expected frequencies of 1.2, 41.5, and 763 years, respectively. On average, 65 percent of the CDX spread is due to firm-specific default risk, 27 percent to clustered industry or sector default risk, and 8 percent to catastrophic or systemic default risk. Recently, however, firm-specific default risk has begun to play a larger role.
    JEL: G1
    Date: 2006–05
  3. By: Evan Gatev; Til Schuermann; Philip E. Strahan
    Abstract: Liquidity risk in banking has been attributed to transactions deposits and their potential to spark runs or panics. We show instead that transactions deposits help banks hedge liquidity risk from unused loan commitments. Bank stock-return volatility increases with unused commitments, but the increase is smaller for banks with high levels of transactions deposits. This deposit-lending risk management synergy becomes more powerful during periods of tight liquidity, when nervous investors move funds into their banks. Our results reverse the standard notion of liquidity risk at banks, where runs from depositors had been seen as the cause of trouble.
    JEL: G18 G21
    Date: 2006–05
  4. By: Christophe Hurlin (LEO - Laboratoire d'économie d'Orleans - [CNRS : UMR6221] - [Université d'Orléans]); Sessi Tokpavi (LEO - Laboratoire d'économie d'Orleans - [CNRS : UMR6221] - [Université d'Orléans])
    Abstract: This paper proposes a new test of Value at Risk (VaR) validation. Our test exploits the idea that the sequence of VaR violations (Hit function) - taking value 1-α, if there is a violation, and -α otherwise - for a nominal coverage rate α verifies the properties of a martingale difference if the model used to quantify risk is adequate (Berkowitz et al., 2005). More precisely, we use the Multivariate Portmanteau statistic of Li and McLeod (1981) - extension to the multivariate framework of the test of Box and Pierce (1970) - to jointly test the absence of autocorrelation in the vector of Hit sequences for various coverage rates considered as relevant for the management of extreme risks. We show that this shift to a multivariate dimension appreciably improves the power properties of the VaR validation test for reasonable sample sizes.
    Keywords: Value-at-Risk; Risk Management; Model Selection
    Date: 2006–05–11
  5. By: Luciano Campi (CEREMADE, Université Paris Dauphine); Simon Polbennikov (Econometrics and Operations Research, Tilburg University, The Netherlands,); Sbuelz (Department of Economics (University of Verona))
    Abstract: Unlike in structural and reduced-form models, we use equity as a liquid and observable primitive to analytically value corporate bonds and credit default swaps. Restrictive assumptions on the firm’s capital structure are avoided. Default is parsimoniously represented by equity value hitting the zero barrier. Default can be either predictable, according to a CEV process that yields a positive probability of diffusive default and enables the leverage effect, or unpredictable, according to a Poisson-process jump that implies non-zero credit spreads for short maturities. Easy cross-asset hedging is enabled. By means of a carefully specified pricing kernel, we also enable analytical credit-risk management under possibly systematic jump-to-default risk.
    Keywords: Equity, Corporate Bonds, Credit Default Swaps, Constant-Elasticity-of-Variance (CEV) Diffusion, Jump to Default
    JEL: G12 G33
    Date: 2005–09
  6. By: Jose L. B. Fernandes; Augusto Hasman; Juan Ignacio Peña
    Abstract: The aim of this paper is twofold: First to test the adequacy of Pareto distributions to describe the tail of financial returns in emerging and developed markets, and second to study the possible correlation between stock market indices observed returns and return’s extreme distributional characteristics measured by Value at Risk and Expected Shortfall. We test the empirical model using daily data from 41 countries, in the period from 1995 to 2005. The findings support the adequacy of Pareto distributions and the use of a log linear regression estimation of their parameters, as an alternative for the usually employed Hill’s estimator. We also report a significant relationship between extreme distributional characteristics and observed returns, especially for developed countries.
    Date: 2006–05
  7. By: Hans Dewachter (Catholic University of Leuven, Center for Economic Studies; Erasmus University Rotterdam, Rotterdam School of Management); Marco Lyrio (University of Warwick, Warwick Business School, Finance Group); Konstantijn Maes (National Bank of Belgium, Financial Stability Department)
    Abstract: How should we value and manage deposit accounts where deposits have a zero contractual maturity, but which, in practice, remain stable through time and are remunerated below market rates? Does the economic value of the deposit account differ from the face value and can we reliably measure it? To what extent is the economic value sensitive to yield curve changes? In this paper, we try to answer the above questions. The valuation is performed on yield curve, deposit rate and deposit balance data between December 1994 and June 2005 for a sample of Belgian bank retail savings deposits accounts. We find that the deposits premium component of Belgian savings deposits is economically and statistically significant, though sensitive to assumptions about servicing costs and outstanding balances average decay rates. We also find that deposit liability values depreciate significantly when market rates increase, thereby offsetting some of the value losses on the asset side. The hedging characteristics of deposit accounts depend primarily on the nature of the underlying interest rate shock (yield curve level versus slope shock) and on the average decay rate. We assess the reliability of the reported point estimates and also report corresponding duration estimates that results from a dynamic replicating portfolio model approach more commonly used by large international banks.
    Keywords: Demand deposits, ALM, risk management, arbitrage free pricing, flexible-affine term structure model, interest rate risk, IFRS 39, fair value accounting
    JEL: G12 G21
    Date: 2006–05
  8. By: J. David Cummins; Georges Dionne; Robert Gagné; Abdelhakim Nouira
    Abstract: Risk management is now present in many economic sectors. This paper investigates the role of risk management in creating value for financial institutions by analyzing U.S. property-liability insurers. Property-liability insurers are financial intermediaries whose primary roles in the economy are risk pooling and risk bearing. The risk pooling and risk bearing functions performed by insurers are the primary determinants of the need for risk management. The main goal of this paper is to test how risk management and financial intermediation activities create value for insurers by enhancing economic efficiency. Insurer cost efficiency is measured relative to an econometric cost function. Since the prices of risk management and financial intermediation services are not observable, we consider these two activities as intermediate outputs and estimate their shadow prices. The shadow prices isolate the contributions of risk management and financial intermediation to insurer cost efficiency. The econometric results show that both activities significantly increase the efficiency of the property-liability insurance industry.
    Keywords: Risk management, US property-liability insurer, risk pooling, financial intermediation, economic efficiency, intermediate output, shadow price, cost function, translog approximation
    JEL: C34 D24 D81 G22
    Date: 2006
  9. By: Menkhoff, Lukas; Schmeling, Maik
    Abstract: The puzzling evidence of seemingly high momentum returns is related to an understanding of risk as a simple covariance. If we consider, however, risk in higher-order statistical moments, momentum returns appear less advantageous. Thus, a prospect-theoretical assessment of US stock momentum returns provides a possible direction for explaining this puzzle.
    Keywords: momentum trading, market efficiency, prospect theory
    JEL: G11 G12 G14
    Date: 2006–05
  10. By: Schmeling, Maik
    Abstract: Using a new data set on investor sentiment we show that institutional and individual sentiment proxy for smart money and noise trader risk, respectively. First, using bias-adjusted long-horizon regressions, we document that institutional sentiment forecasts stock market returns at intermediate horizons correctly, whereas individuals consistently get the direction wrong. Second, VEC models show that institutional sentiment forecasts mean-reversion whereas individuals forecast trend continuation. Finally, institutional investors take into account expected individual sentiment when forming their expectations in a way that higher (lower) expected sentiment of individuals lowers (increases) institutional return forecasts. Individuals neglect the information contained in institutional sentiment.
    Keywords: investor sentiment, predictive regressions, noise trader, smart money
    JEL: G11 G12 G14
    Date: 2006–05
  11. By: D. Johannes Juttner (Department of Economics, Macquarie University); Wayne Leung (Department of Economics, Macquarie University)
    Abstract: The paper analyzes some of the ingredients of currency hedging and portfolio construction against the framework of mean-variance efficient portfolios. The currency hedging analysis is based on a range of exchange rates, consisting of the domestic dollar vis-à-vis the US dollar, the euro, the yen, the pound and Hong Kong dollar mainly from an Australian perspective. Our analysis focuses on the following input factors into the hedging process of foreign assets/liabilities. We explore the implications of the secular downward trend of the real trade-weighted exchange rate index of the domestic dollar for hedging effectiveness. The hedging costs resulting from unexpected cash flows and portfolio adjustments are in part estimated through a simulated forward contract hedging technique. The relevant inputs into the variance-covariance matrix of the optimal portfolio selection process are estimated on the basis of historical data. Comparing the forecast errors of share index and currency volatilities, using historical, implied and GARCH methods, provides mixed results. The paper also investigates a select number of forecasting methods that may be applied to other hedging inputs.
    Date: 2004–10

This nep-rmg issue is ©2006 by Stan Miles. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.