nep-rmg New Economics Papers
on Risk Management
Issue of 2006‒12‒16
eight papers chosen by
Stan Miles
Thompson Rivers University

  1. Mergers and risk By Craig H. Furfine; Richard J. Rosen
  2. The Latin American and Spanish Stock markets By Henry Aray
  3. The economic and statistical value of forecast combinations under regime switching: an application to predictable U.S. returns By Massimo Guidolin; Carrie Fangzhou Na
  4. Modelling Scenario Analysis and Macro Stress-testing By Jan Willem van den End; Marco Hoeberichts en Mostafa Tabbae
  5. Banks’ optimal implementation strategies for a risk sensitive regulatory capital rule: a real options and signalling approach By Kjell Bjørn Nordal
  6. Forecasting market crashes: further international evidence By Jokipii, Terhi
  7. Realized jumps on financial markets and predicting credit spreads By George Tauchen; Hao Zhou
  8. Real-time price discovery in global stock, bond and foreign exchange markets By Torben G. Andersen; Tim Bollerslev; Francis X. Diebold; Clara Vega

  1. By: Craig H. Furfine; Richard J. Rosen
    Abstract: This paper examines the impact of mergers on default risk, finding that, on average, a merger increases the default risk of the acquiring firm. This is surprising for two reasons: risk reduction is among the reasons commonly cited for mergers, and asset diversification should reduce default risk unless the newly-merged firm takes some action to increase risk. We associate the risk increase with mergers satisfying one of a trifecta of conditions related to agency problems: mergers financed with stock, acquirers with a high market- to-book ratio, and acquirers with poor stock price performance prior to a merger announcement. We also demonstrate higher levels of default risk are not accompanied by higher post- merger returns.
    Keywords: Bank mergers ; Risk management
    Date: 2006
  2. By: Henry Aray (Department of Economic Theory and Economic History, University of Granada.)
    Abstract: In this article I analyze the Spanish stock market in an international setting. Using a simple Markov regime switching model I get a time varying measure of the effect of the return on a Latin American portfolio on the Spanish stock returns. The evidence can be summarized as follows. First, I find that this effect is positive and no so large. However, it has increased since the mid-nineties. Second, evidence for the returns on size portfolios shows that most of the effect accrues indirectly through common risk factors. The portfolio composes of stocks with small capitalization is the most affected. Nevertheless, the relative effect of the Latin America to the effect of the world only increases for the portfolio composes of stocks with big capitalization since the mid-nineties. Third, evidence for the returns on sector portfolios shows that the most active sectors investing in Latin America are the most affected. Fourth, I conclude that there is no a positive relationship between â-risk and flows of foreign direct investment.
    Keywords: Markov switching model, maximum likelihood estimation, stock returns.
    JEL: C22 G15
    Date: 2006–12–14
  3. By: Massimo Guidolin; Carrie Fangzhou Na
    Abstract: We address one interesting case - the predictability of excess US asset returns from macroeconomic factors within a flexible regime switching VAR framework - in which the presence of regimes may lead to superior forecasting performance from forecast combinations. After having documented that forecast combinations provide gains in prediction accuracy and these gains are statistically significant, we show that combinations may substantially improve portfolio selection. We find that the best performing forecast combinations are those that either avoid estimating the pooling weights or that minimize the need for estimation. In practice, we report that the best performing combination schemes are based on the principle of relative, past forecasting performance. The economic gains from combining forecasts in portfolio management applications appear to be large.
    Keywords: Forecasting
    Date: 2006
  4. By: Jan Willem van den End; Marco Hoeberichts en Mostafa Tabbae
    Abstract: Macro stress-testing has become an important tool to assess financial stability. This paper describes a tool kit for scenario analysis and macro stress-testing. It is based on a model which maps multivariate scenarios to banks' credit and interest rate risks by deterministic and stochastic simulations. Our approach is an extension of existing macro stress-testing models as it distinguishes between probability of default on the one hand and loss given default on the other and allows for separate models for domestic and foreign portfolios. Another contribution of the paper is that the stochastic simulations generate loss distributions which provide insight in the extreme losses and allow for changing correlations between risk factors in stress situations. The methodology is applied to the Dutch banking sector.
    Keywords: banking; financial stability; stress-tests; credit risk; interest rate risk
    JEL: C33 E44 G21
    Date: 2006–11
  5. By: Kjell Bjørn Nordal (Norges Bank (Central Bank of Norway))
    Abstract: I evaluate a bank's incentives to implement a risk sensitive regulatory capital rule and to invest in improved risk measurement. The decision making is analyzed within a real options framework where optimal policies are derived in terms of threshold levels of risk. I also evaluate the situation where exercise or non-exercise of the options to implement or invest are signals about the underlying quality of the loan portfolio. The framework is used for a numerical evaluation of banks' decision of whether to use internal rating based models for credit risk (the IRB-approach) under the new Basel accord (Basel II), where the dynamic behavior of risk is described by an Ohrnstein-Uhlenbeck process. I discuss empirical implications of the evaluation framework.
    Keywords: Risk measurement, capital structure, real options, Basel II
    JEL: G13 G21 G28 G32
    Date: 2006–12–11
  6. By: Jokipii, Terhi (Bank of Finland Research)
    Abstract: This paper studies the extent to which market crashes are predictable for a set of six countries, focusing in particular on possible differences between transition economies (The Czech Republic, Hungary and Poland) and mature markets (UK, US and EU). We estimate a set of individual country and pooled specifications to find that market crashes, in the broader sense, are predictable for all countries analysed. We additionally investigate the role that investor heterogeneity, proxied by trading volume, plays in this predictability and find some varying results between countries. For the Central and Eastern European Countries (CE3), an increase in trading volume relative to trend appears to have great predictive power, a result that is supportive of the theory of investor heterogeneity outlined in the relevant background studies. For the more mature markets (G5), on the other hand, market crashes appear more likely to follow a period of increased stock prices and returns, a result fitting a number of traditional theories, in particular the stochastic bubble model. Further analysis, allowing for time-varying coefficients, confirms the volume-crash relationship for the CE3 and provides preliminary evidence that macro news releases may additionally contribute to the predictability of market crashes.
    Keywords: aggregate market returns; skewness; trading volume; market crash
    JEL: C14 G12 G15
    Date: 2006–12–14
  7. By: George Tauchen; Hao Zhou
    Abstract: This paper extends the jump detection method based on bi-power variation to identify realized jumps on financial markets and to estimate parametrically the jump intensity, mean, and variance. Finite sample evidence suggests that jump parameters can be accurately estimated and that the statistical inferences can be reliable, assuming that jumps are rare and large. Applications to equity market, treasury bond, and exchange rate reveal important differences in jump frequencies and volatilities across asset classes over time. For investment grade bond spread indices, the estimated jump volatility has more forecasting power than interest rate factors and volatility factors including option-implied volatility, with control for systematic risk factors. A market jump risk factor seems to capture the low frequency movements in credit spreads.
    Date: 2006
  8. By: Torben G. Andersen; Tim Bollerslev; Francis X. Diebold; Clara Vega
    Abstract: Using a unique high-frequency futures dataset, we characterize the response of U.S., German and British stock, bond and foreign exchange markets to real-time U.S. macroeconomic news. We find that news produces conditional mean jumps; hence high-frequency stock, bond and exchange rate dynamics are linked to fundamentals. Equity markets, moreover, react differently to news depending on the stage of the business cycle, which explains the low correlation between stock and bond returns when averaged over the cycle. Hence our results qualify earlier work suggesting that bond markets react most strongly to macroeconomic news; in particular, when conditioning on the state of the economy, the equity and foreign exchange markets appear equally responsive. Finally, we also document important contemporaneous links across all markets and countries, even after controlling for the effects of macroeconomic news.
    Date: 2006

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