New Economics Papers
on Risk Management
Issue of 2007‒01‒02
six papers chosen by

  1. Modelling Term-Structure Dynamics for Risk Management: A Practitioner's Perspective By David Jamieson Bolder
  2. Jump starting GARCH: pricing and hedging options with jumps in returns and volatilities By Jin-Chuan Duan; Peter Ritchken; Zhiqiang Sun
  3. The competitive effects of risk-based bank capital regulation: an example from U.S. mortgage farkets By Diana Hancock; Andreas Lehnert; Wayne Passmore; Shane M. Sherlund
  4. Housing Dynamics By Edward L. Glaeser; Joseph Gyourko
  5. Quantitative selection of hedge funds using data envelopment analysis By Huyen Nguyen-Thi-Thanh
  6. Do bonds span volatility risk in the U.S. Treasury market? a specification test for affine term structure models By Torben G. Andersen; Luca Benzoni

  1. By: David Jamieson Bolder
    Abstract: Modelling term-structure dynamics is an important component in measuring and managing the exposure of portfolios to adverse movements in interest rates. Model selection from the enormous term-structure literature is far from obvious and, to make matters worse, a number of recent papers have called into question the ability of some of the more popular models to adequately describe interest rate dynamics. The author, in attempting to find a relatively simple term-structure model that does a reasonable job of describing interest rate dynamics for risk-management purposes, examines two sets of models. The first set involves variations of the Gaussian affine term-structure model by modestly building on the recent work of Dai and Singleton (2000) and Duffee (2002). The second set includes and extends Diebold and Li (2003). After working through the mathematical derivation and estimation of these models, the author compares and contrasts their performance on a number of in- and out-of-sample forecasting metrics, their ability to capture deviations from the expectations hypothesis, and their predictions in a simple portfolio-optimization setting. He finds that the extended Nelson-Siegel model and an associated generalization, what he terms the "exponential-spline model," provide the most appealing modelling alternatives when considering the various model criteria.
    Keywords: Interest rates; Econometric and statistical methods; Financial markets
    JEL: C0 C6 E4 G1
    Date: 2006
  2. By: Jin-Chuan Duan; Peter Ritchken; Zhiqiang Sun
    Abstract: This paper considers the pricing of options when there are jumps in the pricing kernel and correlated jumps in asset returns and volatilities. Our model nests Duan’s GARCH option models, where conditional returns are constrained to being normal, as well as mixed jump processes as used in Merton. The diffusion limits of our model have been shown to include jump diffusion models, stochastic volatility models and models with both jumps and diffusive elements in both returns and volatilities. Empirical analysis on the S&P 500 index reveals that the incorporation of jumps in returns and volatilities adds significantly to the description of the time series process and improves option pricing performance. In addition, we provide the first-ever hedging effectiveness tests of GARCH option models.
    Keywords: Options (Finance) ; Hedging (Finance)
    Date: 2006
  3. By: Diana Hancock; Andreas Lehnert; Wayne Passmore; Shane M. Sherlund
    Abstract: Basel II bank capital regulations are designed to be substantially more risk sensitive than the current regulations. In the United States, only the largest banks would be required to adopt Basel II; other depositories could choose to adopt such standards or to remain under the Basel I capital standards. We consider possible effects of this two-pronged or "bifurcated" approach on the market for residential mortgages. Specifically, we analyze whether those institutions that adopt Basel II will enjoy lower costs than nonadopters and whether they have an incentive to retain mortgages in their own portfolios. We find that (1) despite the large differences in regulatory capital requirements between adopters and nonadopters, it is unlikely that there will be any measurable effect of Basel II implementation on most mortgage rates and, consequently, any direct impact on the competition between adopters and nonadopters for originating or holding residential mortgages; (2) the most significant competitive impact may be felt among mortgage securitizers; and (3) adopters might have increased profits from some mortgages relative to nonadopters because they will capture some of the deadweight losses that occur under the current regulatory regime, but nonadopters would likely retain their market shares.
    Date: 2006
  4. By: Edward L. Glaeser; Joseph Gyourko
    Abstract: The key stylized facts of the housing market are positive serial correlation of price changes at one year frequencies and mean reversion over longer periods, strong persistence in construction, and highly volatile prices and construction levels within markets. We calibrate a dynamic model of housing in the spatial equilibrium tradition of Rosen and Roback to see whether such a model can generate these facts. With reasonable parameter values, this model readily explains the mean reversion of prices over five year periods, but cannot explain the observed positive serial correlation at higher frequencies. The model predicts the positive serial correlation of new construction that we see in the data and the volatility of both prices and quantities in the typical market, but not the volatility of the nation's more extreme markets. The strong serial correlation in annual house price changes and the high volatility of prices in coastal markets are the two biggest housing market puzzles. More research is needed to determine whether measurement error-related data smoothing or market inefficiency can best account for the persistence of high frequency price changes. The best rational explanations of the volatility in high cost markets are shocks to interest rates and unobserved income shocks.
    JEL: A1
    Date: 2006–12
  5. By: Huyen Nguyen-Thi-Thanh
    Abstract: Previous studies have documented that Data Envelopment Analysis<br />(DEA) could be a good tool to evaluate fund performance,<br />especially the performance of hedge funds as it can incorporate<br />multiple risk-return attributes characterizing hedge fund's non<br />normal return distribution in an unique performance score. The<br />purpose of this paper is to extend the use of DEA to the context<br />of hedge fund selection when investors must face multi-dimensional<br />constraints, each one associated to a relative importance level.<br />Unlike previous studies which used DEA in an empirical framework,<br />this research puts emphasis on methodological issues. I showed<br />that DEA can be a good tailor-made decision-making tool to assist<br />investors in selecting funds that correspond the most to their<br />financial, risk-aversion, diversification and investment horizon<br />constraints.
    Keywords: hedge funds, data envelopment analysis, fund selection, performance measurement, alternative investment
    Date: 2006–12–14
  6. By: Torben G. Andersen; Luca Benzoni
    Abstract: We investigate whether bonds span the volatility risk in the U.S. Treasury market, as predicted by most 'affine' term structure models. To this end, we construct powerful and model-free empirical measures of the quadratic yield variation for a cross-section of fixed- maturity zero-coupon bonds ('realized yield volatility') through the use of high-frequency data. We find that the yield curve fails to span yield volatility, as the systematic volatility factors are largely unrelated to the cross- section of yields. We conclude that a broad class of affine diffusive, Gaussian-quadratic and affine jump-diffusive models is incapable of accommodating the observed yield volatility dynamics. An important implication is that the bond markets per se are incomplete and yield volatility risk cannot be hedged by taking positions solely in the Treasury bond market. We also advocate using the empirical realized yield volatility measures more broadly as a basis for specification testing and (parametric) model selection within the term structure literature.
    Date: 2006

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