nep-rmg New Economics Papers
on Risk Management
Issue of 2007‒03‒10
nine papers chosen by
Stan Miles
Thompson Rivers University

  1. Banking integration and co-movements in EU banks’ fragility By Vulpes, Giuseppe; Brasili, Andrea
  2. Bank behaviour with access to credit risk transfer markets By Goderis, Benedikt; Marsh, Ian; Vall Castello , Judit; Wagner, Wolf
  3. An Analysis of Financial Stability Indicators in European Banking: The Role of Common Factors By Clemens Kool
  4. An Asset Pricing Model for Mean-Variance-Downside-Risk Averse Investors By José Olmo
  5. A Predictive Comparison of Some Simple Long Memory and Short Memory Models of Daily U.S. Stock Returns, With Emphasis on Business Cycle Effects By Norman Swanson; Geetesh Bhardwaj
  6. Robust Portfolio Optimisation with Multiple Experts By Lutgens, Frank; Schotman, Peter C
  7. On s-additive robust representation of convex risk measures for unbounded financial positions in the presence of uncertainty about the market model By Volker Krätschmer
  8. The use of derivatives to hedge embedded options : the case of pension institutions in Denmark By Ladekarl, Jeppe; Ladekarl, Regitze; Andersen, Erik Brink; Vittas, Dimitri
  9. Evaluating conditional asset pricing models for the German stock market By Schrimpf, Andreas; Schröder, Michael; Stehle, Richard

  1. By: Vulpes, Giuseppe; Brasili, Andrea
    Abstract: The aim of this paper is to verify whether and to which extent co-movements in EU banks’ risk, i.e. their degree of exposures of European banks to common shocks, have increased in time, following the completion of Monetary Union, the introduction of the euro and the process of European banking integration. To this end, we provide a measure of co-movements in bank risk by means of a dynamic factor model, which allows to decompose an indicator of bank fragility, the Distance-to-Default, into three main components: an EU-wide, a country-specific and a bank-level idiosyncratic component. Our results show the commonality in bank risk appears to have significantly increased since 1999, in particular if one concentrates on large banks. We also show that co-movements in EU banks’ fragility are only in part related to common macro shocks and that a banking system specific component at the EU-wide level appears relevant. This has obvious consequences in terms of systemic stability, but may also have far reaching policy implications with regards to the structuring of banking supervision in Europe
    Keywords: Co-movements; dynamic factor models; distance-to-default; Systemic risk
    JEL: C51 G21 G15
    Date: 2006–06
  2. By: Goderis, Benedikt (Oxford University); Marsh, Ian (Cass Business School); Vall Castello , Judit (Universitat Autonoma); Wagner, Wolf (Tilburg University and Cambridge Endowment for Research in Finance (CERF))
    Abstract: One of the most important recent innovations in financial markets has been the development of credit derivative products that allow banks to more actively manage their credit portfolios than ever before. We analyse the effect that access to these markets has had on the lending behaviour of a sample of banks, using a sample of banks that have not accessed these markets as a control group. We find that banks that adopt advanced credit risk management techniques (proxied by the issuance of at least one collateralized loan obligation) experience a permanent increase in their target loan levels of around 50%. Partial adjustment to this target, however, means that the impact on actual loan levels is spread over several years. Our findings confirm the general efficiency-enhancing implications of new risk management techniques in a world with frictions suggested in the theoretical literature.
    Keywords: credit derivatives; bank loans; moral hazard
    JEL: G20 G21 G28
    Date: 2007–02–28
  3. By: Clemens Kool
    Abstract: In this paper, we investigate the information content of three market indicators of financial instability using daily data on subordinated debt spreads (SND), credit default swap spreads (CDS) and implied option volatility (IV) over the period January 2001 Ð January 2004 for a sample of twenty major European banks. Using common factor analysis, we find for each indicator a significant common factor across banks, which we label the ÒmarketÓ factor. This market factor explains between 61 and 92 percent of total variation. Cointegration analysis shows that the market factor in each case is significantly related to macro financial variables such as the short term nominal interest rate, the yield spread and a European Price earning stock ratio. Hence, market risk is primarily affected by aggregate economic and financial developments which are widely seen to impact financial markets. The driving variables of market risk are different for the bond and equity markets with short-term interest rates and yield curve dominating the bond market (SND) and P/E ratio and short-term interest rate significantly influencing the equity market (IV). The CDS market seems to lie somewhat in between these two classical markets, with closer links, however, to the traditional bond market. Little evidence is found that idiosyncratic bank-specific risks are a major component of SND, CDS and IV developments.
    Keywords: Credit Default Swap Spreads, Risk Premium, Financial Integration
    JEL: G12 G15 G21 C30
    Date: 2006–12
  4. By: José Olmo (Department of Economics, City University, London)
    Abstract: We introduce a family of utility functions that describe the preferences of mean-variance-downside-risk (mvdr) averse investors. The risk premium on a risky asset in an economy with these individuals is given by a weighted sum of CAPM systematic risk and a systematic risk given by the level of comovements between the asset and the market in distress episodes. Hence investors require a higher reward than predicted by CAPM for holding assets correlated with the market in distress episodes, and a lower reward for holding assets with negative correlation in market downturns. The application of this pricing theory to financial sectors in FTSE-100 is illuminating. The empirical failure of standard CAPM is explained by the extra reward required by investors from market downturns. While Chemicals and Mining sectors exhibit positive comovements with FTSE downturns; Banking and Oil and Gas sectors are robust to them and Telecommunications Services exhibit negative comovements serving as refugee of investors fleeing from domestic market distress episodes.
    Keywords: Asset Pricing, CAPM, Downside-risk, Mean-variance
    JEL: G11 G12 G13
    Date: 2007–01
  5. By: Norman Swanson (Rutgers University); Geetesh Bhardwaj (Rutgerst University)
    Abstract: This chapter builds on previous work by Bhardwaj and Swanson (2004) who address the notion that many fractional I(d) processes may fall into the “empty box” category, as discussed in Granger (1999). However, rather than focusing primarily on linear models, as do Bhardwaj and Swanson, we analyze the business cycle effects on the forecasting performance of these ARFIMA, AR, MA, ARMA, GARCH, and STAR models. This is done via examination of ex ante forecasting evidence based on an updated version of the absolute returns series examined by Ding, Granger and Engle (1993); and via the use of Diebold and Mariano (1995) and Clark and McCracken (2001) predictive accuracy tests. Results are presented for a variety of forecast horizons and for recursive and rolling estimation schemes. We find that the business cycle does not seem to have an effect on the relative forecasting performance of ARFIMA models.
    Keywords: fractional integration, long horizon prediction, long memory, parameter estimation error, stock returns
    JEL: C15 C22 C53
    Date: 2006–09–22
  6. By: Lutgens, Frank; Schotman, Peter C
    Abstract: We consider mean-variance portfolio choice of a robust investor. The investor receives advice from J experts, each with a different prior for the distribution of returns. Confronted with these multiple priors the investor follows a min-max portfolio strategy. We study the structure of the robust mean-variance portfolio and empirically compare its performance with a variety of alternative portfolio strategies. The empirical tests are based on bootstrap simulations on the 25 Fama-French portfolios and on 81 European country and value portfolios. We find that the robust portfolio performs well in both settings. Robust portfolios do not exhibit the extreme weights typically observed in naive mean-variance portfolios. Robust portfolios are also better diversified than portfolios that impose short-sell constraints to suppress the symptoms of extreme weights.
    Keywords: mean-variance; model uncertainty; portfolio choice
    JEL: C11 D80
    Date: 2007–03
  7. By: Volker Krätschmer
    Abstract: Recently, Frittelli and Scandolo ([9]) extend the notion of risk measures, originally introduced by Artzner, Delbaen, Eber and Heath ([1]), to the risk assessment of abstract financial positions, including pay offs spread over different dates, where liquid derivatives are admitted to serve as financial instruments. The paper deals with s-additive robust representations of convex risk measures in the extended sense, dropping the assumption of an existing market model, and allowing also unbounded financial positions. The results may be applied for the case that a market model is available, and they encompass as well as improve criteria obtained for robust representations of the original convex risk measures for bounded positions ([4], [7], [16]).
    Keywords: Convex risk measures, model uncertainty, s-additive robust representation, Fatou property, nonsequential Fatou property, strong s-additive robust representation, Krein-Smulian theorem, Greco theorem, inner Daniell stone theorem, general Dini theorem, Simons’ lemma.
    JEL: G10
    Date: 2007–03
  8. By: Ladekarl, Jeppe; Ladekarl, Regitze; Andersen, Erik Brink; Vittas, Dimitri
    Abstract: The main purpose of this paper is to examine the growing use of derivatives by Danish pension institutions as a risk management tool to hedge embedded options on their balance sheets. Throughout the 1980s and 1990s it was a widespread practice for Danish pension institutions to guarantee a minimum interest rate on new pension policies. With the new millennium global interest rates declined steeply and equity markets came crashing down. Suddenly the guarantees on pension contracts were in the money. The policies already written could not be changed, leaving liabilities and assets mismatched, profits in the red, and capital reserves drained. Out of necessity, and in some cases virtue, Danish pension institutions turned in scale to derivatives, allowing for a more active approach to hedging, asset and liability management, and even profit generation. Through the use of derivatives, pension institutions have avoided the need to renegotiate their guaranteed contracts with policy holders. They have succeeded as an industry in transforming their pay-off curves and have emerged with better matched asset/liability positions and lower exposure to interest rate risk. But the expanded use of derivatives also raises some risk management and regulatory issues, such as operational and counterparty risks as well as effective internal control systems and regulatory oversight.
    Keywords: Investment and Investment Climate,Economic Theory & Research,Insurance & Risk Mitigation,Non Bank Financial Institutions,Settlement of Investment Disputes
    Date: 2007–03–01
  9. By: Schrimpf, Andreas; Schröder, Michael; Stehle, Richard
    Abstract: We study the performance of conditional asset pricing models in explaining the German cross-section of stock returns. Our test assets are portfolios sorted by size and book-to-market as in the paper by Fama and French (1993). Our results show that the empirical performance of the Capital Asset Pricing Model (CAPM) can be improved substantially when allowing for time-varying parameters of the stochastic discount factor. A conditional CAPM with the term spread as a conditioning variable is able to explain the cross-section of German stock returns about as well as the Fama-French model. Structural break tests do not indicate parameter instability of the model - whereas the reverse is found for the Fama-French model. Unconditional model specifications however do a better job than conditional ones at capturing time-series predictability of the test portfolio returns.
    Keywords: Asset Pricing, Conditioning Information, Hansen-Jagannathan Distance, Multifactor Models
    JEL: G12
    Date: 2006

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