nep-rmg New Economics Papers
on Risk Management
Issue of 2007‒03‒31
nine papers chosen by
Stan Miles
Thompson Rivers University

  1. The Equity Premium: UK Industry Evidence. By Andrew Vivian
  2. Durability of Output and Expected Stock Returns By Joao F. Gomes; Leonid Kogan; Motohiro Yogo
  3. Economic capital allocation under liquidity constraints By Mierzejewski, Fernando
  4. Multivariate Realized Stock Market Volatility<br> By Gregory H. Bauer; Keith Vorkink
  5. Model comparison using the Hansen-Jagannathan distance By Raymond Kan; Cesare Robotti
  6. Realized Correlation Tick-by-Tick By Fulvio Corsi; Francesco Audrino
  7. The Impact of Central Bank Announcements on Asset Prices in Real Time: Testing the Efficiency of the Euribor Futures Market By Carlo Rosa; Giovanni Verga
  8. An Economic Index of Riskiness By Robert J. Aumann; Roberto Serrano
  9. Rounding and the impact of news: a simple test of market rationality By Meredith Beechey; Jonathan H. Wright

  1. By: Andrew Vivian
    Abstract: Recent US research has suggested that market expected returns have fallen. Most studies propose this fall in market expected returns occurred during the 1990’s. Our UK empirical analysis finds a fall in expected returns in the 1990’s for the market index, but, in general, this is not evident across many segments of the market. Specifically,we find for the majority of UK industries a) over recent decades there has not been a general or overall fall in expected returns and b) there was not a common decline in expected returns during the 1990’s. We propose changing industry composition of the market portfolio rather than a decline in systematic risk is primarily responsible for this recent proposed fall in value-weighted market returns.
    Keywords: Equity Premium, Declining Returns, Industry Composition.
    JEL: G12 G15
    Date: 2007–03
  2. By: Joao F. Gomes; Leonid Kogan; Motohiro Yogo
    Abstract: The demand for durable goods is more cyclical than that for nondurable goods and services. Consequently, the cash flow and stock returns of durable-good producers are exposed to higher systematic risk. Using the NIPA input-output tables, we construct portfolios of durable-good, nondurable-good, and service producers. In the cross-section, a strategy that is long on durables and short on services earns a sizable risk premium. In the time series, a strategy that is long on durables and short on the market portfolio earns a countercyclical risk premium. We develop an equilibrium asset-pricing model that explains these empirical findings.
    JEL: D57 E21 G12
    Date: 2007–03
  3. By: Mierzejewski, Fernando
    Abstract: Since the capital structure affects the performance of financial institutions confronted to liquidity constraints, the Economic Capital is determined by the maximisation of value. Allowing economic decisions to be characterised by a distorted probability distribution, so assessing the attitude towards risk as well as information and knowledge, the optimal surplus is expressed as a Value-at-Risk, as recommended by the Basel Committee. Thus, demanding more capital than regulatory requirements accounts for different expectations about risks. The optimal surplus is allocated to the lines of business of a conglomerate according to the borne risk and the type of divisional managers. Full-allocation is assured and no covariances are required. Further, a mechanism is provided, which allows for the distribution of equity in a decentralised organisation.
    Keywords: economic capital; capital allocation; distorted probability principle; Value-at-Risk
    JEL: G38 G33 G32
    Date: 2006–04–01
  4. By: Gregory H. Bauer; Keith Vorkink
    Abstract: We present a new matrix-logarithm model of the realized covariance matrix of stock returns. The model uses latent factors which are functions of both lagged volatility and returns. The model has several advantages: it is parsimonious; it does not require imposing parameter restrictions; and, it results in a positive-definite covariance matrix. We apply the model to the covariance matrix of size-sorted stock returns and find that two factors are sufficient to capture most of the dynamics. We also introduce a new method to track an index using our model of the realized volatility covariance matrix.
    Keywords: Econometric and statistical methods; Financial markets
    JEL: G14 C53 C32
    Date: 2007
  5. By: Raymond Kan; Cesare Robotti
    Abstract: Although it is of interest to empirical researchers to test whether or not a particular assetpricing model is true, a more useful task is to determine how wrong a model is and to compare the performance of competing asset-pricing models. In this paper, we propose a new methodology to test whether two competing linear asset-pricing models have the same Hansen-Jagannathan distance. We show that the asymptotic distribution of the test statistic depends on whether the competing models are correctly specified or misspecified and are nested or nonnested. In addition, given the increasing interest in misspecified models, we propose a simple methodology for computing the standard errors of the estimated stochastic discount factor parameters that are robust to model misspecification. Using the same data as in Hodrick and Zhang (2001), we show that the commonly used returns and factors are, for the most part, too noisy to conclude that one model is superior to the other models in terms of Hansen-Jagannathan distance. In addition, we show that many of the macroeconomic factors commonly used in the literature are no longer priced once potential model misspecification is taken into account.
    Date: 2007
  6. By: Fulvio Corsi; Francesco Audrino
    Abstract: We propose the Heterogeneous Autoregressive (HAR) model for the estimation and prediction of realized correlations. We construct a realized correlation measure where both the volatilities and the covariances are computed from tick-by-tick data. As for the realized volatility, the presence of market microstructure can induce significant bias in standard realized covariance measure computed with artificially regularly spaced returns. Contrary to these standard approaches we analyse a simple and unbiased realized covariance estimator that does not resort to the construction of a regular grid, but directly and efficiently employs the raw tick-by-tick returns of the two series. Montecarlo simulations calibrated on realistic market microstructure conditions show that this simple tick-by-tick covariance possesses no bias and the smallest dispersion among the covariance estimators considered in the study. In an empirical analysis on S&P 500 and US bond data we find that realized correlations show significant regime changes in reaction to financial crises. Such regimes must be taken into account to get reliable estimates and forecasts.
    Keywords: High frequency data, Realized Correlation, Market Microstructure, Bias correction, HAR, Regimes
    JEL: C13 C22 C51 C53
    Date: 2007–01
  7. By: Carlo Rosa; Giovanni Verga
    Abstract: This paper examines the effect of European Central Bank communication on the pricediscovery process in the Euribor futures market using a new tick-by-tick dataset. First, weshow that two pieces of news systematically hit financial markets on Governing Councilmeeting days: the ECB policy rate decision and the explanation of its monetary policy stance.Second, we find that the unexpected component of ECB explanations has a significant andsizeable impact on futures prices. This indicates that the ECB has already acquired somecredibility: financial markets seem to believe that it does what it says it will do. Finally, ourresults suggest that the Euribor futures market is semi-strong form informational efficient.
    Keywords: market efficiency, central bank communication, news shock, tickby-tick Euriborfutures data, event-study analysis.
    JEL: E52 E58 G14
    Date: 2006–12
  8. By: Robert J. Aumann; Roberto Serrano
    Abstract: Define the riskiness of a gamble as the reciprocal of the absolute risk aversion (ARA) of an individual with constant ARA who is indifferent between taking and not taking that gamble. We characterize this index by axioms, chief among them a "duality" axiom which, roughly speaking, asserts that less risk-averse individuals accept riskier gambles. The index is homogeneous of degree 1, monotonic with respect to first and second order stochastic dominance, and for gambles with normal distributions, is half of variance/mean. Examples are calculated, additional properties derived, and the index is compared with others in the literature.
    Keywords: Riskiness; Risk Aversion; Expected Utility; Decision Making under Uncertainty; Portfolio Choice; Sharpe Ratio; Variance-Mean Ratio; Value at Risk
    JEL: C00 C43 D00 D80 D81 E44 G00
    Date: 2007–02
  9. By: Meredith Beechey; Jonathan H. Wright
    Abstract: Certain prominent scheduled macroeconomic news releases contain a rounded number on the first page of the release that is widely cited by newswires and the press and a more precise number in the text of the release. The whole release comes out at once. We propose a simple test of whether markets are paying attention to the rounded or unrounded numbers by studying the high-frequency market reaction to such news announcements. In the case of inflation releases, we find evidence that markets systematically ignore some of the information in the unrounded number. This is most pronounced for core CPI, a prominent release for which the rounding in the headline number is large relative to the information content of the release.
    Date: 2007

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