nep-rmg New Economics Papers
on Risk Management
Issue of 2007‒04‒28
five papers chosen by
Stan Miles
Thompson Rivers University

  1. Expected stock returns and variance risk premia By Tim Bollerslev; Hao Zhou
  2. Modeling the distribution of credit losses with observable and latent factors By Gabriel Jiménez; Javier Mencía
  3. Markov switching GARCH models of currency turmoil in Southeast Asia By Celso Brunetti; Roberto S. Mariano; Chiara Scotti; Augustine H.H. Tan
  4. Stochastic Dominance and Mean-Variance Measures of Profit and Loss for Business Planning and Investment By Wing-Keung Wong
  5. On the Rand: Determinants of the South African Exchange Rate By Jeffrey Frankel

  1. By: Tim Bollerslev; Hao Zhou
    Abstract: We find that the difference between implied and realized variances, or the variance risk premium, is able to explain more than fifteen percent of the ex-post time series variation in quarterly excess returns on the market portfolio over the 1990 to 2005 sample period, with high (low) premia predicting high (low) future returns. The magnitude of the return predictability of the variance risk premium easily dominates that afforded by standard predictor variables like the P/E ratio, the dividend yield, the default spread, and the consumption-wealth ratio (CAY). Moreover, combining the variance risk premium with the P/E ratio results in an R^2 for the quarterly returns of more than twenty-five percent. The results depend crucially on the use of "model-free", as opposed to standard Black-Scholes, implied variances, and realized variances constructed from high-frequency intraday, as opposed to daily, data. Our findings suggest that temporal variation in risk and risk-aversion both play an important role in determining stock market returns.
    Date: 2007
  2. By: Gabriel Jiménez (Banco de España); Javier Mencía (Banco de España)
    Abstract: This paper develops a flexible and computationally efficient model to estimate the credit loss distribution of the loans in a banking system. We consider a sectorial structure, where default frequencies and the total number of loans are allowed to depend on macroeconomic conditions as well as on unobservable credit risk factors, which can capture contagion effects between sectors. In addition, we also model the distributions of the Exposure at Default and the Loss Given Default. We apply our model to the Spanish credit market, where we find that sectorial default frequencies are affected by a persistent latent factor. Finally, we also identify the potentially riskier sectors and perform stress tests.
    Keywords: credit risk, probability of default, loss distribution, stress test, contagion
    JEL: G21 E32 E37
    Date: 2007–04
  3. By: Celso Brunetti; Roberto S. Mariano; Chiara Scotti; Augustine H.H. Tan
    Abstract: This paper analyzes exchange rate turmoil with a Markov Switching GARCH model. We distinguish between two different regimes in both the conditional mean and the conditional variance: "ordinary" regime, characterized by low exchange rate changes and low volatility, and "turbulent" regime, characterized by high exchange rate movements and high volatility. We also allow the transition probabilities to vary over time as functions of economic and financial indicators. We find that real effective exchange rates, money supply relative to reserves, stock index returns, and bank stock index returns and volatility contain valuable information for identifying turbulence and ordinary periods.
    Date: 2007
  4. By: Wing-Keung Wong (Risk Management Institute and Department of Economics, National University of Singapore)
    Abstract: In this paper, we first extend the stochastic dominance (SD) theory by introducing the first three orders of both ascending SD (ASD) and descending SD (DSD) to decisions in business planning and investment to risk-averse and risk- loving decision makers so that they can compare both return and loss. We provide investors with more tools for empirical analysis, with which they can identify the first order ASD and DSD prospects and discern arbitrage opportunities that could increase his/her utility as well as wealth and set up a zero dollar portfolio to make huge profit. Our tools also enable investors and business planners to identify the third order ASD and DSD prospects and make better choices. To complement the stochastic dominance approach, we also introduce an improved mean-variance criterion to decisions in business planning or investment on both return and loss for risk-averse and risk-loving investors. We then illustrate the superiority of the present approaches with well-known examples in the literature and discuss the relationship between the improved stochastic dominance and mean-variance criteria.
    Keywords: Applied probability, Decision analysis, Risk analysis, Risk management, Uncertainty modelling
  5. By: Jeffrey Frankel
    Abstract: This paper is an econometric investigation of the determinants of the real value of the South African rand over the period 1984-2006. The results show a relatively good fit. As so often with exchange rate equations, there is substantial weight on the lagged exchange rate, which can be attributed to a momentum component. Nevertheless, economic fundamentals are significant and important. This is especially true of an index of the real prices of South African mineral commodities, which even drives out real income as a significant determinant of the rand's value. An implication is that the 2003-2006 real appreciation can be attributed to the Dutch Disease. In other respects, the rand behaves like currencies of industrialized countries with well-developed financial markets. In particular, high South African interest rates raise international demand for the rand and lead to real appreciation, controlling for a forward-looking measure of expected inflation and a measure of default risk or country risk. It is in the latter respects, in particular, that the paper hopes to have improved on earlier studies of the rand.
    JEL: F31
    Date: 2007–04

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