New Economics Papers
on Risk Management
Issue of 2007‒06‒02
fourteen papers chosen by

  1. An Analysis of Off-Site Supervision of Banks' Profitability, Risk and Capital Adequacy: a portfolio simulation approach applied to brazilian banks By Theodore M. Barnhill; Marcos R. Souto; Benjamin M. Tabak
  2. Risk Premium: Insights Over The Threshold By José L. B. Fernandes; Augusto Hasman; Juan Ignacio Peña
  3. Volatility modelling and accurate minimun capital risk requirements : a comparison among several approaches By Aurea Grane; Helena Veiga
  4. Predictability in Financial Markets: What Do Survey Expectations Tell Us? By Philippe Bacchetta; Elmar Mertens; Eric VanvWincoop
  5. Evaluation of Default Risk for The Brazilian Banking Sector By Marcelo Y. Takami; Benjamin M. Tabak
  6. A New Proposal for Collection and Generation of Information on Financial Institutions' Risk: the case of derivatives By Gilneu F. A. Vivan; Benjamin M. Tabak
  7. Feedback Effects of Rating Downgrades By Fulop, Andras
  8. Credit Risk Monte Carlos Simulation Using Simplified Creditmetrics' Model: the joint use of importance sampling and descriptive sampling By Jaqueline Terra Moura Marins; Eduardo Saliby
  9. Estimating the Structural Credit Risk Model When Equity Prices Are Contaminated by Trading Noises By Duan, Jin-Chuan; Fulop, Andras
  10. Interdependence and Contagion: an Analysis of Information Transmission in Latin America's Stock Markets By Angelo Marsiglia Fasolo
  11. Contagion, Bankruptcy and Social Welfare Analysis in a Financial Economy with Risk Regulation Constraint By Aloísio P. Araújo; José Valentim M. Vicente
  12. The Dynamic Relationship between Stock Prices and Exchange Rates: evidence for Brazil By Benjamin M. Tabak
  13. The Use of Mortgage Covered Bonds By Antonio Garcia Pascual; Elina Ribakova; Renzo G. Avesani
  14. The Small World of Investing: Board Connections and Mutual Fund Returns By Lauren Cohen; Andrea Frazzini; Christopher Malloy

  1. By: Theodore M. Barnhill; Marcos R. Souto; Benjamin M. Tabak
    Abstract: In most countries, the role of off-site bank supervision involves continuous monitoring of profitability, risk and capital adequacy. The objective of this article is to demonstrate the value of bringing together advanced modeling techniques with data on banks' assets and liabilities and credit worthiness. More specifically, we apply an integrated market and credit risk simulation methodology to a group of six hypothetical banks. We show the capacity of the methodology: (i) to simulate credit transition probabilities of default close to the historical values estimated by the Central Bank of Brazil; and (ii) to simulate asset and equity returns that are unbiased estimators of average historical returns and standard deviations. Our results also indicate that: (i) a sharp reduction in the interest rate spreads of Brazilian banks reduces bank profitability and increases the probability of default; and (ii) most banks have low probability of bankruptcy. Our position is that utilization of forward looking risk evaluation methodologies in databases, such as those developed by the Central Bank of Brazil, has significant potential as an instrument of indirect supervision to identify potential risks before they materialize.
    Date: 2006–09
  2. By: José L. B. Fernandes; Augusto Hasman; Juan Ignacio Peña
    Abstract: The aim of this paper is twofold: First to test the adequacy of Pareto distributions to describe the tail of financial returns in emerging and developed markets, and second to study the possible correlation between stock market indices observed returns and return’s extreme distributional characteristics measured by Value at Risk and Expected Shortfall. We test the empirical model using daily data from 41 countries, in the period from 1995 to 2005. The findings support the adequacy of Pareto distributions and the use of a log linear regression estimation of their parameters, as an alternative for the usually employed Hill’s estimator. We also report a significant relationship between extreme distributional characteristics and observed returns, especially for developed countries.
    Date: 2006–12
  3. By: Aurea Grane; Helena Veiga
    Abstract: In this paper we estimate, for several investment horizons, minimum capital risk requirements for short and long positions, using the unconditional distribution of three daily indexes futures returns and a set of GARCH-type and stochastic volatility models. We consider the possibility that errors follow a t-Student distribution in order to capture the kurtosis of the returns distributions. The results suggest that an accurate modeling of extreme returns obtained for long and short trading investment positions is possible with a simple autoregressive stochastic volatility model. Moreover, modeling volatility as a fractional integrated process produces, in general, excessive volatility persistence and consequently leads to large minimum capital risk requirement estimates. The performance of models is assessed with the help of out-of-sample tests and p-values of them are reported.
    Date: 2007–05
  4. By: Philippe Bacchetta (Study Center Gerzensee, University of Lausanne, Swiss Finance Institute & CEPR); Elmar Mertens (Study Center Gerzensee & University of Lausanne); Eric VanvWincoop (University of Virginia & NBER)
    Abstract: There is widespread evidence of excess return predictability in financial markets.vIn this paper we examine whether this predictability is related to expectational errors. To consider this issue, we use data on survey expectations of market participants in the stock market, the foreign exchange market, and the bond and money markets in various countries. We find that the predictability of expectational errors coincides with the predictability of excess returns: when a variable predicts expectational errors in a given market, it typically predicts the excess return as well. Understanding expectational errors appears crucial for explaining excess return predictability.
    Keywords: excess returns, expectations survey, predictability
    JEL: F31 G12 G14
    Date: 2006–07
  5. By: Marcelo Y. Takami; Benjamin M. Tabak
    Abstract: This paper employs new methods to measure and monitor risk in the Brazilian banking sector. We prove that the option-based risk measure is negatively sensitive to interest rates. As this is an important issue for emerging market economies, the risk measures are built as deviations from mean. Additionally, the option-based indicator is compared with market-based financial fragility indicators. Results show that these indicators are useful for risk managers and regulators, especially during crisis. Furthermore, option-based methods are preferable to classify banks in periods of high distress, such as the banking crises that occurred in the early nineties in Brazil.
    Date: 2007–05
  6. By: Gilneu F. A. Vivan; Benjamin M. Tabak
    Abstract: This article aims at providing a new alternative for the collection of information on risks taken by financial institutions, which enables the calculation of risk tools usually used in risk management, such as VaR and stress tests. This approach should help risk managers, off-site supervision and academics in assessing the potential risks in financial institutions principally due to derivatives positions. The basic idea, for linear financial instruments, like the traditionally used by the management risk systems, is to reduce positions in risk factors and then mapping by vertices. For the nonlinear financial instruments all of the positions in different types of options – European, Americans, exotic, etc.– are represented as plain vanilla European options or replicated by portfolios of plain vanilla European options. The methodology was applied to Brazil, within the worst scenarios during the period from 1994 to 2004, and the paper demonstrates that the proposed approach captured the risks satisfactorily in the analyzed portfolios, including the risk existent in the strategies involving options, given an accepted error margin. This approach could be useful for regulators, risk managers; financial institutions and risk management modeling as it can be used as an input in general risk management models.
    Date: 2007–03
  7. By: Fulop, Andras (ESSEC Business School)
    Abstract: This paper addresses whether credit rating downgrades feed back on the asset value of the downgraded companies, causing real losses. To investigate this issue we construct a structural credit risk model incorporating ratings and the feedback loss. To estimate the parameters of the model we develop a maximum likelihood estimator using time series of equity prices and credit ratings. Implementing the model on a sample of US public firms downgraded from investment grade to junk, we find strong support for the existence of feedback losses. First, estimated feedback losses are significant for a third of our sample with the cross-sectional averages of the feedback loss around 7 %. Second, the behavior of estimated asset volatilities around downgrades in real data is consistent with the predictions of our model. We observe a hump-shaped pattern of estimated asset volatilities when feedback is ignored. Using the feedback model, the hump-shaped pattern disappears. These findings suggest that ignoring feedback can lead to the appearance of changing asset volatility even when the real volatility is constant. Last, accounting for feedback helps in asset volatility prediction.
    Keywords: Credit Ratings; Credit Risk; Distress Costs; Maximum Likelihood; Option Pricing
    JEL: C22 G00
    Date: 2006–10
  8. By: Jaqueline Terra Moura Marins; Eduardo Saliby
    Abstract: Monte Carlo simulation is implemented in some of the main models for estimating portfolio credit risk, such as CreditMetrics, developed by Gupton, Finger and Bhatia (1997). As in any Monte Carlo application, credit risk simulation according to this model produces imprecise estimates. In order to improve precision, simulation sampling techniques other than traditional Simple Random Sampling become indispensable. Importance Sampling (IS) has already been successfully implemented by Glasserman and Li (2005) on a simplified version of CreditMetrics, in which only default risk is considered. This paper tries to improve even more the precision gains obtained by IS over the same simplified CreditMetrics' model. For this purpose, IS is here combined with Descriptive Sampling (DS), another simulation technique which has proved to be a powerful variance reduction procedure. IS combined with DS was successful in obtaining more precise results for credit risk estimates than its standard form.
    Date: 2007–03
  9. By: Duan, Jin-Chuan (Rotman School of Management, University of Toronto); Fulop, Andras (ESSEC Business School)
    Abstract: The transformed-data maximum likelihood estimation (MLE) method for structural credit risk models developed by Duan (1994) is extended to account for the fact that observed equity prices may have been contaminated by trading noises. With the presence of trading noises, the likelihood function based on the observed equity prices can only be evaluated via some nonlinear filtering scheme. We devise a particle filtering algorithm that is practical for conducting the MLE estimation of the structural credit risk model of Merton (1974). We implement the method on the Dow Jones 30 firms and on 100 randomly selected firms, and find that ignoring trading noises can lead to significantly over-estimating the firm’s asset volatility. The estimated magnitude of trading noise is in line with the direction that a firm’s liquidity will predict based on three common liquidity proxies. A simulation study is then conducted to ascertain the performance of the estimation method.
    Keywords: Credit Risk; Maximum Likelihood; Microstructure; Option Pricing; Particle Filtering
    JEL: C22
    Date: 2006–10
  10. By: Angelo Marsiglia Fasolo
    Abstract: This paper brings evidences about the hypotheses of financial crisis contagion over Latin American stock markets in the 90's using a multivariate GARCH model. Beside the traditional volatility structure, we added a leverage term like GJR framework in order to avoid problems due to the use of conditional correlation as a measure of relationship between stock markets. The results show the existence of contagion only during the Asian (1997) and the Russian (1998) crises. The consequences of the Brazilian crisis (1999) can be identified as a result of interdependence among Latin American markets, while the crises of Mexico (1994) and Argentina (2001) show a specific mechanism of propagation. This result raises questions about the "contagion" and "interdependence" concepts' adequacy for the analysis of information transmission among stock markets.
    Date: 2006–07
  11. By: Aloísio P. Araújo; José Valentim M. Vicente
    Abstract: In the last years, regulatory agencies of many countries in the world, following recomendations of Basel Committee, have compeled financial institutions to maintain a minimum capital requirements to cover market and credit risks. This paper investigates the consequences about social welfare, contagion and the bankruptcy probability of such practice. We show that for each financial institution there is a level of regulation that maximizes its utility. Another important result asserts that risk regulation decreases contagion and under certain conditions can reduce the bankruptcy probability. We also analyze the trade-off faced by regulators involving the financial institutions welfare versus bankruptcy and contagion probabilities.
    Date: 2006–10
  12. By: Benjamin M. Tabak
    Abstract: This paper studies the dynamic relationship between stock prices and exchange rates in the Brazilian economy. We use recently developed unit root and cointegration tests, which allow endogenous breaks, to test for a long run relationship between these variables. We performed linear, and nonlinear causality tests after considering both volatility and linear dependence. We found that there is no long-run relationship, but there is linear Granger causality from stock prices to exchange rates, in line with the portfolio approach: stock prices lead exchange rates with a negative correlation. Furthermore, we found evidence of nonlinear Granger causality from exchange rates to stock prices, in line with the traditional approach: exchange rates lead stock prices. We believe these findings have practical applications for international investors
    Date: 2006–11
  13. By: Antonio Garcia Pascual; Elina Ribakova; Renzo G. Avesani
    Abstract: The rapid mortgage credit growth experienced in recent years in mature and emerging countries has raised some stability concerns. Many European credit institutions in mature markets have reacted by increasing securitization, particularly via mortgage covered bonds. From the issuer's perspective, these instruments have become an attractive funding source and a tool for assetliability management; from the investor's perspective, covered bonds enjoy a favorable risk-return profile and a very liquid market. In this paper, we examine the two largest "jumbo" covered bond markets, Germany and Spain. We show how movements in covered bond prices can be used to analyze the credit developments of the underlying issuer and the quality of its mortgage portfolio. Our analysis also suggests that mortgage covered bonds could be of interest to other mature and emerging markets facing similar risks related to mortgage credit.
    Keywords: Bonds , Germany , Spain , Credit , Financial institutions , Economic indicators ,
    Date: 2007–02–01
  14. By: Lauren Cohen; Andrea Frazzini; Christopher Malloy
    Abstract: This paper uses social networks to identify information transfer in security markets. We focus on connections between mutual fund managers and corporate board members via shared education networks. We find that portfolio managers place larger bets on firms they are connected to through their network, and perform significantly better on these holdings relative to their non-connected holdings. A replicating portfolio of connected stocks outperforms a replicating portfolio of non-connected stocks by up to 8.4% per year. Returns are concentrated around corporate news announcements, consistent with mutual fund managers gaining an informational advantage through the education networks. Our results suggest that social networks may be an important mechanism for information flow into asset prices.
    JEL: G10 G11 G14
    Date: 2007–05

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