nep-rmg New Economics Papers
on Risk Management
Issue of 2007‒06‒18
fifteen papers chosen by
Stan Miles
Thompson Rivers University

  1. Determinants of Insurers’ Performance in Risk Pooling, Risk Management, and Financial Intermediation Activities By Georges Dionne; Robert Gagné; Abdelhakim Nouira
  2. Extreme risk in Asian equity markets By Cotter, John
  3. Evaluating the Precision of Estimators of Quantile-Based Risk Measures By Cotter, John; Dowd, Kevin
  4. The pricing of portfolio credit risk By Nikola A. Tarashev; Haibin Zhu
  5. An empirical evaluation of structural credit risk models By Nikola A. Tarashev
  6. Business Process Risk Management, Compliance and Internal Control: A Research Agenda By Rikhardsson, Pall; Best, Peter; Green, Peter; Rosemann, Michael
  7. Hedging Effectiveness under Conditions of Asymmetry By Cotter, John; Hanly, James
  8. Estimating financial risk measures for futures positions: a non-parametric approach By Cotter, John; Dowd, Kevin
  9. An assessment of Basel II procyclicality in mortgage portfolios By Jesús Saurina; Carlos Trucharte
  10. Exponential Spectral Risk Measures By Cotter, John; Dowd, Kevin
  11. Risk in financial reporting: status, challenges and suggested directions By Claudio E. V. Borio; Kostas Tsatsaronis
  12. Modeling Long Memory in REITs By Cotter, John; Stevenson, Simon
  13. Intra-Day Seasonality in Foreign Exchange Market Transactions By Cotter, John; Dowd, Kevin
  14. The tail risks of FX return distributions: a comparison of the returns associated with limit orders and market orders By Cotter, John; Dowd, Kevin
  15. Predictable Returns and Asset Allocation: Should a Skeptical Investor Time the Market? By Jessica A. Wachter; Missaka Warusawitharana

  1. By: Georges Dionne (HEC Montréal); Robert Gagné (IEA, HEC Montréal); Abdelhakim Nouira
    Abstract: Corporate finance theory predicts that firms’ characteristics affect agency costs and hence their efficiency. Cummins et al (2006) have proposed a cost function specification that measures separately insurer efficiency in handling risk pooling, risk management, and financial intermediation functions. We investigate the insurer characteristics that determine these efficiencies. Our empirical results show that mutuals outperform stock insurers in handling the three functions. Independent agents and high capitalization reduce the cost efficiency of risk pooling. Certain characteristics such as being a group of affiliated insurers, handling a higher volume of business in commercial lines, assuming more reinsurance, or investing a higher proportion of assets in bonds, do significantly increase insurers’ efficiency in risk management and financial intermediation.
    Keywords: Risk pooling, risk management, financial intermediation, property-liability insurance, efficiency, agency costs.
    JEL: D21 D23 G22
    Date: 2007–04
  2. By: Cotter, John
    Abstract: Extreme price movements associated with tail returns are catastrophic for all investors and it is necessary to make accurate predictions of the severity of these events. Choosing a time frame associated with large financial booms and crises this paper investigates the tail behaviour of Asian equity market returns and quantifies two risk measures, quantiles and average losses, along with their associated average waiting periods. Extreme value theory using the Peaks over Threshold method generates the risk measures where tail returns are modelled with a fat-tailed Generalised Pareto Distribution. We find that lower tail risk measures are more severe than upper tail realisations at the lowest probability levels. Moreover, the Kuala Lumpar Composite exhibits the largest risk measures.
    JEL: G15 G1
    Date: 2007
  3. By: Cotter, John; Dowd, Kevin
    Abstract: This paper examines the precision of estimators of Quantile-Based Risk Measures (Value at Risk, Expected Shortfall, Spectral Risk Measures). It first addresses the question of how to estimate the precision of these estimators, and proposes a Monte Carlo method that is free of some of the limitations of existing approaches. It then investigates the distribution of risk estimators, and presents simulation results suggesting that the common practice of relying on asymptotic normality results might be unreliable with the sample sizes commonly available to them. Finally, it investigates the relationship between the precision of different risk estimators and the distribution of underlying losses (or returns), and yields a number of useful conclusions.
    JEL: G00
    Date: 2007
  4. By: Nikola A. Tarashev; Haibin Zhu
    Abstract: Equity and credit-default-swap (CDS) markets are in disagreement as to the extent to which asset returns co-move across firms. This suggests market segmentation and casts ambiguity about the asset-return correlations underpinning observed prices of portfolio credit risk. The ambiguity could be eliminated by – currently unavailable – data that reveal the market valuation of low-probability/large-impact events. At present, judicious assumptions about this valuation can be used to reconcile observed prices with asset-return correlations implied by either equity or CDS markets. These conclusions are based on an analysis of tranche spreads of a popular CDS index, which incorporate a rather small premium for correlation risk.
    Keywords: CDS index tranche, joint distribution of asset returns, correlation risk premium, copula
    JEL: C15 G13
    Date: 2006–09
  5. By: Nikola A. Tarashev
    Abstract: This paper evaluates empirically the performance of six structural credit risk models by comparing the probabilities of default (PDs) they deliver to ex post default rates. In contrast to previous studies pursuing similar objectives, the paper employs firm-level data and finds that theory-based PDs tend to match closely the actual level of credit risk and to account for its time path. At the same time, nonmodelled macro variables from the financial and real sides of the economy help to substantially improve the forecasts of default rates. The finding suggests that theory-based PDs fail to fully reflect the dependence of credit risk on the business and credit cycles. Most of the upbeat conclusions regarding the performance of the PDs are due to models with endogenous default. For their part, frameworks that assume exogenous default tend to underpredict credit risk. Three borrower characteristics influence materially the predictions of the models: the leverage ratio; the default recovery rate; and the risk-free rate of return.
    Keywords: Basel II, Probability of default, Credit risk models, Macroeconomic factors of credit risk
    JEL: C52 G1 G3
    Date: 2005–07
  6. By: Rikhardsson, Pall (Department of Management Science and Logistics, Aarhus School of Business); Best, Peter (Faculty of Business); Green, Peter (The University of Queensland Business School); Rosemann, Michael (Faculty of Information Technology)
    Abstract: Integration of risk management and management control is emerging as an important area in the wake of the Sarbanes-Oxley Act and with ongoing development of frameworks such as the Enterprise Risk Management (ERM) framework from the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on an inductive methodological approach using literature review and interviews with managers engaged in risk management and internal control projects, this paper identifies three main areas that currently have management attention. These are business process risk management, compliance management and internal control development. This paper discusses these areas and identifies a series of research questions regarding these critical issues
    Keywords: Risk management; Internal control; Business processes; Compliance; Sarbanes-Oxley Act; ERP systems; COSO; COBIT
    Date: 2006–09–18
  7. By: Cotter, John; Hanly, James
    Abstract: We examine whether hedging effectiveness is affected by asymmetry in the return distribution by applying tail specific metrics to compare the hedging effectiveness of short and long hedgers using Oil futures contracts. The metrics used include Lower Partial Moments (LPM), Value at Risk (VaR) and Conditional Value at Risk (CVAR). Comparisons are applied to a number of hedging strategies including OLS and both Symmetric and Asymmetric GARCH models. Our findings show that asymmetry reduces in-sample hedging performance and that there are significant differences in hedging performance between short and long hedgers. Thus, tail specific performance metrics should be applied in evaluating hedging effectiveness. We also find that the Ordinary Least Squares (OLS) model provides consistently good performance across different measures of hedging effectiveness and estimation methods irrespective of the characteristics of the underlying distribution.
    Keywords: Hedging Performance; Asymmetry; Downside Risk; Value at Risk, Conditional Value at Risk. JEL classification: G10, G12, G15. ____________________________________________________________________ John Cotter, Director of Centre for Financial Markets, Department of Banking and Finance, University College Dublin, Blackrock, Co. Dublin, Ireland, tel 353 1 716 8900, e-mail Jim Hanly, School of Accounting and Finance, Dublin Institute of Technology, tel 353 1 402 3180, e-mail The authors would like to thank the participants at the Global Finance Annual Conference for their constructive comments.
    JEL: G15 G13
    Date: 2007
  8. By: Cotter, John; Dowd, Kevin
    Abstract: This paper presents non-parametric estimates of spectral risk measures applied to long and short positions in 5 prominent equity futures contracts. It also compares these to estimates of two popular alternative measures, the Value-at-Risk (VaR) and Expected Shortfall (ES). The spectral risk measures are conditioned on the coefficient of absolute risk aversion, and the latter two are conditioned on the confidence level. Our findings indicate that all risk measures increase dramatically and their estimators deteriorate in precision when their respective conditioning parameter increases. Results also suggest that estimates of spectral risk measures and their precision levels are of comparable orders of magnitude as those of more conventional risk measures. Running head: financial risk measures for futures positions.
    JEL: G10 G00
    Date: 2007
  9. By: Jesús Saurina (Banco de España); Carlos Trucharte (Banco de España)
    Abstract: In this paper we develop a probability of default (PD) model for mortgage loans, taking advantage of the Spanish Credit Register, a comprehensive database on loan characteristics and credit quality. From that model, we calculate different types of PDs: point in time, PIT, through the cycle, TTC, average across the cycle and acyclical. Then, we compare capital requirements coming from the different Basel II approaches. We show that minimum regulatory capital under Basel II can be very sensitive to the risk measurement methodology employed. Thus, the procyclicality of regulatory capital requirements under Basel II is an open question, depending on the way internal rating systems are implemented and their output is utilised. We focus on the mortgage portfolio since it is one of the most under researched areas regarding the impact of Basel II and because it is one of the most important banks’ portfolios.
    Keywords: procyclicality, basel ii, rating systems, mortgages
    JEL: E32 G18 G21
    Date: 2007–05
  10. By: Cotter, John; Dowd, Kevin
    Abstract: Spectral risk measures are attractive risk measures as they allow the user to obtain risk measures that reflect their subjective risk-aversion. This paper examines spectral risk measures based on an exponential utility function, and finds that these risk measures have nice intuitive properties. It also discusses how they can be estimated using numerical quadrature methods, and how confidence intervals for them can be estimated using a parametric bootstrap. Illustrative results suggest that estimated exponential spectral risk measures obtained using such methods are quite precise in the presence of normally distributed losses.
    JEL: G10 G0
    Date: 2007
  11. By: Claudio E. V. Borio; Kostas Tsatsaronis
    Abstract: Advances in risk measurement technology have reshaped financial markets and the functioning of the financial system. More recently, they have been reshaping the prudential framework. Looking forward, they have the potential to reshape financial reporting too. Recent initiatives to improve financial reporting standards have brought to the fore significant differences in perspective between accounting standard setters and prudential authorities. Building on previous work, we argue that risk measurement and management technology can be instrumental in bridging this gap and, by the same token, in improving financial reporting. Risk measurement plays a crucial role in the measurement, verification and validation of valuations. It is the basis for giving more prominence to risk and measurement error information in public disclosures. And it could act as more of a focal point in the design of accounting standards, as greater consistency between sound risk management practices and accounting standards can help to narrow the wedge between accounting and underlying economic valuations.
    Keywords: risk measurement and management, accounting, regulation, financial reporting
    JEL: D52 G00 G12 G28 M41
    Date: 2006–08
  12. By: Cotter, John; Stevenson, Simon
    Abstract: One stylized feature of financial volatility impacting the modeling process is long memory. This paper examines long memory for alternative risk measures, observed absolute and squared returns for Daily REITs and compares the findings for a market equity index. The paper utilizes a variety of tests for long memory finding evidence that REIT volatility does display persistence. Trading volume is found to be strongly associated with long memory. The results do however suggest differences in the findings with regard to REITs in comparison to the broader equity sector.
    JEL: G0
    Date: 2007
  13. By: Cotter, John; Dowd, Kevin
    Abstract: This paper examines the intra-day seasonality of transacted limit and market orders in the DEM/USD foreign exchange market. Empirical analysis of completed transactions data based on the Dealing 2000-2 electronic inter-dealer broking system indicates significant evidence of intraday seasonality in returns and return volatilities under usual market conditions. Moreover, analysis of realised tail outcomes supports seasonality for extraordinary market conditions across the trading day.
    JEL: G15 G1
    Date: 2007
  14. By: Cotter, John; Dowd, Kevin
    Abstract: This paper measures and compares the tail risks of limit and market orders using Extreme Value Theory. The analysis examines realised tail outcomes using the Dealing 2000-2 electronic broking system based on completed transactions rather than the more common analysis of indicative quotes. In general, limit and market orders exhibit broadly similar tail behaviour, but limit orders have significantly heavier tails and larger tail quantiles than market orders.
    JEL: G20 G0
    Date: 2007
  15. By: Jessica A. Wachter; Missaka Warusawitharana
    Abstract: Are excess returns predictable and if so, what does this mean for investors? Previous literature has tended toward two polar viewpoints: that predictability is useful only if the statistical evidence for it is incontrovertible, or that predictability should affect portfolio choice, even if the evidence is weak according to conventional measures. This paper models an intermediate view: that both data and theory are useful for decision-making. We investigate optimal portfolio choice for an investor who is skeptical about the amount of predictability in the data. Skepticism is modeled as an informative prior over the R^2 of the predictive regression. We find that the evidence is sufficient to convince even an investor with a highly skeptical prior to vary his portfolio on the basis of the dividend-price ratio and the yield spread. The resulting weights are less volatile and deliver superior out-of-sample performance as compared to the weights implied by an entirely model-based or data-based view.
    JEL: C11 C32 G11
    Date: 2007–06

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