nep-rmg New Economics Papers
on Risk Management
Issue of 2007‒09‒30
seven papers chosen by
Stan Miles
Thompson Rivers University

  1. A Causal Framework for Credit Default Theory By Wilson Sy
  2. An Extended Structural Credit Risk Model (forthcoming in the Icfai Journal of Financial Risk Management; all copyrights rest with the Icfai University Press) By Marco Realdon
  3. Factoring governance risk into investors´expected rates of return by means of a weighted average governance index By ; Rodolfo Apreda;
  4. An Empirical Analysis of Asset-Backed Securitization By Vink, Dennis
  5. ABS, MBS and CDO compared: an empirical analysis By Vink, Dennis
  6. Short-Sale Constraints and the Non-January Idiosyncratic Volatility Puzzle By Doran, James; Jiang, Danling; Peterson, David
  7. Estimating the Equity Premium By John Y. Campbell

  1. By: Wilson Sy (Australian Prudential Regulation Authority)
    Abstract: Most existing credit default theories do not link causes directly to the effect of default and are unable to evaluate credit risk in a rapidly changing market environment, as experienced in the recent mortgage and credit market crisis. Causal theories of credit default are needed to understand lending risk systematically and ultimately to measure and manage credit risk dynamically for financial system stability. Unlike existing theories, credit default is treated in this paper by a joint model with dual causal processes of delinquency and insolvency. A framework for developing causal credit default theories is introduced through the example of a new residential mortgage default theory. This theory overcomes many limitations of existing theories, solves several outstanding puzzles and integrates both micro and macroeconomic factors in a unified financial economic theory for mortgage default.
    Date: 2007–09–24
  2. By: Marco Realdon
    Abstract: This paper presents an extended structural credit risk model that pro- vides closed form solutions for fixed and floating coupon bonds and credit default swaps. This structural model is an "extended" one in the following sense. It allows for the default free term structure to be driven by the a multi-factor Gaussian model, rather than by a single factor one. Expected default occurs as a latent diffusion process first hits the default barrier, but the diffusion process is not the value of the firm's assets. Default can be "expected" or "unexpected". Liquidity risk is correlated with credit risk. It is not necessary to disentangle the risk of unexpected default from liquidity risk. A tractable and accurate recovery assumption is proposed.
    Keywords: structural credit risk model, Vasicek model, Gaussian term structure model, bond pricing, credit default swap pricing, unexpected default, liquidity risk.
    JEL: G13
    Date: 2007–09
  3. By: ; Rodolfo Apreda;
    Abstract: Although global investors have been paying more heed than ever to Corporate Governance for the last decade, the evolving premium risk stemming from variegated governance issues has not been factored yet into the expected return of any investor’s portfolio. From a theoretical standpoint, this paper sets forth firstly a weighted-average index built up by choosing distinctive and relevant governance variables that go beyond provisions usually embedded in the founding charter. Afterwards, a measure of governance risk premium will be derived out of the index rate of change. Lastly, it will be introduced a multiplicative model of expected returns with a risk adjustment factor over the risk-free asset comprising systematic, nonsystematic, country and governance risk premiums.
    Keywords: governance risk, governance index, governance rate, expected return, risk adjustment
    JEL: G11 G34 G12
    Date: 2007–09
  4. By: Vink, Dennis
    Abstract: In this study we provide empirical evidence demonstrating a relationship between the nature of the assets and the primary market spread. The model also provides predictions on how other pricing characteristics affect spread, since little is known about how and why spreads of asset-backed securities are influenced by loan tranche characteristics. We find that default and recovery risk characteristics represent the most important group in explaining loan spread variability. Within this group, the credit rating dummies are the most important variables to determine loan spread at issue. Nonetheless, credit rating is not a sufficient statistic for the determination of spreads. We find that the nature of the assets has a substantial impact on the spread across all samples, indicating that primary market spread with backing assets that cannot easily be replaced is significantly higher relative to issues with assets that can easily be obtained. Of the remaining characteristics, only marketability explains a significant portion of the spreads’ variability. In addition, variations of the specifications were estimated in order to asses the robustness of the conclusions concerning the determinants of loan spreads.
    Keywords: asset securitization; asset-backed securitisation; bank lending; default risk; risk management; leveraged financing.
    JEL: G21 G20
    Date: 2007–08–28
  5. By: Vink, Dennis
    Abstract: The capital market in which the asset-backed securities are issued and traded is composed of three main categories: ABS, MBS and CDOs. We were able to examine a total number of 3,951 loans (worth €730.25 billion) of which 1,129 (worth €208.94 billion) have been classified as ABS. MBS issues represent 2,224 issues (worth €459.32 billion) and 598 are CDO issues (worth €61.99 billion). We have investigated how common pricing factors compare for the main classes of securities. Due to the differences in the assets related to these securities, the relevant pricing factors for these securities should differ, too. Taking these three classes as a whole, we have documented that the assets attached as collateral for the securities differ between security classes, but that there are also important univariate differences to consider. We found that most of the common pricing characteristics between ABS, MBS and CDO differ significantly. Furthermore, applying the same pricing estimation model to each security class revealed that most of the common pricing characteristics associated with these classes have a different impact on the primary market spread exhibited by the value of the coefficients. The regression analyses we performed demonstrated econometrically that ABS, MBS, and CDOs are in fact different financial instruments.
    Keywords: asset securitization; asset-backed securitisation; bank lending; default risk; risk management; spreads; leveraged financing
    JEL: G12 G0 G21
    Date: 2007–08–28
  6. By: Doran, James; Jiang, Danling; Peterson, David
    Abstract: The underperformance of high idiosyncratic volatility stocks, as documented by Ang, Hodrick, Ying, and Zhang (2006, JF), is a pure non-January phenomenon. This non-January negative relation between idiosyncratic volatility and stock returns is more pronounced among firms with greater constraints in short selling, and when short-sale constraints are mitigated from the introduction of options and the end of the IPO lockup period. Apart from an average underperformance, highly volatile stocks also have the greatest dispersion in expected returns and in price reactions around earnings announcements. These findings support behavioral models suggesting that noise trading and investor overconfidence, combined with short-sale constraints, generate excess volatility, greater mispricing, and on average lower expected returns.
    Keywords: Idiosyncratic Volatility; January Effect; Limits of Arbitrage; Short-Sale Constraints; Noise Trading; Overconfidence
    JEL: G12 G14
    Date: 2007–08–07
  7. By: John Y. Campbell
    Abstract: To estimate the equity premium, it is helpful to use finance theory: not the old-fashioned theory that efficient markets imply a constant equity premium, but theory that restricts the time-series behavior of valuation ratios, and that links the cross-section of stock prices to the level of the equity premium. Under plausible conditions, valuation ratios such as the dividend-price ratio should not have trends or explosive behavior. This fact can be used to strengthen the evidence for predictability in stock returns. Steady-state valuation models are also useful predictors of stock returns given the high degree of persistence in valuation ratios and the difficulty of estimating free parameters in regression models for stock returns. A steady-state approach suggests that the world geometric average equity premium was almost 4% at the end of March 2007, implying a world arithmetic average equity premium somewhat above 5%. Both valuation ratios and the cross-section of stock prices imply that the equity premium fell considerably in the late 20th Century, but has risen modestly in the early years of the 21st Century.
    JEL: G12
    Date: 2007–09

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