New Economics Papers
on Risk Management
Issue of 2007‒10‒20
ten papers chosen by

  1. A Causal Framework for Credit Default Theory By Wilson Sy
  2. Robust Value at Risk Prediction By Loriano Mancini; Fabio Trojani
  3. Applying a Structured Approach to Operational Risk Scenario Analysis in Australia By Emily Watchorn
  4. Credit Risk Models for Managing Bank’s Agricultural Loan Portfolio By Bandyopadhyay, Arindam
  5. Background Filtrations andCanonical Loss Processes for Top-Down Models of Portfolio Credit Risk By Philippe Ehlers; Philipp J. Schoenbucher
  6. Stochastic Volatility: Risk Minimization and Model Risk By Christian-Olivier Ewald; Rolf Poulsen; Klaus Reiner Schenk-Hoppe
  7. The performance of credit rating systems in the assessment of collateral used in Eurosystem monetary policy operations By François Coppens; Fernando Gonzáles; Gerhard Winkler
  8. Sovereign Rating Transitions And The Price Of Default Risk In Emerging Markets By Alena Audzeyeva; Klaus Reiner Schenk-Hoppe
  9. Stock Returns in Mergers and Acquisitions By Dirk Hackbarth; Erwan Morellec
  10. Economic Integration and the Co-movement of Stock Returns By Morgado, Pedro; Tavares, José

  1. By: Wilson Sy (Australian Prudential Regulatory 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.
    Keywords: causal framework; credit default risk; delinquency; insolvency; mortgage defualt
    JEL: B41 C81 D14 E44 G21 G32 G33
    Date: 2007–10–01
  2. By: Loriano Mancini; Fabio Trojani
    Abstract: We propose a general robust semiparametric bootstrap method to estimate conditional predictive distributions of GARCH-type models. Our approach is based on a robust estimator for the parameters in GARCH-type models and a robustified resampling method for standardized GARCH residuals, which controls the bootstrap instability due to influential observations in the tails of standardized GARCH residuals. Monte Carlo simulation showsthat our method consistently provides lower VaR forecast errors, often to a large extent, and in contrast to classical methods never fails validation tests at usual significance levels. We test extensively our approach in the context of real data applications to VaR prediction for market risk, and find that only our robust procedure passes all validation tests at usualconfidence levels. Moreover, the smaller tail estimation risk of robust VaR forecasts implies VaR prediction intervals that can be nearly 20% narrower and 50% less volatile over time. This is a further desirable property of our method, which allows to adapt risky positions to VaR limits more smoothly and thus more efficiently.
    Keywords: Backtesting, M-estimator, Extreme Value Theory, Breakdown Point
    JEL: C14 C15 C23 C59
    Date: 2007–09
  3. By: Emily Watchorn (Australian Prudential Regulation Authority)
    Abstract: Banks intending to apply the Advanced Measurement Approach (AMA) to Operational Risk are required to use scenario analysis as one of the key data inputs into their capital model. Scenario analysis is a forward-looking approach, and it can be used to complement the banks’ short recorded history of operational risk losses, especially for low frequency high impact events (LFHI).
    Date: 2007–09–12
  4. By: Bandyopadhyay, Arindam
    Abstract: In this paper, we have developed a credit scoring model for agricultural loan portfolio of a large Public Sector Bank in India and suggest how such model would help the Bank to mitigate risk in Agricultural lending. The logistic model developed in this study reflects major risk characteristics of Indian agricultural sector, loans and borrowers and designed to be consistent with Basel II, including consideration given to forecasting accuracy and model applicability. In this study, we have shown how agricultural exposures are typically can be managed on a portfolio basis which will not only enable the bank to diversify the risk and optimize the profit in the business, but also will strengthen banker-borrower relationship and enables the bank to expand its reach to farmers because of transparency in loan decision making process.
    Keywords: Credit Risk Modelling; Lending; Agriculture
    JEL: G21 C53 Q14
    Date: 2007–10–12
  5. By: Philippe Ehlers (ETH Zurich, D-MATH); Philipp J. Schoenbucher (ETH Zurich, D-MATH)
    Abstract: In single-obligor default risk modelling, using a background filtration in conjunction with a suitable embedding hypothesis (generally known as H-hypothesis or immersion property) has proven a very successful tool to separate the actual default event from the model for the default arrival intensity. In this paper we analyze the conditions under which this approach can be extended to the situation of a portfolio of several obligors, with a particular focus on the so-called top-down approach. We introduce the natural H-hypothesis of this setup (the successive H-hypothesis) and show that it is equivalent to a seemingly weaker one-step H-hypothesis. Furthermore, we provide a canonical construction of a loss process in this setup and provide closed-form solutions for some generic pricing problems.
    Keywords: credit risk, default correlation, point processes, generalized Cox processes, hypothesis H
    JEL: G13
    Date: 2006–12
  6. By: Christian-Olivier Ewald (School of Mathematics, University of Leeds); Rolf Poulsen (Department of Mathematical Sciences, University of Copenhagen); Klaus Reiner Schenk-Hoppe (School of Mathematics and Leeds University Business School, University of Leeds)
    Abstract: In this paper locally risk-minimizing hedge strategies for European-style contingent claims are derived and tested for a general class of stochastic volatility models. These strategies are as easy to implement as ordinary delta hedges, yet in realistic settings they produce markedly lower hedge errors. Our experimental investigations on model risk furthermore show that locally risk-minimizing hedges are robust with respect to parameter uncertainty as well as misspecifications of the stochastic volatility model.
    Keywords: Locally risk-minimizing hedge, delta hedge, stochastic volatility, model risk
    JEL: C90 G13
    Date: 2007–02
  7. By: François Coppens (National Bank of Belgium, Microeconomic Information Department); Fernando Gonzáles (European Central Bank); Gerhard Winkler (Oesterreichische Nationalbank)
    Abstract: The aims of this paper are twofold: first, we attempt to express the threshold of a single “A” rating as issued by major international rating agencies in terms of annualised probabilities of default. We use data from Standard & Poor’s and Moody’s publicly available rating histories to construct confidence intervals for the level of probability of default to be associated with the single “A” rating. The focus on the single A rating level is not accidental, as this is the credit quality level at which the Eurosystem considers financial assets to be eligible collateral for its monetary policy operations. The second aim is to review various existing validation models for the probability of default which enable the analyst to check the ability of credit assessment systems to forecast future default events. Within this context the paper proposes a simple mechanism for the comparison of the performance of major rating agencies and that of other credit assessment systems, such as the internal ratings-based systems of commercial banks under the Basel II regime. This is done to provide a simple validation yardstick to help in the monitoring of the performance of the different credit assessment systems participating in the assessment of eligible collateral underlying Eurosystem monetary policy operations. Contrary to the widely used confidence interval approach, our proposal, based on an interpretation of p-values as frequencies, guarantees a convergence to an ex ante fixed probability of default (PD) value. Given the general characteristics of the problem considered, we consider this simple mechanism to also be applicable in other contexts.
    Keywords: credit risk, rating, probability of default (PD), performance checking, backtesting
    JEL: G20 G28 C49
    Date: 2007–09
  8. By: Alena Audzeyeva (University of Leeds, Business School); Klaus Reiner Schenk-Hoppe (University of Leeds, School of Mathematics)
    Abstract: This paper introduces an expected value estimator with “expert knowledge” to the robust estimation of sovereign rating transitions which are characterised by few observations. Our estimates of default premia within Mexican, Colombian and Brazilian Eurobond yield spreads provide a better fit than ‘cohort’ and continuous-time observation approaches. The analysis suggests that default risk accounted for a rather small share (decreasing with maturity) of the yield spreads for non-investment grade Colombian and Brazilian Eurobonds in 2003. This share increased while yield spreads fell during 2003-2005 mainly due to non-default risk factors. Default and liquidity premia for investment-grade Mexican spreads both decreased at similar rates.
    Keywords: Emerging markets, sovereign default, rating transitions, yield spreads, default premia
    JEL: G15 C11 F34
    Date: 2007–05
  9. By: Dirk Hackbarth (Washington University, St. Louis - John M. Olin School of Business); Erwan Morellec (University of Lausanne - Institute of Banking and Finance (IBF))
    Abstract: This paper develops a real options framework to analyze the behavior of stock returns in mergers and acquisitions. In this framework, the timing and terms of takeovers are endogenous and result from value-maximizing decisions. The implications of the model for abnormal announcement returns are consistent with the available empirical evidence. In addition, the model generates new predictions regarding the dynamics of firm-level betas for the time period surrounding control transactions. Using a sample of 1090 takeovers of publicly traded US firms between 1985 and 2002, we present new evidence on the dynamics of firm-level betas, which is strongly supportive of the model's predictions.
    Keywords: takeovers, real options, stock returns, firm-level betas
    JEL: G13 G14 G31 G34
    Date: 2006–10
  10. By: Morgado, Pedro; Tavares, José
    Abstract: In this paper we analyze the determinants of co-movements in stock returns among 40 developed and emerging markets, from the 1970s to the 1990s. We provide empirical estimates of the impact of bilateral indicators of economic integration such as bilateral trade intensity, the dissimilarity of export structures, the asymmetry of output growth and bilateral real exchange rate volatility. We find that each indicator has the expected effect on the correlation of stock returns: trade intensity increases the correlation of stock returns, while real exchange rate volatility, the asymmetry of output growth and the degree of export dissimilarity decrease it. We also find that countries with more developed and more analogous institutions - in terms of either rule of law or civil liberties - display a higher correlation of stock returns.
    Keywords: Bilateral Trade Intensity; Co-movement of Stock Returns; Economic Integration; Real Exchange Rate Volatility
    JEL: E44 F15 F36 G15
    Date: 2007–10

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