nep-rmg New Economics Papers
on Risk Management
Issue of 2007‒11‒03
six papers chosen by
Stan Miles
Thompson Rivers University

  1. How useful are historical data for forecasting the long-run equity return distribution? By John M. Maheu; Thomas H. McCurdy
  2. Asset correlations and credit portfolio risk: an empirical analysis By Düllmann, Klaus; Scheicher, Martin; Schmieder, Christian
  3. On the robustness of international portfolio diversification benefits to regime-switching volatility By Thomas J.Flavin; Ekaterini Panopoulou
  4. Hedging tranches index products : illustration of model dependency By Dominique Guegan; Julien Houdain
  5. Crisis-Robust Bond Portfolios By Marie Brière; Ariane Szafarz
  6. The Equity Premium Puzzle, Ambiguity Aversion, and Institutional Quality By S. Nuri Erbas; Abbas Mirakhor

  1. By: John M. Maheu (University of Toronto, Canada and The Rimini Centre for Economics Analysis, Rimini, Italy.); Thomas H. McCurdy (University of Toronto, Canada)
    Abstract: We provide an approach to forecasting the long-run (unconditional) distribution of equity returns making optimal use of historical data in the presence of structural breaks. Our focus is on learning about breaks in real time and assessing their impact on out-of-sample density forecasts. Forecasts use a probability-weighted average of submodels, each of which is estimated over a different historyof data. The paper illustrates the importance of uncertainty about structural breaks and the value of modeling higher-order moments of excess returns when forecasting the return distribution and its moments. The shape of the long-run distribution and the dynamics of the higher-order moments are quite different from those generated by forecasts which cannot capture structural breaks. The empirical results strongly reject ignoring structural change in favor of our forecasts which weight historical data to accommodate uncertainty about structural breaks. We also strongly reject the common practice of using a fixed-length moving window. These differences in long-run forecasts have implications for many financial decisions, particularly for risk management and long-run investment decisions.
    Keywords: density forecasts, structural change, model risk, parameter uncertainty, Bayesian learning, market returns
    JEL: F22 J24 J61
    Date: 2007–07
  2. By: Düllmann, Klaus; Scheicher, Martin; Schmieder, Christian
    Abstract: In credit risk modelling, the correlation of unobservable asset returns is a crucial component for the measurement of portfolio risk. In this paper, we estimate asset correlations from monthly time series of Moody’s KMV asset values for around 2,000 European firms from 1996 to 2004. We compare correlation and value-atrisk (VaR) estimates in a one–factor or market model and a multi-factor or sector model. Our main finding is a complex interaction of credit risk correlations and default probabilities affecting total credit portfolio risk. Differentiation between industry sectors when using the sector model instead of the market model has only a secondary effect on credit portfolio risk, at least for the underlying credit portfolio. Averaging firm-dependent asset correlations on a sector level can, however, cause a substantial underestimation of the VaR in a portfolio with heterogeneous borrower size. This result holds for the market as well as the sector model. Furthermore, the VaR of the IRB model is more stable over time than the VaR of the market model and the sector model, while its distance from the other two models fluctuates over time.
    Keywords: Asset correlations, sector concentration, credit portfolio risk
    JEL: C15 G21
    Date: 2007
  3. By: Thomas J.Flavin (Economics, National University of Ireland, Maynooth); Ekaterini Panopoulou (Department of Statistics and Insurance Science, University of Piraeus, Greece)
    Abstract: We examine if the benefits of international portfolio diversification are robust to time-varying asset return volatility. Since diversified portfolios are subject to common cross-country shocks, we focus on the transmission mechanism of such shocks in the presence of regime-switching volatility. Generally, market linkages are stable with little evidence of increased market interdependence in turbulent periods. Furthermore, risk reduction is consistently delivered for the US investor who holds foreign equity.
    Keywords: Market comovement; Shift contagion; Financial market crises; International portfolio diversification; Regime switching
    JEL: F42 G15 C32
    Date: 2007
  4. By: Dominique Guegan (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Panthéon-Sorbonne - Paris I); Julien Houdain (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Panthéon-Sorbonne - Paris I)
    Abstract: In this paper, index tranches’properties and several hedging strategies are discussed. Model risk and correlation risk are analysed through the study of the efficiency of several factor based copula models, like the Gaussian, the double-t and the double NIG using implied correlation and a particular NIG one factor model, using historical data in terms of hedging capabilities.
    Keywords: CDO – Factor models – NIG distribution
    Date: 2006
  5. By: Marie Brière (Centre Emile Bernheim, Solvay Business School, Université Libre de Bruxelles, Brussels.); Ariane Szafarz (Centre Emile Bernheim, Solvay Business School, Université Libre de Bruxelles, Brussels and DULBEA, Brussels.)
    Abstract: This paper defines a “crisis-robust portfolio” that satisfies the minimal crisis-to-quiet time volatility ratio. This type of portfolio is less demanding for the investor than a regime-wise asset allocation. Although general, the concept of a crisis-robust portfolio is especially pertinent when applied to the bond market, which offers a flight-to-quality trade-off during crises (all volatilities increase but most correlations decrease). Using three categories of bonds (sovereign, investment grade corporate, and high yield corporate) in the U.S. and Eurozone for the period 1998-2007, we demonstrate the composition of crisis-robust portfolios and discuss the stabilizing role played by low-quality bonds during crises.
    Keywords: financial crisis, portfolio management, bonds, fly-to-quality.
    JEL: G11 G15 N20
    Date: 2007–10
  6. By: S. Nuri Erbas; Abbas Mirakhor
    Abstract: With cross-section data from 53 emerging and mature markets, we provide evidence that equity premium puzzle is a global phenomenon. In addition to risk aversion, equity premium may reflect ambiguity aversion. We explore the sources of equity premium using some pertinent fundamental independent variables, as well as the World Bank institutional quality indexes and other proxies for the degree of ambiguity in the sample countries. Some World Bank and other indexes are statistically significant, which indicates that a large part of equity premium may reflect investor aversion to ambiguities resulting from institutional weaknesses.
    Keywords: Working Paper , Risk premium , Stock prices ,
    Date: 2007–10–01

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