New Economics Papers
on Risk Management
Issue of 2008‒01‒12
fourteen papers chosen by

  1. Value-at-Risk and Expected Shortfall when there is long range dependence. By Wolfgang Härdle; Julius Mungo
  2. Corporate Cash Flow and Stock Price Exposures to Foreign Exchange Rate Risk By Bartram, Söhnke M.
  3. Balance-sheet ratios and stock returns: An analysis for Italian banks By Angela Romagnoli
  4. Identifying common spectral and asymmetric features in stock returns By Caiado, Jorge; Crato, Nuno
  5. Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance By Xavier Gabaix
  6. Crossing the Lines: The Conditional Relation between Exchange Rate Exposure and Stock Returns in Emerging and Developed Markets By Bartram, Söhnke M.
  7. In the core of longevity risk: hidden dependence in stochastic mortality models and cut-offs in prices of longevity swaps By Stéphane Loisel; Daniel Serant
  8. What captures liquidity risk? A comparison of trade and order based liquidity factors By Lorán Chollete; Randi Næs; Johannes A. Skjeltorp
  9. Finite-Time Horizon Ruin Probabilities for Independent or Dependent Claim Amounts By Stéphane Loisel; Claude Lefèvre
  10. Liquidity-Induced Dynamics in Futures Markets By Fagan, Stephen; Gencay, Ramazan
  11. The Default Risk of Firms Examined with Smooth Support Vector Machines By Wolfgang Härdle; Yuh-Jye Lee; Dorothea Schäfer; Yi-Ren Yeh
  12. The Bayesian Additive Classification Tree Applied to Credit Risk Modelling By Junni L. Zhang; Wolfgang Härdle
  13. Lessons from the 2007 Financial Crisis By Buiter, Willem H
  14. An alternative framework for foreign exchange risk management of sovereign debt By Melecky, Martin

  1. By: Wolfgang Härdle; Julius Mungo
    Abstract: Empirical studies have shown that a large number of financial asset returns exhibit fat tails and are often characterized by volatility clustering and asymmetry. Also revealed as a stylized fact is Long memory or long range dependence in market volatility, with significant impact on pricing and forecasting of market volatility. The implication is that models that accomodate long memory hold the promise of improved long-run volatility forecast as well as accurate pricing of long-term contracts. On the other hand, recent focus is on whether long memory can affect the measurement of market risk in the context of Value-at- Risk (V aR). In this paper, we evaluate the Value-at-Risk (V aR) and Expected Shortfall (ESF) in financial markets under such conditions. We examine one equity portfolio, the British FTSE100 and three stocks of the German DAX index portfolio (Bayer, Siemens and Volkswagen). Classical V aR estimation methodology such as exponential moving average (EMA) as well as extension to cases where long memory is an inherent characteristics of the system are investigated. In particular, we estimate two long memory models, the Fractional Integrated Asymmetric Power-ARCH and the Hyperbolic-GARCH with different error distribution assumptions. Our results show that models that account for asymmetries in the volatility specifications as well as fractional integrated parametrization of the volatility process, perform better in predicting the one-step as well as five-step ahead V aR and ESF for short and long positions than short memory models. This suggests that for proper risk valuation of options, the degree of persistence should be investigated and appropriate models that incorporate the existence of such characteristic be taken into account.
    Keywords: Backtesting, Value-at-Risk, Expected Shortfall, Long Memory, Fractional Integrated Volatility Models
    JEL: C14 C32 C52 C53 G12
    Date: 2008–01
  2. By: Bartram, Söhnke M.
    Abstract: This paper estimates the foreign exchange rate exposure of 6,917 U.S. nonfinancial firms on the basis of stock prices and corporate cash flows. The results show that several firms are significantly exposed to at least one of the foreign exchange rates Canadian Dollar, Japanese Yen and Euro, and significant exposures are more frequent at longer horizons. The percentage of firms for which stock price and earnings exposures are significantly different is relatively low, though it increases with time horizon. Overall, the impact of exchange rate risk on stock prices and cash flows is similar and determined by a related set of economic factors.
    Keywords: corporate finance; risk management; exposure; foreign exchange rates; hedging
    JEL: F4 F3 G3
    Date: 2007–05–07
  3. By: Angela Romagnoli (Bank of Italy)
    Abstract: The paper assesses whether the monthly returns of the listed shares of Italian banks are predicted by changes in balance-sheet indicators. The sample covers the period from January 1997 to June 2003. Estimates use both unadjusted and risk-adjusted returns. Results show that the stock returns of Italian banks are positively related to past profitability, liquidity, and asset quality, while they are not significantly affected by banksÂ’ capital ratios. Furthermore, in the sample period an increase in traditional lending activity leads to higher stock returns.
    Keywords: bank stock returns, bank-specific accounting ratios
    JEL: C14 G12 G21
    Date: 2007–11
  4. By: Caiado, Jorge; Crato, Nuno
    Abstract: This paper proposes spectral and asymmetric-volatility based methods for cluster analysis of stock returns. Using the information about both the periodogram of the squared returns and the estimated parameters in the TARCH equation, we compute a distance matrix for the stock returns. Clusters are formed by looking to the hierarchical structure tree (or dendrogram) and the computed principal coordinates. We employ these techniques to investigate the similarities and dissimilarities between the "blue-chip" stocks used to compute the Dow Jones Industrial Average (DJIA) index. For reference, we investigate also the similarities among stock returns by mean and squared correlation methods.
    Keywords: Asymmetric effects; Cluster analysis; DJIA stock returns; Periodogram; Threshold ARCH model; Volatility
    JEL: C32 G10
    Date: 2007–12
  5. By: Xavier Gabaix
    Abstract: This paper incorporates a time-varying intensity of disasters in the Rietz-Barro hypothesis that risk premia result from the possibility of rare, large disasters. During a disaster, an asset's fundamental value falls by a time-varying amount. This in turn generates time-varying risk premia and thus volatile asset prices and return predictability. Using the recent technique of linearity-generating processes (Gabaix 2007), the model is tractable, and all prices are exactly solved in closed form. In the "variable rare disasters" framework, the following empirical regularities can be understood qualitatively: (i) equity premium puzzle (ii) risk-free rate-puzzle (iii) excess volatility puzzle (iv) predictability of aggregate stock market returns with price-dividend ratios (v) value premium (vi) often greater explanatory power of characteristics than covariances for asset returns (vii) upward sloping nominal yield curve (viiii) a steep yield curve predicts high bond excess returns and a fall in long term rates (ix) corporate bond spread puzzle (x) high price of deep out-of-the-money puts. I also provide a calibration in which those puzzles can be understood quantitatively as well. The fear of disaster can be interpreted literally, or can be viewed as a tractable way to model time-varying risk-aversion or investor sentiment.
    JEL: E43 E44 G12
    Date: 2008–01
  6. By: Bartram, Söhnke M.
    Abstract: This paper examines the importance of exchange rate exposure for firm-level stock returns based on a large sample of non-financial firms from 37 countries. Because of the impact of exchange rates on firm value we argue that any predictable relation between exchange rate exposure and return will be conditional. We show strong evidence for a return premium to a firm’s currency exposure conditional on the exchange rate change. The return premium is directly related to the interaction between exchange rate exposure and the realized exchange rate change, suggesting the fluctuations in exchange rates themselves as a source for the previously identified time-variation in currency risk premia. The return premium to currency exposure is largest for firms in emerging markets, while it is statistically significant in developed markets only for local currency depreciations. Its magnitude ranges from 2.5% to 8.0% (p.a.) per unit of exposure depending on the sample, indicating that exchange rate exposure plays an important role in explaining cross-sectional return variation.
    Keywords: exchange rate exposure; exchange rate risk; return premia; international finance
    JEL: F4 G1 F3 G3
    Date: 2007–05–01
  7. By: Stéphane Loisel (SAF - EA2429 - Laboratoire de Science Actuarielle et Financière - Université Claude Bernard - Lyon I); Daniel Serant (SAF - EA2429 - Laboratoire de Science Actuarielle et Financière - Université Claude Bernard - Lyon I)
    Abstract: In most stochastic mortality models, either one stochastic intensity process (for example a jump-diffusion process) or a collection of independent processes is used to model the stochastic evolution of survival probabilities. We propose and calibrate a new model that takes inter-age correlations into account. The so-called stochastic logit's Deltas model is based on the study of the multivariate time series of the differences of logits of yearly mortality rates. These correlations are important and we illustrate our study on a real-life portfolio. We determine their impact on the price of a longevity swap type reinsurance contract, in which most of the financial risk is taken by a third party. The hypotheses of our model are statistically tested and various measures of risk of the present value of liabilities are found to be significantly smaller in our model than in the case of one common underlying stochastic process.
    Keywords: Longevity risk; longevity swap; inter-age correlations; stochastic mortality; multivariate process; logit; Lee-Carter
    Date: 2007–12
  8. By: Lorán Chollete; Randi Næs (Norges Bank (Central Bank of Norway)); Johannes A. Skjeltorp (Norges Bank (Central Bank of Norway))
    Abstract: Is the effect of liquidity risk on asset prices sensitive to our choice of liquidity proxy? In addressing this fundamental question, we achieve two main results. First, when we estimate factor models on a broad range of liquidity measures we uncover a profound distinction between trade and order based liquidity. Second, although the order based factor provides a better signal of available liquidity, we find that only the factor related to information risk explains expected returns both in a theoretical liquidity-CAPM model and in a linear pricing framework. Our results suggest a surprising fragility of liquidity-based asset pricing.
    Keywords: CPAM, Liquidity risk, Liquidity factor, Order based measure, Trade based measure, Information risk
    JEL: G12 G14
    Date: 2007–06–28
  9. By: Stéphane Loisel (SAF - EA2429 - Laboratoire de Science Actuarielle et Financière - Université Claude Bernard - Lyon I); Claude Lefèvre (Département de Mathématique - Université Libre de Bruxelles)
    Abstract: This paper is concerned with the compound Poisson risk model and two generalized models with still Poisson claim arrivals. One extension incorporates inhomogeneity in the premium input and in the claim arrival process, while the other takes into account possible dependence between the successive claim amounts. The problem under study for these risk models is the evaluation of the probabilities of (non-)ruin over any horizon of finite length. The main recent methods, exact or approximate, used to compute the ruin probabilities are reviewed and discussed in a unified way. Special attention is then paid to an analysis of the qualitative impact of dependence between claim amounts.
    Keywords: compound Poisson model; ruin probability; finite-time horizon; recursive methods; (generalized) Appell polynomials; non-constant premium; non-stationary claim arrivals; interdependent claim amounts; impact of dependence; comonotonic risks; heavy-tailed distributions
    Date: 2007–12
  10. By: Fagan, Stephen; Gencay, Ramazan
    Abstract: Futures contracts on the New York Mercantile Exchange are the most liquid instruments for trading crude oil, which is the world’s most actively traded physical commodity. Under normal market conditions, traders can easily find counterparties for their trades, resulting in an efficient market with virtually no return predictability. Yet even this extremely liquid instrument suffers from liquidity shocks that induce periods of increased volatility and significant return predictability. This paper identifies an important and recurring cause of these shocks: the accumulation of extreme and opposing positions by the two main trader classes in the market, namely hedgers and speculators. As positions become extreme, approaching their historical limits, counterparties for trades become scarce and prices must adjust to induce trade. These liquidity-induced price adjustments are found to be driven by systematic speculative behavior and are determined to be significant.
    Keywords: Liquidity; Futures Markets; Return Predictability; Volatility; Trader Positions; Directional Realized Volatility; Hedgers; Speculators; Position Bounds
    JEL: G14 C53 G13 G10 C1
    Date: 2008–01–09
  11. By: Wolfgang Härdle; Yuh-Jye Lee; Dorothea Schäfer; Yi-Ren Yeh
    Abstract: In the era of Basel II a powerful tool for bankruptcy prognosis is vital for banks. The tool must be precise but also easily adaptable to the bank's objections regarding the relation of false acceptances (Type I error) and false rejections (Type II error). We explore the suitabil- ity of Smooth Support Vector Machines (SSVM), and investigate how important factors such as selection of appropriate accounting ratios (predictors), length of training period and structure of the training sample in°uence the precision of prediction. Furthermore we show that oversampling can be employed to gear the tradeo® between error types. Finally, we illustrate graphically how di®erent variants of SSVM can be used jointly to support the decision task of loan o±cers.
    Keywords: Insolvency Prognosis, SVMs, Statistical Learning Theory, Non-parametric Classification models, local time-homogeneity
    JEL: G30 C14 G33 C45
    Date: 2008–01
  12. By: Junni L. Zhang; Wolfgang Härdle
    Abstract: We propose a new nonlinear classification method based on a Bayesian "sum-of-trees" model, the Bayesian Additive Classification Tree (BACT), which extends the Bayesian Additive Regression Tree (BART) method into the classi- fication context. Like BART, the BACT is a Bayesian nonparametric additive model specified by a prior and a likelihood in which the additive components are trees, and it is fitted by an iterative MCMC algorithm. Each of the trees learns a different part of the underlying function relating the dependent variable to the input variables, but the sum of the trees offers a flexible and robust model. Through several benchmark examples, we show that the BACT has excellent performance. We apply the BACT technique to classify whether firms would be insolvent. This practical example is very important for banks to construct their risk profile and operate successfully. We use the German Creditreform database and classify the solvency status of German firms based on financial statement information. We show that the BACT outperforms the logit model, CART and the Support Vector Machine in identifying insolvent Firms.
    Keywords: Classi¯cation and Regression Tree, Financial Ratio, Misclassification Rate, Accuracy Ratio
    JEL: C14 C11 C45 C01
    Date: 2008–01
  13. By: Buiter, Willem H
    Abstract: The paper studies the causes of the current financial crisis and considers proposals for mitigation and prevention of future crises. The crisis is was the product of a ‘perfect storm’ bringing together a number of microeconomic and macroeconomic pathologies. Among the microeconomic systemic failures were: wanton securitisation, fundamental flaws in the rating agencies’ business model, the procyclical behaviour of leverage in much of the financial system and of the Basel capital adequacy requirements, privately rational but socially inefficient disintermediation, and competitive international de-regulation. Proximate local drivers of the specific way in which these problems manifested themselves were regulatory and supervisory failure in the US home loan market. Among the macroeconomic pathologies that contributed to the crisis were, first, excessive global liquidity creation by key central banks and, second, an ex-ante global saving glut, brought about by the entry of a number of high-saving countries (notably China) into the global economy and a global redistribution of wealth and income towards commodity exporters that also had, at least in the short run, high propensities to save. In the UK, failures of the Tripartite financial stability arrangement between the Treasury the Bank of England and the FSA, weaknesses in the Bank of England’s liquidity management, regulatory failure of the FSA, an inadequate deposit insurance arrangement and deficient insolvency laws for the banking sector contributed to the financial disarray. Despite this, it may well be possible to minimize the spillovers over from the crisis beyond the financial sectors of the industrial countries and the housing sectors of the US and a few European countries.
    Keywords: collateral; financial stability; leverage; liquidity; rating agencies; regulation; securitization
    JEL: D52 D53 E32 E44 E58 F37 G21 G24 G28
    Date: 2007–12
  14. By: Melecky, Martin
    Abstract: This paper proposes a measure of synchronization in the movements of relevant domestic and foreign fundamentals for choosing suitable currency for denomination of foreign debt. The selection of explanatory variables for exchange rate volatility is motivated using a New Keynesian Policy model. The model predicts that not only traditional optimal currency area variables, but also variables considered by the literature on currency preferences, such as money velocity, should be relevant for explaining exchange rate volatility. The findings show that measures of inflation synchronization, money velocity synchronization, and interest rate synchronization can be useful indicators for decisions on the currency denomination of foreign debt.
    Keywords: Debt Markets,Emerging Markets,Currencies and Exchange Rates,,Economic Theory & Research
    Date: 2008–01–01

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