nep-rmg New Economics Papers
on Risk Management
Issue of 2008‒01‒26
nine papers chosen by
Stan Miles
Thompson Rivers University

  1. Differential Evolution for Multiobjective Portfolio Optimization By Thiemo Krink; Sandra Paterlini
  2. Bank capital: a myth resolved By Van Laere, Elisabeth; Baesens, Bart; Thibeault, André
  3. Idiosyncratic risk, returns and liquidity in the London Stock Exchange: a spillover approach By Andreas Andrikopoulos; Timotheos Angelidis
  4. Stochastic Volatilities and Correlations, Extreme Values and Modeling the Macroeconomic Environment, Under Which Brazilian Banks Operate By Marcos Souto; Theodore M. Barnhill
  5. High Idiosyncratic Volatility and Low Returns: International and Further U.S. Evidence By Andrew Ang; Robert J. Hodrick; Yuhang Xing; Xiaoyan Zhang
  6. The Default Risk of Firms Examined with Smooth Support Vector Machines By Wolfgang Härdle; Yuh-Jye Lee; Dorothea Schäfer; Yi-Ren Yeh
  7. Financial Instruments to Hedge Commodity Price Risk for Developing Countries By Salih N. Neftci; Y. Lu
  8. Does Interbank Borrowing Reduce Bank Risk? By Valeriya Dinger; Jürgen von Hagen
  9. Impact of US Macroeconomic Surprises on Stock Market Returns in Developed Economies By Brian Lucey, Ali Nejadmalayeri and Manohar Singh

  1. By: Thiemo Krink; Sandra Paterlini
    Abstract: Financial portfolio optimization is a challenging problem. First, the problem is multiobjective (i.e.: minimize risk and maximize profit) and the objective functions are often multimodal and non smooth (e.g.: value at risk). Second, managers have often to face real-world constraints, which are typically non-linear. Hence, conventional optimization techniques, such as quadratic programming, cannot be used. Stochastic search heuristic can be an attractive alternative. In this paper, we propose a new multiobjective algorithm for portfolio optimization: DEMPO - Differential Evolution for Multiobjective Portfolio Optimization. The main advantage of this new algorithm is its generality, i.e., the ability to tackle a portfolio optimization task as it is, without simplifications. Our empirical results show the capability of our approach of obtaining highly accurate results in very reasonable runtime, in comparison with quadratic programming and another state-of-art search heuristic, the so-called NSGA II.
    Keywords: Portfolio optimization; multiobjective; real world constraints; value at risk; expected shortfall; differential evolution
    JEL: G11 C61 D81
    Date: 2008–01
  2. By: Van Laere, Elisabeth; Baesens, Bart; Thibeault, André (Vlerick Leuven Gent Management School)
    Abstract: In order to promote financial stability, regulatory authorities pay a lot of attention in setting minimum capital levels. In addition to these requirements, financial institutions calculate their own economic capital reflecting the unexpected losses and true risk according to the specific characteristics of their portfolio. The current Basel I framework pays little or no attention to the creditworthiness of a borrower in deciding on the regulatory capital requirements. As a result, a lot of banks remove low-risk assets from their balance sheets and only retain relatively high risk assets on balance. The recently introduced Basel II framework should result in a further convergence between regulatory and economic capital. However, recent papers (Elizalde et al., 2006; Jackson et al., 2002 and Jacobson et al. 2006) argue that also under Basel II, regulatory and economic capital will have different determinants. This paper first gives an overview of capital adequacy and then further describes the differences and similarities between economic and regulatory capital based on a literature review.
    Date: 2008–01–08
  3. By: Andreas Andrikopoulos; Timotheos Angelidis
    Abstract: In the light of recent evidence that liquidity and idiosyncratic risk may be priced factors in the cross section of expected stock returns and that market capitalization significantly affects investor behavior and liquidity, we explore the interactions between liquidity, idiosyncratic risk and return across time as well as across size-based portfolios of stocks listed in the London Stock Exchange. In a Vector Autoregressive (VAR) analytical framework, we find that volatility spills over from large cap stocks to small cap stocks and vice versa. Volatility shocks can be predicted by illiquidity shocks in both large cap as well as in the small cap portfolios. Illiquidity can be predicted by return shocks in small cap stocks. Finally, we document some evidence of asymmetric liquidity spillovers, from large cap stocks to small cap ones, supporting the intuition that common information is first incorporated in the trading behavior of large-cap investors and the liquidity of large cap stocks and is then transmitted in the trading of small stocks.
    Keywords: Liquidity; Spillover.
    Date: 2008
  4. By: Marcos Souto; Theodore M. Barnhill
    Abstract: Using monthly data for a set of variables, we examine the out-of-sample performance of various variance/covariance models and find that no model has consistently outperformed the others. We also show that it is possible to increase the probability mass toward the tails and to match reasonably well the historical evolution of volatilities by changing a decay factor appropriately. Finally, we implement a simple stochastic volatility model and simulate the credit transition matrix for two large Brazilian banks and show that this methodology has the potential to improve simulated transition probabilities as compared to the constant volatility case. In particular, it can shift CTM probabilities towards lower credit risk categories.
    Keywords: Emerging markets , Brazil , Banks , Interest rates , Credit risk ,
    Date: 2007–12–21
  5. By: Andrew Ang; Robert J. Hodrick; Yuhang Xing; Xiaoyan Zhang
    Abstract: Stocks with recent past high idiosyncratic volatility have low future average returns around the world. Across 23 developed markets, the difference in average returns between the extreme quintile portfolios sorted on idiosyncratic volatility is -1.31% per month, after controlling for world market, size, and value factors. The effect is individually significant in each G7 country. In the U.S., we rule out explanations based on trading frictions, information dissemination, and higher moments. There is strong comovement in the low returns to high idiosyncratic volatility stocks across countries, suggesting that broad, not easily diversifiable, factors may lie behind this phenomenon.
    JEL: F3 G12 G15
    Date: 2008–01
  6. 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 suitability 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 influence the precision of prediction. Furthermore we showthat oversampling can be employed to gear the tradeoff between error types. Finally, we illustrate graphically how different variants of SSVM can be used jointly to support the decision task of loan officers.
    Keywords: Insolvency Prognosis, SVMs, Statistical Learning Theory, Non-parametric Classification
    JEL: G30 C14 G33 C45
    Date: 2007
  7. By: Salih N. Neftci; Y. Lu
    Abstract: Many developing economies are heavily exposed to commodity markets, leaving them vulnerable to the vagaries of international commodity prices. This paper examines the use of commodity options-including plain vanilla, risk reversal, and barrier options-to hedge such risk. It then proposes the use of a new structured product-a sovereign Eurobond with an embedded option on a specific commodity price. By extracting commodity price risk out of the bond, such an instrument insulates the bond default risk from commodity price movements, allowing it to be marketed at a lower credit spread. The product is also designed to help developing countries establish a credit derivatives market, which would in turn enhance the marketability and liquidity of sovereign bonds.
    Keywords: Commodity markets , Bonds , Revenues , Prices , Developing countries ,
    Date: 2008–01–11
  8. By: Valeriya Dinger (University of Bonn; Jürgen von Hagen (Zentrum für Europäische Integrationsforschung Rheinische Friedrich-Wilhelms-Universität Bonn Walter Flex Strasse 3 53113 Bonn Tel. (0228) 73-9199 Fax (0228) 73-1809 Email
    Abstract: In this paper we investigate whether banks that borrow from other banks have lower risk levels. We concentrate on a large sample of Central and Eastern European banks which allows us to explore the impact of interbank lending when exposures are long-term and interbank borrowers are small banks. The results of the empirical analysis generally confirm the hypothesis that long-term interbank exposures result in lower risk of the borrowing banks.
    Keywords: interbank market, bank risk, market discipline, transition countries
    JEL: G21 E53
    Date: 2007–11
  9. By: Brian Lucey, Ali Nejadmalayeri and Manohar Singh
    Date: 2008–01–18

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