New Economics Papers
on Risk Management
Issue of 2008‒02‒16
twelve papers chosen by

  1. Hedge fund portfolio selection with modified expected shortfall By Boudt, Kris; Peterson, Brian; Carl, Peter
  2. Measuring downside risk-realised semivariance By Ole E. Barndorff-Nielsen; Silja Kinnebrock; Neil Shephard
  3. Liquidity Risk and Syndicate Structure By Evan Gatev; Philip Strahan
  4. Equity portfolio diversification under time-varying predictability and comovements: evidence from Ireland, the US, and the UK By Massimo Guidolin; Stuart Hyde
  5. Mixed Exponential Power Asymmetric Conditional Heteroskedasticity By Mohammed Bouaddi; Jeroen V.K. Rombouts
  6. Using participating and financial contracts to insure catastrophe risk: Implications for crop risk management By Geoffroy Enjolras; Robert Kast
  7. Towards an understanding approach of the insurance linked securities market. By Mathieu Gatumel; Dominique Guegan
  8. Bond positions, expectations, and the yield curve By Monika Piazzesi; Martin Schneider
  9. Indebtedness, macroeconomic conditions and banks’ loan losses: evidence from Italy By Simona Castellani; Chiara Pederzoli; Costanza Torricelli
  10. Rare Disasters and Exchange Rates By Emmanuel Farhi; Xavier Gabaix
  11. The Emergence of Cross-Border Insurance Groups within Europe with Centralised Risk Management By Otto Winkels; Dirk Schoenmaker; Sander Osterloo
  12. CAN EXCHANGE RATES FORECAST COMMODITY PRICES? By Chen, Yu-chin; Rogoff, Kenneth; Rossi, Barbara

  1. By: Boudt, Kris; Peterson, Brian; Carl, Peter
    Abstract: Modified Value-at-Risk (VaR) and Expected Shortfall (ES) are recently introduced downside risk estimators based on the Cornish-Fisher expansion for assets such as hedge funds whose returns are non-normally distributed. Modified VaR has been widely implemented as a portfolio selection criterion. We are the first to investigate hedge fund portfolio selection using modified ES as optimality criterion. We show that for the EDHEC hedge fund style indices, the optimal portfolios based on modified ES outperform out-of-sample the EDHEC Fund of Funds index and have better risk characteristics than the equal-weighted and Fund of Funds portfolios.
    Keywords: portfolio optimization; modified expected shortfall; non-normal returns
    JEL: C4
    Date: 2008–02–04
  2. By: Ole E. Barndorff-Nielsen (Dept of Mathematical Sciences, University of Aarhus); Silja Kinnebrock (Oxford-Man Institute and Merton College, University of Oxford); Neil Shephard (Oxford-Man Institute and Dept of Economics, Oxford University)
    Abstract: We propose a new measure of risk, based entirely on downwards moves measured using high frequency data. Realised semivariances are shown to have important predictive qualities for future market volatility. The theory of these new measures is spelt out, drawing on some new results from probability theory.
    Keywords: Market frictions; Quadratic variation; Realised variance; Semimartingale; Semivariance
    Date: 2008–01–21
  3. By: Evan Gatev; Philip Strahan
    Abstract: We offer a new explanation of loan syndicate structure based on banks' comparative advantage in managing systematic liquidity risk. When a syndicated loan to a rated borrower has systematic liquidity risk, the fraction of passive participant lenders that are banks is about 8% higher than for loans without liquidity risk. In contrast, liquidity risk does not explain the share of banks as lead lenders. Using a new measure of ex-ante liquidity risk exposure, we find further evidence that syndicate participants specialize in liquidity-risk management while lead banks manage lending relationships. Links from transactions deposits to liquidity exposure are about 50% larger at participant banks than at lead arrangers.
    JEL: G2 G32
    Date: 2008–02
  4. By: Massimo Guidolin; Stuart Hyde
    Abstract: We use multivariate regime switching vector autoregressive models to characterize the time-varying linkages among short-term interest rates (monetary policy) and stock returns in the Irish, the US and UK markets. We find that two regimes, characterized as bear and bull states, are required to characterize the dynamics of returns and short-term rates. This implies that we cannot reject the hypothesis that the regimes driving the markets in the small open economy are largely synchronous with those typical of the major markets. We compute time-varying Sharpe ratios and recursive mean-variance portfolio weights and document that a regime switching framework produces out-of-sample portfolio performance that outperforms simpler models that ignore regimes. Interestingly, the portfolio shares derived under regime switching dynamics implies a fairly low committment to the Irish market, in spite of its brilliant unconditional risk-return trade-off.
    Keywords: Stock exchanges
    Date: 2008
  5. By: Mohammed Bouaddi; Jeroen V.K. Rombouts
    Abstract: To match the stylized facts of high frequency financial time series precisely and parsimoniously, this paper presents a finite mixture of conditional exponential power distributions where each component exhibits asymmetric conditional heteroskedasticity. We provide stationarity conditions and unconditional moments to the fourth order. We apply this new class to Dow Jones index returns. We find that a two-component mixed exponential power distribution dominates mixed normal distributions with more components, and more parameters, both in-sample and out-of-sample. In contrast to mixed normal distributions, all the conditional variance processes become stationarity. This happens because the mixed exponential power distribution allows for component-specific shape parameters so that it can better capture the tail behaviour. Therefore, the more general new class has attractive features over mixed normal distributions in our application: Less components are necessary and the conditional variances in the components are stationarity processes. Results on NASDAQ index returns are similar.
    Keywords: Finite mixtures, exponential power distributions, conditional heteroskedasticity, asymmetry, heavy tails, value at risk
    JEL: C11 C22 C52
    Date: 2007
  6. By: Geoffroy Enjolras; Robert Kast
    Abstract: This paper proposes a combination of participating and financial contracts in order to hedge catastrophic risk. Assuming unfair policies and the existence of a basis risk, we prove the optimal coverage is realized using: first, a participating contract, which covers the idiosyncratic part of the risk under a variable premium; second, a financial contract, which hedges the systemic part of the risk under a fixed premium. The necessary intermediation of insurance companies in the conception of such contracts is emphasized as well as the impact of unfair premia. From then, potential implications for crop risk management are examined.
    Date: 2007–01
  7. By: Mathieu Gatumel (Axa et Centre d'Economie de la Sorbonne); Dominique Guegan (Centre d'Economie de la Sorbonne et Paris School of Economics)
    Abstract: The paper aims to present the insurance linked securities market behaviour, that has changed a lot the past three years, both in terms of structure and in terms of ceded risks. After having introduced some stylized facts characterizing the insurance linked securities we capture their market price of risk, following the methodologies of Wang (2004), Lane (2000) and Fermat Capital Management (2005). A dynamical study of the insurance linked securities is also provided in order to understand the elements driving the spreads : the consequences of the catastrophic events, the seasonality and the diversification effects between some different risks are highlighted.
    Keywords: Insurance linked securities, cat. bonds, market price of risk.
    JEL: G10 G12 G14
    Date: 2008–01
  8. By: Monika Piazzesi; Martin Schneider
    Abstract: This paper implements a structural model of the yield curve with data on nominal positions and survey forecasts. Bond prices are characterized in terms of investors' current portfolio holdings as well as their subjective beliefs about future bond payoffs. Risk premia measured by an econometrician vary because of changes in investors' subjective risk premia that are identified from portfolios and subjective beliefs but also because subjective beliefs differ from those of the econometrician. The main result is that investors' systematic forecast errors are an important source of business cycle variation in measured risk premia. By contrast, subjective risk premia move less and more slowly over time.
    Date: 2008
  9. By: Simona Castellani; Chiara Pederzoli; Costanza Torricelli
    Abstract: The Basel II capital accord has fostered the debate over the financial stability of the aggregate banking sector. There is a large empirical literature focused on the effects of macroeconomic disturbances on the banking system. Specifically, loan losses are an important factor for the banking stability and a stream of research in this field aims to identify explanatory variables for this critical indicator. This paper focuses on Italian banks data over the period 1990-2007 and investigates the relationship between the ratio of non-performing loans to total loans, the business cycle and firms’ indebtedness so as to test the impact of both real and financial fragility on banks’ default losses. We use a regression model with an interaction term representing the joint effect of real and financial fragility, which to our knowledge has never been applied before to Italian default data. The results show that the impact of financial fragility on default losses is enhanced by adverse economic conditions.
    Keywords: default; GDP; financial fragility
    JEL: G21 E44
    Date: 2008–01
  10. By: Emmanuel Farhi; Xavier Gabaix
    Abstract: We propose a new model of exchange rates, which yields a theory of the forward premium puzzle. Our explanation combines two ingredients: the possibility of rare economic disasters, and an asset view of the exchange rate. Our model is frictionless, has complete markets, and works for an arbitrary number of countries. In the model, rare worldwide disasters can occur and affect each country's productivity. Each country's exposure to disaster risk varies over time according to a mean-reverting process. Risky countries command high risk premia: they feature a depreciated exchange rate and a high interest rate. As their risk premium mean reverts, their exchange rate appreciates. Therefore, currencies of high interest rate countries appreciate on average. To make the notion of disaster risk more implementable, we show how options prices might in principle uncover latent disaster risk, and help forecast exchange rate movements. We then extend the framework to incorporate two factors: a disaster risk factor, and a business cycle factor. We calibrate the model and obtain quantitatively realistic values for the volatility of the exchange rate, the forward premium puzzle regression coefficients, and near-random walk exchange rate dynamics. Finally, we solve a model of stock markets across countries, which yields a series of predictions about the joint behavior of exchange rates, bonds, options and stocks across countries. The evidence from the options market appears to be supportive of the model.
    JEL: E43 E44 F31 G12 G15
    Date: 2008–02
  11. By: Otto Winkels; Dirk Schoenmaker; Sander Osterloo
    Abstract: This paper analyses the degree of internationalisation of insurance business. Using a novel dataset of 25 large EU insurance groups, we find that the insurance industry has a strong international orientation. About 55 per cent of the business of these large insurance groups is conducted abroad. The cross-border activities are predominantly within Europe (30 to 35 per cent) and less so in the rest of the world (20 to 25 per cent). Next, this paper examines the impact of internationalisation on the organisational structure. We find a clear trend towards centralising risk and capital management activities within large insurance groups, though insurance remains at the same time a local business. Applying the hub and spoke model, we identify which functions are executed at the centre (hub) and which functions are performed at the local business units (spokes).
    Date: 2007–12
  12. By: Chen, Yu-chin; Rogoff, Kenneth; Rossi, Barbara
    Abstract: This paper studies the dynamic relationship between exchange rate fluctuations and world commodity price movements. Taking into account parameter instability, we demonstrate surprisingly robust evidence that exchange rates predict world commodity price movements, both in-sample and out-of-sample. Because commodity prices are exogenous to the exchange rates we consider, we are able to overcome the identification problems that plague the existing empirical exchange rate literature. Because our finding that exchange rates predict future commodity prices can be given a true causal interpretation, it provides the most concrete support yet for the importance of selected macroeconomic fundamentals in determining exchange rates. As an important by-product of our analysis, we show that exchange rate-based forecasts may be a viable alternative for predicting future commodity price movements.
    Keywords: Exchange rates, forecasting, commodity prices, random walk
    JEL: C52 C53 F31 F47
    Date: 2008

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