nep-rmg New Economics Papers
on Risk Management
Issue of 2008‒02‒23
seven papers chosen by
Stan Miles
Thompson Rivers University

  1. Credit Risk Assessment Considering Variations in Exposure: Application to Commitment Lines By Shigeaki Fujiwara
  2. A Real Options Perspective on R&D Portfolio Diversification By Sjoerd van Bekkum; Enrico Pennings; Han Smit
  3. The Impact of the FOMC's Monetary Policy Actions on the growth of Credit Risk: the Monetary Policy - Liquidity Paradox By Kwamie Dunbar
  4. Corporate Management of Highly Dynamic Risks: The Case of Terrorism Insurance in Germany By Thomann, Christian; Pascalau, Razvan; von der Schulenburg, J.-Matthias Graf; Gas, Bruno
  5. On the Qualitative Effect of Volatility and Duration on Prices of Asian Options By Peter Carr; Christian-Oliver Ewald; Yajun Xiao
  6. Stress testing of the Czech banking sector By Petr Jakubík; Jaroslav Heømánek
  7. Oil Prices: Heavy Tails, Mean Reversion and the Convenience Yield By Bernard, Jean-Thomas; Khalaf, Lynda; Kichian, Maral; McMahon, Sébastien

  1. By: Shigeaki Fujiwara (Deputy Director and Institute for Monetary and Economic Studies, Bank of Japan (E-mail: shigeaki.fuiiwarafalboj.or.ip'))
    Abstract: With the worldwide financial market confUsion caused by the subprime mortgage problem and the increase in credit line contracts with relaxed covenants, there are cases where financial institutions are facing demands to provide additional credit to securitized vehicles with heightened liquidity and credit risks. These are typical examples demonstrating the importance of risk management considering variations in exposure. There are also calls for incorporation of future variations in exposure into the model for the Basel II advanced internal ratings-based approach. This paper adopts commitment lines as a credit provision with variable exposure and constructs a credit risk model whereby stochastic new borrowing demand is linked to changes in a firm's asset value. Through simulations, the paper then considers the interdependence among exposure at default, probability of default, loss given default, expected loss, and unexpected loss. The paper also prepares a simple model for the covenants, and verifies the influence of the rigidness of covenants on expected loss and other risk factors.
    Keywords: : Commitment lines, Probability of default, Loss given default, Exposure at default, Expected loss, Unexpected loss
    JEL: G21 G32 G33
    Date: 2008–02
  2. By: Sjoerd van Bekkum (Erasmus University Rotterdam); Enrico Pennings (Erasmus University Rotterdam); Han Smit (Erasmus University Rotterdam)
    Abstract: This paper shows that the presence of conditional staging in R&D (Research & Development) has a critical impact on portfolio risk, and changes diversification arguments when a portfolio is constructed. When R&D projects exhibit option-like characteristics, correlation between projects plays a more complicated role than traditional portfolio diversification would suggest. Real option theory argues that research projects with conditional phases have option-like risk and return properties, and are different from unconditional projects. We show that although the risk of a portfolio always depends on the correlation between projects, a portfolio of conditional R&D projects with real option characteristics has fundamentally different risk than a portfolio of unconditional projects. When conditional R&D projects are negatively correlated, portfolio risk is hardly reduced by diversification. When projects are positively correlated, however, diversification is more effective than these tools predict.
    Keywords: Real Options; Research & Development (R&D); Risk Management; Monte Carlo Simulation
    JEL: G31 G32 O30 O32
    Date: 2007–01–15
  3. By: Kwamie Dunbar (University of Connecticut)
    Abstract: Credit risk is influenced by interest rates and market liquidity. This paper examines the direct and indirect impacts of unexpected monetary policy shifts on the growth of corporate credit risk, with the aim of quantifying the size and direction of the response. The results surprisingly indicate that monetary policy and liquidity impulses move counter to each other in their effects on credit risk ("The monetary policy-liquidity paradox"). The analysis indicates that while contractionary monetary policy creates tight money which subsequently leads to a slowing in the growth of credit risk and a reduction of liquidity in credit markets, reduced liquidity indirectly affects credit risk by accelerating its growth. The net effect of these transitory opposing forces generates the final impact on credit risk. An unexpected policy shifts is captured via a combination of the forward Fed fund rate curve and the Fed's FOMC policy announcements. Following the approach of Bernanke and Kuttner (2005), Hausman and Wongswan (2006) who examined asset prices under FOMC announcements, the study found that the estimated credit risk responses to FOMC announcements vary across credit qualities. Hence the analyses indicates that a typical unanticipated 25 basis point cut in the target fed funds rate generally resulted in an acceleration in the growth of credit risk by 0.50 percent for AAA rated corporate grade debt, and by 3.5 percent for BB rated corporate debt. Moreover, the study found a direct effect of the FOMC's policy instrument on market liquidity which had a significant effect on the growth in credit risk. The results indicate that a 1 percentage point increase in liquidity for AAA and CCC rated bonds resulted in a 0.7% and 52.45% decrease in the rate of growth in credit risk respectively.
    Keywords: Credit Risk, Default Risk, Credit Default Swap, Monetary Policy, Credit Markets, Financial Markets, Vector Autoregressive Model, Federal funds rate.
    Date: 2008–02
  4. By: Thomann, Christian; Pascalau, Razvan; von der Schulenburg, J.-Matthias Graf; Gas, Bruno
    Abstract: This article extends the theory of corporate risk management to encompass highly dynamic risks. Taking Viscusi's (1989) prospective reference from the context of individual decision making and applying it to a corporate context we propose a theory of how corporations process new information. Using unique data on all terrorism insurance policies sold in Germany we find support for this concept of risk-updating by showing that the demand for terrorism insurance is strongly determined by the recent occurrence of terrorist attacks.
    Keywords: Corporate Insurance; Risk Management; Terrorism Insurance; Expected Utility; Prospect Theory.
    JEL: D81 D83 G32
    Date: 2007–12–13
  5. By: Peter Carr; Christian-Oliver Ewald; Yajun Xiao
    Abstract: We show that under the Black Scholes assumption the price of an arithmetic average Asian call option with fixed strike increases with the level of volatility . This statement is not trivial to prove and for other models in general wrong. In fact we demonstrate that in a simple binomial model no such relationship holds. Under the Black-Scholes assumption however, we give a proof based on the maximum principle for parabolic partial differential equations. Furthermore we show that an increase in the length of duration over which the average is sampled also increases the price of an arithmetic average Asian call option, if the discounting effect is taken out. To show this, we use the result on volatility and the fact that a reparametrization in time corresponds to a change in volatility in the Black-Scholes model. Both results are extremely important for the risk management and risk assessment of portfolios that include Asian options.
    Keywords: Asian Options, Volatility, Vega, Duration, Qualitative Riskmanagement.
    JEL: G11 G31 G39
    Date: 2008–02
  6. By: Petr Jakubík (Institute of Economic Studies, Faculty of Social Sciences, Charles University, Prague, Czech Republic; Czech National Bank); Jaroslav Heømánek (Czech National Bank)
    Abstract: This article presents the results of stress tests of the Czech banking sector conducted using models of credit risk and credit growth broken down by sector. The use of these models enables the stress tests to be linked to the CNB’s official quarterly macroeconomic forecast. In addition, the article updates the stress scenarios, including simple sensitivity analyses of credit risk for individual sectors. Based on the analysis, an answer is sought to the question of whether the observed credit growth to corporate sector and households poses any threat to the stability of the banking sector. The analyses conclude that the banking sector as a whole seems to be resilient to the macroeconomic shocks under consideration.
    Keywords: stress testing, financial stability, credit risk, credit growth
    JEL: G21 G28 G33
    Date: 2008–02
  7. By: Bernard, Jean-Thomas; Khalaf, Lynda; Kichian, Maral; McMahon, Sébastien
    Abstract: Empirical research on oil price dynamics for modeling and forecasting purposes has brought forth several unsettled issues. Indeed, statistical support is claimed for various models of price paths, yet many of the competing models differ importantly with respect to their fundamental temporal properties. In this paper, we study one such property that is still debated in the literature, namely mean-reversion, with focus on forecast performance. Because of their impact on mean-reversion, we account for non-constancies in the level and in volatility. Three specifications are considered: (i) random-walk models with GARCH and normal or student-t innovations, (ii) Poisson-based jump-diffusion models with GARCH and normal or student-t innovations, and (iii) mean-reverting models that allow for uncertainty in equilibrium price and for time-varying convenience yields. We compare forecasts in real time, for 1, 3 and 5 year horizons. For the jump-based models, we rely on numerical methods to approximate forecast errors. Results based on future price data ranging from 1986 to 2007 strongly suggest that imposing the random walk for oil prices has pronounced costs for out-of-sample forecasting. Evidence in favor of price reversion to a continuously evolving mean underscores the importance of adequately modeling the connvenience yield.
    Keywords: Heavy tails, oil price, convenience yield, oil forecasts, mean reversion, structural stability
    JEL: Q4 C52 C53 G1
    Date: 2008

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