nep-rmg New Economics Papers
on Risk Management
Issue of 2008‒04‒29
eleven papers chosen by
Stan Miles
Thompson Rivers University

  1. Value-at-Risk and Expected Shortfall for Rare Events By Stefan Mittnik; Tina Yener
  2. BankCaR (Bank Capital-at-Risk): a credit risk model for U.S. commercial bank charge-offs By Jon Frye; Eduard Pelz
  3. The Default Risk of Firms Examined with Smooth Support Vector Machines By Wolfgang Härdle; Yuh-Jye Lee; Dorothea Schäfer; Yi-Ren Yeh
  4. Cross-Sectional Dispersion of Firm Valuations and Expected Stock Returns By Jiang, Danling
  5. A solution to the default risk-business cycle disconnect By Enrique G. Mandoza; Vivian Z. Yue
  6. Capital Adequacy Regime in India: An Overview By Mandira Sarma; Yuko Nikaido
  7. Understanding Credit Risk: A Classroom Experiment By Maroš Servátka; George Theocharides
  8. The financial turmoil of 2007-?: a preliminary assessment and some policy considerations By Clauio Borio
  9. Endogenous Systemic Liquidity Risk By Cao, Jin; Illing, Gerhard
  10. Derivatives Markets for Home Prices By Robert J. Shiller
  11. Predicting cycles in economic activity By Jane Haltmaier

  1. By: Stefan Mittnik (Ludwig-Maximilians-University Munich, Center for Financial Studies, Frankfurt, and Ifo Institute for Economic Research, Munich); Tina Yener (Ludwig-Maximilians-University Munich)
    Abstract: Abstract. We show that the use of correlations for modeling dependencies may lead to counterintuitive behavior of risk measures, such as Value-at-Risk (VaR) and Expected Short- fall (ES), when the risk of very rare events is assessed via Monte-Carlo techniques. The phenomenon is demonstrated for mixture models adapted from credit risk analysis as well as for common Poisson-shock models used in reliability theory. An obvious implication of this finding pertains to the analysis of operational risk. The alleged incentive suggested by the New Basel Capital Accord (Basel II), namely decreasing minimum capital requirements by allowing for less than perfect correlation, may not necessarily be attainable.
    Keywords: Operational Risk, Latent Variables, Correlated Events
    JEL: C52 G11 G32
    Date: 2408–04
  2. By: Jon Frye; Eduard Pelz
    Abstract: BankCaR is a credit risk model that forecasts the distribution of a commercial bank's charge-offs. The distribution depends only on systematic factors; BankCaR takes each bank and projects its expected charge-off across a distribution of good years and bad years. Since most bank failures occur in bad years, this analysis has promise for both banks and bank supervisors. In BankCaR, charge-offs depend on the bank's loan balances and the charge-off rates of twelve categories of lending. A joint distribution of the twelve charge-off rates is calibrated to a long history of regulatory reporting data. Applied to the US banking system, BankCaR finds that credit risk is rising and is concentrated most significantly in construction lending. Applied to individual banks, BankCaR efficiently identifies those that have an adverse combination of credit risk and capital. BankCaR uses publicly available regulatory reporting data, the most common credit portfolio model, and standard quantitative techniques. These generic qualities can provide a standard of comparison between banks. They also can provide an individual commercial bank with a benchmark for more elaborate vended credit models.
    Date: 2008
  3. 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
  4. By: Jiang, Danling
    Abstract: This paper develops two competing hypotheses for the relation between the cross-sectional standard deviation of logarithmic firm fundamental-to-price ratios (``dispersion'') and expected aggregate returns. In models with fully rational beliefs, greater dispersion indicates greater risk and higher expected aggregate returns. In models with investor overconfidence, greater dispersion indicates greater mispricing and lower expected aggregate returns. Consistent with the behavioral models, the results show that (1) measures of dispersion are negatively related to subsequent market excess returns, (2) this negative relation is more pronounced among riskier firms, and (3) dispersion is positively related to aggregate trading volume, idiosyncratic volatility, and investor sentiment, and increases after good past market performance.
    Keywords: Return predictability; Dispersion; Overconfidence; Idiosyncratic volatility; Investor sentiment
    JEL: G14 G12
    Date: 2008–04–18
  5. By: Enrique G. Mandoza; Vivian Z. Yue
    Abstract: Models of business cycles in emerging economies explain the negative correlation between country spreads and output by modeling default risk as an exogenous interest rate on working capital. Models of strategic default explain the cyclical properties of sovereign spreads by assuming an exogenous output cost of default with special features, and they underestimate debt-output ratios by a wide margin. This paper proposes a solution to this default risk-business cycle disconnect based on a model of sovereign default with endogenous output dynamics. The model replicates observed V-shaped output dynamics around default episodes, countercyclical sovereign spreads, and high debt ratios, and it also matches the variability of consumption and the countercyclical fluctuations of net exports. Three features of the model are key for these results: (1) working capital loans pay for imported inputs; (2) imported inputs support more efficient factor allocations than when these inputs are produced internally; and (3) default on the foreign obligations of firms and the government occurs simultaneously.
    Date: 2008
  6. By: Mandira Sarma (Indian Council for Research on International Economic Relations); Yuko Nikaido (Indian Council for Research on International Economic Relations)
    Abstract: In this paper we present an analytical review of the capital adequacy regime and the present state of capital to risk-weighted asset ratio (CRAR) of the banking sector in India. In the current regime of Basel I, Indian banking system is performing reasonably well, with an average CRAR of about 12 per cent, which is higher than the internationally accepted level of 8 per cent as well as India's own minimum regulatory requirement of 9 per cent. As the revised capital adequacy norms, Basel II, are being implemented from March 2008, several issues emerge. We examine these issues from the Indian perspective.
    Keywords: Capital Adequacy Ratio, Basel I, Basel II, Reserve Bank of India, SMEs lending
    JEL: G20 G21 G28
    Date: 2007–07
  7. By: Maroš Servátka (University of Canterbury); George Theocharides
    Abstract: This classroom experiment introduces students to the notion of credit risk by allowing them to trade on comparable corporate bond issues from two types of markets - investment-grade and high-yield. Investment-grade issues have a lower probability of default than high-yield issues, and thus provide a lower yield. There are three ways in which participants can earn money - from coupon payments, the face value of the bond, and by capital gains. Students learn about the notion of risk and return, how credit risk affects bond prices, as well as some general characteristics of the bond markets.
    Keywords: Teaching Experiment; Credit Risk; Bond Market; Risk and Return
    JEL: A20 C90 D84
    Date: 2007–12–11
  8. By: Clauio Borio
    Abstract: The unfolding financial turmoil in mature economies has prompted the official and private sectors to reconsider policies, business models and risk management practices. Regardless of its future evolution, it already threatens to become one of the defining economic moments of the 21st century. This essay seeks to provide a preliminary assessment of the events and to draw some lessons for policies designed to strengthen the financial system on a long-term basis. It argues that the turmoil is best seen as a natural result of a prolonged period of generalised and aggressive risk-taking, which happened to have the subprime market at its epicentre. In other words, it represents the archetypal example of financial instability with potentially serious macroeconomic consequences that follows the build-up of financial imbalances in good times. The significant idiosyncratic elements, including the threat of an unprecedented involuntary "reintermediation" wave for banks and the dislocations associated with new credit risk transfer instruments, are arguably symptoms of more fundamental common causes. The policy response, while naturally taking into account the idiosyncratic weaknesses brought to light by the turmoil, should be firmly anchored to the more enduring factors that drive financial instability. This essay highlights possible mutually reinforcing steps in three areas: accounting, disclosure and risk management; the architecture of prudential regulation; and monetary policy.
    Keywords: financial turmoil, risk, liquidity, prudential regulation, accounting, ratings, monetary policy
    Date: 2008–03
  9. By: Cao, Jin; Illing, Gerhard
    Abstract: Traditionally, aggregate liquidity shocks are modelled as exogenous events. Extending our previous work (Cao & Illing, 2007), this paper analyses the adequate policy response to endogenous systemic liquidity risk. We analyse the feedback between lender of last resort policy and incentives of private banks, determining the aggregate amount of liquidity available. We show that imposing minimum liquidity standards for banks ex ante are a crucial requirement for sensible lender of last resort policy. In addition, we analyse the impact of equity requirements and narrow banking, in the sense that banks are required to hold sufficient liquid funds so as to pay out in all contingencies. We show that such a policy is strictly inferior to imposing minimum liquidity standards ex ante combined with lender of last resort policy.
    Keywords: Liquidity risk; Free-riding; Narrow banking; Lender of last resort
    JEL: E5 G21 G28
    Date: 2008–04–21
  10. By: Robert J. Shiller
    Abstract: The establishment recently of risk management vehicles for home prices is described. The potential value of such vehicles, once they become established, is seen in consideration of the inefficiency of the market for single family homes. Institutional changes that might derive from the establishment of these new markets are described. An important reason for these beginnings of real estate derivative markets is the advance in home price index construction methods, notably the repeat sales method, that have appeared over the last twenty years. Psychological barriers to the full success of such markets are discussed.
    JEL: G13 R31
    Date: 2008–04
  11. By: Jane Haltmaier
    Abstract: Predicting cycles in economic activity is one of the more challenging but important aspects of economic forecasting. This paper reports the results from estimation of binary probit models that predict the probability of an economy being in a recession using a variety of financial and real activity indicators. The models are estimated for eight countries, both individually and using a panel regression. Although the success of the models varies, they are all able to identify a significant number of recessionary periods correctly.
    Date: 2008

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