New Economics Papers
on Risk Management
Issue of 2008‒06‒13
seven papers chosen by

  1. Private Equity and Regulatory Capital By Bongaerts, D.; Charlier, E.
  2. Value at Risk (VaR) and the alpha-stable distribution By John C. Frain
  3. MARKET RISK DYNAMICS AND COMPETITIVENESS AFTER THE EURO: Evidence from EMU Members By Juan Piñeiro Chousa,; Artur Tamazian,; Davit N. Melikyan,
  4. Bank Capital Requirements, Business Cycle Fluctuations and the Basel Accords: A Synthesis By Inês Drumond
  5. Model Averaging in Risk Management with an Application to Futures Markets By Pesaran, M.H.; Schleicher, C.; Zaffaroni, P.
  6. Partial Likelihood-Based Scoring Rules for Evaluating Density Forecasts in Tails By Cees Diks; Valentyn Panchenko; Dick van Dijk
  7. Management of FX settlement risk in Hungary (Report II) By Eszter Tanai

  1. By: Bongaerts, D.; Charlier, E. (Tilburg University, Center for Economic Research)
    Abstract: Regulatory Capital requirements for European banks have been put forward in the Basel II Capital Framework and subsequently in the Capital Requirements Directive (CRD) of the EU. We provide a detailed discussion of the capital requirements for private equity investments under the simple risk weight approach, the PD/LGD approach and the internal model approach. For the latter we present a structural model for which we calibrate the parameters from a proprietary dataset. We modify the standard Merton structural model to make it applicable in practice and to capture stylized facts of these investments. We also show how to implement the early default features of our model in a simulation algorithm with very low computational costs. Our results support capital requirements lower than in Basel II, but not as low as in CRD. A sensitivity analysis shows that this finding is robust to parameter uncertainty and stress scenarios. This is likely to give adverse incentives to banks for using advanced risk models.
    Keywords: Private Equity;Regulatory Capital;Risk Management
    JEL: G21 G28 G32
    Date: 2008
  2. By: John C. Frain (Department of Economics, Trinity College Dublin)
    Abstract: Volatility in financial markets is a matter of considerable concern to financial institutions and their supervisors. Already it is clear that this volatility has had an adverse effect on the real economy. Many measures of risk that are used today do not take full account of the kind of extreme changes in asset prices that have been observed. This paper finds that the Value at Risk measure of risk can be improved by the use of an alpha-stable distribution in place of more conventional measures. The paper describes the use of this measure and implements it for six total returns equity portfolios. We find that alpha-stable based measures are feasible and are better than conventional measures. They are a useful tool for the risk manager and the financial regulator.
    Keywords: alpha stable distribution, Value at Risk, VaR
    JEL: C13 C16 C46 G18 G19 G28 G29
    Date: 2008–05
  3. By: Juan Piñeiro Chousa,; Artur Tamazian,; Davit N. Melikyan,
    Abstract: In this paper we propose an empirical model that considers theoretical facts on the relationship between real exchange rates and the net exports of the economy to supplement the interaction of a number of financial and economic factors with the stock market. We discuss the impact of exchange rate fluctuations on market risk in terms of Value at Risk (VaR). Our empirical findings show that common currency introduction produced increments in VaR whereas European stock returns are more sensitive to changes in competitiveness regarding the EMU rather than national exports. Finally, we show that the synchronisation of variation in competitiveness through the introduction of a single currency has made these changes more decisive in explaining financial market fluctuations.
    Keywords: Euro, Competitiveness, Market Risk, Net Export, Value-at-Risk, Volatility
    JEL: F33 G24 G28 O24
    Date: 2008–02–01
  4. By: Inês Drumond (CEMPRE, Faculdade de Economia, Universidade do Porto)
    Abstract: In order to survey the mechanisms through which the introduction of Basel II bank capital requirements is likely to accentuate the procyclical tendencies of banking, this paper brings together the theoretical literature on the bank capital channel of propagation of exogenous shocks and the literature on the regulatory framework of capital requirements under the Basel Accords. We conclude that, although the theoretical models that revisit the bank capital channel under the new Accord generally support the Basel II procyclicality hypothesis, this issue is still subject to some debate. In particular, the magnitude of the procyclical effects under Basel II should essentially depend on (i) the composition of banks' asset portfolios, (ii) the approach adopted by banks to compute their minimum capital requirements, (iii) the nature of the rating system used by banks, (iv) the view adopted concerning how credit risk evolves through time, (v) the capital buffers over the regulatory minimum held by the banking institutions, (vi) the improvements in credit risk management, and (vii) the supervisor and market intervention under Basel II.
    Keywords: Bank Capital Channel, Basel Accords, Business Cycles, Procyclicality
    JEL: E44 G28
    Date: 2008–06
  5. By: Pesaran, M.H.; Schleicher, C.; Zaffaroni, P.
    Abstract: This paper considers the problem of model uncertainty in the case of multi-asset volatility models and discusses the use of model averaging techniques as a way of dealing with the risk of inadvertently using false models in portfolio management. Evaluation of volatility models is then considered and a simple Value-at-Risk (VaR) diagnostic test is proposed for individual as well as `average' models. The asymptotic as well as the exact ¯nite-sample distribution of the test statistic, dealing with the possibility of parameter uncertainty, are established. The model averaging idea and the VaR diagnostic tests are illustrated by an application to portfolios of daily returns on six currencies, four equity indices, four ten year government bonds and four commodities over the period 1991-2007. The empirical evidence supports the use of `thick' model averaging strategies over single models or Bayesian type model averaging procedures.
    Keywords: Model Averaging, Value-at-Risk, Decision Based Evaluations.
    JEL: C32 C52 C53 G11
    Date: 2008–01
  6. By: Cees Diks (University of Amsterdam); Valentyn Panchenko (School of Economics, University of New South Wales); Dick van Dijk (Econometric Institute, Erasmus University Rotterdam)
    Abstract: We propose new scoring rules based on partial likelihood for assessing the relative out-of-sample predictive accuracy of competing density forecasts over a specific region of interest, such as the left tail in financial risk management. By construction, existing scoring rules based on weighted likelihood or censored normal likelihood favor density forecasts with more probability mass in the given region, rendering predictive accuracy tests biased towards such densities. Our novel partial likelihoodbased scoring rules do not suffer from this problem, as illustrated by means of Monte Carlo simulations and an empirical application to daily S&P 500 index returns.
    Keywords: density forecast evaluation; scoring rules; weighted likelihood ratio scores; partial likelihood; risk management.
    JEL: C12 C22 C52 C53
    Date: 2008–05
  7. By: Eszter Tanai (Magyar Nemzeti Bank)
    Abstract: The concept known as FX settlement risk (aka Herstatt risk) came into focus some thirty years ago when Bankhaus Herstatt, a small German bank, became insolvent leaving its counterparties with credit exposure equivalent to the nominal value of receivables in US dollar from FX transactions, for which they had already transferred their payables in Deutsch mark to the failed bank. There was no way to withdraw their payment orders. These events, however, shed some light on the – usually significant – risks inherent in clearing and settlement procedures of financial transactions. Under the aegis of the Bank for International Settlements (BIS), central banks set out in 1996 to take joint action and find a solution for this matter. They consequently came up with a methodology, which is now broadly used by a great many central banks for mapping and measuring FX settlement risk. The MNB undertook an analysis among banks active on the FX markets with questionnaires following the BIS methodology and personal interviews for the first time in October 2000, and published the results and observations in 2001 (MNB, 2001) under the title ‘Management of FX settlement risk in Hungary’. As the FX trading data indicated significant risks faced by the Hungarian banking system in terms of FX settlement, in 2005 the MNB decided to revisit the same area and conduct a survey similar to the review completed in 2000. The MNB received a significant boost in its efforts early in 2006 when BIS announced its intention to conduct a survey of the subject once again among the G10 central banks. The objective of this study is to analyse – relying on 2006 data – FX settlement risk that may arise in the domestic banking system under its current operations, and to chart the changes which took place after 2000, covering improvements and, if necessary, formulating (new) recommendations to reduce risks. As will be referred to in many cases, this study actively relies on the material published in 2000, including the methodology it describes in detail. As a number of central banks (for example Riksbank and Norges Bank) are using the BIS methodology plus other (regular and specific) statistical reports to analyse FX settlement risk in the credit institution sector, along with all its consequences for financial stability, this latest analysis involves a deeper approach, reaching somewhat beyond the constraints of the 2000 publication. In the first chapter we will demonstrate how FX settlement risk is treated among other risks to which banks are exposed, including its dimensions and the impact it may have on financial stability, and the means available to reduce risks in general. The second chapter contains a brief description of the 2006 survey and a summary of general views and overall concepts relating to the information obtained through the questionnaires and personal interviews. The third chapter provides an analysis of the data conveyed in the 2006 survey and – minus the composition effect – a comparison of the results from 2000 and 2006. The fourth chapter offers an overview of the personal interviews, and at the end a summary of the results, conclusions and recommendations for future purposes, where deemed necessary.
    Keywords: FX settlement riks, Continuous Linked Settlement, CLS, payment system, settlement limit, risk management.
    JEL: F31 G21 G32
    Date: 2008

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