nep-rmg New Economics Papers
on Risk Management
Issue of 2009‒01‒03
sixteen papers chosen by
Stan Miles
Thompson Rivers University

  1. Stress Testing Banks' Credit Risk Using Mixture Vector Autoregressive Models By Tom Pak-wing Fong; Chun-shan Wong
  2. Stress testing of real credit portfolios By Mager, Ferdinand; Schmieder, Christian
  3. Security and Risk-Based Models in Shipping and Ports: Review and Critical Analysis By Khalid Bichou
  4. The Price Discovery Process in Credit Derivative Markets: Evidence from Sovereign CDS Market By Li, Nan
  5. An Empirical Characteristic Function Approach to VaR under a Mixture of Normal Distribution with Time-Varying Volatility By Dinghai Xu; Tony S. Wirjanto
  6. Exact inference in diagnosing value-at-risk estimates: A Monte Carlo device By Herwartz, Helmut
  7. Relevancy of the Cost-of-Capital Rate for the Insurance Companies By Mathieu Gatumel
  8. Multiple-Bank Lending, Creditor Rights and Information Sharing By Alberto Bennardo; Marco Pagano; Salvatore Piccolo
  9. How Important Is Liquidity Risk for Sovereign Bond Risk Premia? Evidence from the London Stock Exchange By Ron Alquist
  10. Risk Perception, Risk Attitude and Decision : a Rank-Dependent Approach By Michèle Cohen
  11. Banking Deregulation and Financial Stability : is it Time to re-regulate in Canada ? By Christian Calmès; Raymond Théoret
  12. Counterparty Risk in the Over-The-Counter Derivatives Market By Miguel A. Segoviano Basurto; Manmohan Singh
  13. A Primer on Financial System Meltdown. The Economists' View By Franz R. Hahn
  14. Real estate markets and bank distress By Koetter, Michael; Poghosyan, Tigran
  15. Capital requirements: Are they the best solution? By Alejandro Balbas
  16. Economic Impact Analysis of Terrorism Events: Recent Methodological Advances and Findings By Peter Gordon; Harry W. Richardson

  1. By: Tom Pak-wing Fong (Research Department, Hong Kong Monetary Authority); Chun-shan Wong (Department of Finance, The Chinese University of Hong Kong)
    Abstract: This paper estimates macroeconomic credit risk of banks¡¦ loan portfolio based on a class of mixture vector autoregressive models. Such class of models can differentiate distributions of default rates and macroeconomic conditions for different market situations and can capture their dynamics evolving over time, including the feedback effect from an increase in fragility back to the macroeconomy. These extensions can facilitate the evaluation of credit risks of loan portfolio based on different credit loss distributions.
    Keywords: Stress test; Hong Kong Banking; Credit risk; Mixture autoregressive models; Macroeconomic shocks; Value-at-risk.
    JEL: C15 C32 C53 E37 G21
    Date: 2008–10
  2. By: Mager, Ferdinand; Schmieder, Christian
    Abstract: Stress testing has become a crucial point on the Basel II agenda, mainly as Pillar I estimates do not explicitly take portfolio concentration into account. We start from the credit portfolio of the German pension insurer being a cross-sectional representation of the German economy and subsequently compose three bank portfolios corresponding to a small, medium and large bank. We apply univariate and multivariate stress tests both by using the Internal Rating based (IRB) model and by a model that additionally allows for variation of correlation. In a severe multivariate stress scenario based on historical data for Germany IRB capital requirements increase by more than 80% with little differences between the credit portfolios. If stress testing is additionally applied to correlation, the Value-at-Risk increases by up to 300% and portfolio differences materialize.
    Keywords: Credit Portfolio, Exposure concentration, Stress Testing, Basel II, Economic Capital
    JEL: G21 G28
    Date: 2008
  3. By: Khalid Bichou
    Abstract: The primary aim of maritime security assessment models is to assess the level of security within and across the maritime network. When managing risk through legislation, regulatory assessment models are used to assess risk levels and examine the impact of policy options, usually in terms of the costs and benefits of a regulatory proposal. This paper reviews the development, application and adequacy of existing risk assessment and management models to maritime and port security. In particular, we examine the problematical issues of security perception, value and impact, and discuss the limitations of the current regulatory framework in providing an integrated and effective approach to risk assessment and management, including for supply chain security.
    Date: 2008–12–02
  4. By: Li, Nan
    Abstract: The U.S. subprime loan crisis in 2007 has caused astonishing domestic and international financial turmoil, both directly and indirectly. Being a main factor in facilitating mortgage securitization, credit derivative market is now under the blame of underestimating credit risk and aggregating the impact of credit risk. It is worthy of revisiting the contribution of credit derivative products to their underlying bond markets in discovering the true level of credit risk. In this paper, I use sampled Credit Default Swap (CDS) contracts written on sovereign borrowers, to investigate the pricing relationship between sovereign CDS and bond markets. My purpose is to find whether the newly innovated derivative market can help bond market to reveal more pricing information on credit risk, or just add more noise to it. Applying Vector Error Correction Model (VECM) to a data sample ranging from 1999 to 2002, I find no statistical evidences with regard to the pricing contribution of sovereign CDS market. Instead, sovereign bond market advances in price discovery process by at least one week. Moreover, there exists a significant price gap between the two measures of credit risk: CDS rate and the yield spread of its underlying bond. This further reduces the effectiveness of using sovereign CDS in credit risk hedge.
    Keywords: sovereign bond; sovereign CDS; yield spread; price discovery process
    JEL: G15 G13
    Date: 2008–07
  5. By: Dinghai Xu (Department of Economics, University of Waterloo); Tony S. Wirjanto (Department of Economics, University of Waterloo)
    Abstract: This paper considers Value at Risk measures constructed under a discrete mixture of normal distribution on the innovations with time-varying volatility, or MN-GARCH, model. We adopt an approach based on the continuous empirical characteristic function to estimate the param eters of the model using several daily foreign exchange rates' return data. This approach has several advantages as a method for estimating the MN-GARCH model. In particular, under certain weighting measures, a closed form objective distance function for estimation is obtained. This reduces the computational burden considerably. In addition, the characteristic function, unlike its likelihood function counterpart, is always uniformly bounded over parameter space due to the Fourier transformation. To evaluate the VaR estimates obtained from alternative specifications, we construct several measures, such as the number of violations, the average size of violations, the sum square of violations and the expected size of violations. Based on these measures, we find that the VaR measures obtained from the MN-GARCH model outperform those obtained from other competing models.
    Keywords: Value at Risk; Mixture of Normals; GARCH; Characteristic Function.
    Date: 2008–12
  6. By: Herwartz, Helmut
    Abstract: In this note a Monte Carlo approach is suggested to determine critical values for diagnostic tests of Value-at-Risk models that rely on binary random variables. Monte Carlo testing offers exact significance levels in finite samples. Conditional on exact critical values the dynamic quantile test suggested by Engle and Manganelli (2004) turns out more powerful than a recently proposed Portmanteau type test (Hurlin and Tokpavi 2006).
    Keywords: Value-at-Risk, Monte Carlo test
    JEL: C22 C52 G28
    Date: 2008
  7. By: Mathieu Gatumel (Axa - AXA, CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Panthéon-Sorbonne - Paris I)
    Abstract: For many assets and liabilities there exist deep and liquid markets so that the market value are reasily observed. However, for non-hedgeable risks, the market value of liabilities must be estimated. The Draft Solvency II Directive suggests in article 75 that the valuation of technical provisions (for non hedgeable risks) shall be the sum of a best estimate and a market value margin measuring the cost of risk. The market value margin is calculated as the present value of the cost of holding the solvency capital requirement for non-hedgeable risks during the whole run-off period of the in-force portfolio. One of the majour input of the market value margin is the cost-of-capital rate which corresponds to the risk premium applied on each unit of risk. According to European Commission (2007), European insurance and Reinsurance Federation (2008), and Chief Risk Officer Forum (2008), a single cost-of-capital rate shall be used by all insurance undertakings and for all lines of business. This paper aims at analyzing the cost-of-capital rate given by European Insurance and Reinsurance Federation (2008), and Chief Risk Officer Forum (2008). In particular, we highlight that it is very difficult to assess a cost-of- capital rate by using either the frictional cost approach or the full industry information beta methodology. Nevertheless, we highlight also that it seems to be irrelevant to use only one risk premium or all the risks and all the companies. We show that risk is not characterized by a fixed prices. In fact, the price of risk depends on the basket of risks at which it belongs, the risk level considered and the time period.
    Keywords: Market value margin, cost-of-capital rate, diversification effect, risk level.
    Date: 2008–11
  8. By: Alberto Bennardo (Università di Salerno, CSEF, and CEPR); Marco Pagano (Università di Napoli Federico II, CSEF, EIEF and CEPR); Salvatore Piccolo (Università di Napoli Federico II, CSEF, and TSE)
    Abstract: When a customer can borrow from several competing banks, lending by each of them raises the customer’s default risk. If creditor rights are poorly protected, this contractual externality can generate equilibria with rationing, as well as others with excessive lending or non-competitive rates. Information sharing among banks about clients’ past indebtedness reduces interest and default rates, improves entrepreneurs’ access to credit (unless the value of collateral is very uncertain) and may act as a substitute for creditor rights protection. If information sharing also allows banks to monitor their clients’ subsequent indebtedness, the credit market may achieve full efficiency.
    Keywords: information sharing, multiple banks, creditor rights, seniority, non-exclusivity
    JEL: D73 K21 K42 L51
    Date: 2008–12–31
  9. By: Ron Alquist
    Abstract: This paper uses the framework of arbitrage-pricing theory to study the relationship between liquidity risk and sovereign bond risk premia. The London Stock Exchange in the late 19th century is an ideal laboratory in which to test the proposition that liquidity risk affects the price of sovereign debt. This period was the last time that the debt of a heterogeneous set of countries was traded in a centralized location and that a sufficiently long time series of observable bond prices are available to conduct asset-pricing tests. Empirical analysis of these data establishes three new results. First, sovereign bonds with wide bid-ask spreads earn 3-4% more per year than bonds with narrow bid-ask spreads, and the difference is reflected in greater sensitivity to innovations in market liquidity. Second, small sovereign bonds, as measured by market value, earn 1.8-3.5% more per year than large sovereign bonds, and the difference is also reflected in their exposure to innovations in market liquidity. Third, market liquidity is a state variable important for pricing the cross-section of sovereign bonds. This paper thus provides estimates of the quantitative importance of liquidity risk as a determinant of the sovereign risk premium and underscores the significance of market liquidity as a nondiversifiable risk.
    Keywords: Financial markets; International topics
    JEL: F21 F34 F36 G12 G15
    Date: 2008
  10. By: Michèle Cohen (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Panthéon-Sorbonne - Paris I, EEP-PSE - Ecole d'Économie de Paris - Paris School of Economics - Ecole d'Économie de Paris)
    Abstract: The classical expected utility model of decision under risk (von Neumann-Morgenstern, 1944) has been criticized from an experimental point of view (Allais' paradox) as well as for its restrictive lack of explanatory power. The Rank-Dependent Expected Utility model (RDU) model (Quiggin, 1982) attempts to answer some of these criticisms. The decision maker is characterized by two functions : a utility function on consequences measuring preferences over sure outcomes and a probability weighting function measuring the subjective weighting of probabilities. As we show and illustrate in this paper, this model allows for more diversified types of behavior : it is consistent with the behavior revealed by the Allais paradox ; the decision maker could dislike risk (prefer to any lottery its expectation) without necessarily avoiding any increase in risk ; diminishing marginal utility may coexists with "weak" risk seeking attitudes ; decision makers with the same utility function may differ in their choices between lotteries when they have different probability weighting functions ; furthemore, the same decision maker may have different, context-dependent, subjective beliefs on events.
    Keywords: Decision under risk, risk perception, risk aversion, Allais paradox, Rank-Dependent Expected Utility Model.
    Date: 2008–12
  11. By: Christian Calmès (Département des sciences administratives, Université du Québec (Outaouais), et LRSP); Raymond Théoret (Département de stratégie des affaires, Université du Québec (Montréal), et Chaire d'information financière et organisationnelle)
    Abstract: We provide new evidence of a worsening of the risk-return trade-off in Canadian banking. Surging OBS activities have led to increasingly volatile net operating revenues, and might have reduced well-known measures of bank profitability, like return on assets and return on equity. In this context, a natural question arises: should we re-regulate? On this matter, we confirm Calmès(2003) prediction: a maturation process took place after 1997. Using a new approach based on ARCH-M estimation, we find that an additional risk premium has emerged. In this sense, there is no need to re-regulate.
    Keywords: ARCH-M Models, risk premium, financial stability
    JEL: G20 G21
    Date: 2008–10–20
  12. By: Miguel A. Segoviano Basurto; Manmohan Singh
    Abstract: The financial market turmoil of recent months has highlighted the importance of counterparty risk. Here, we discuss counterparty risk that may stem from the OTC derivatives markets and attempt to assess the scope of potential cascade effects. This risk is measured by losses to the financial system that may result via the OTC derivative contracts from the default of one or more banks or primary broker-dealers. We then stress the importance of "netting" within the OTC derivative contracts. Our methodology shows that, even using data from before the worsening of the crisis in late Summer 2008, the potential cascade effects could be very substantial. We summarize our results in the context of the stability of the banking system and provide some policy measures that could be usefully considered by the regulators in their discussions of current issues.
    Date: 2008–11–20
  13. By: Franz R. Hahn
    Abstract: Ideologues are quick to explain the current financial meltdown: it's the markets, stupid. Economists agree but add: it's politics too, stupid. Ideologues agree but counter: first and foremost it's capitalism, stupid. Economists agree but reply: §$%&?!, stupid. This is where this short paper takes us: it makes an attempt to give a brief overview of the economists' views on the ongoing financial system crisis explaining "§$%&?!, stupid".
    Keywords: financial system crisis, systemic risk, macroeconomic stability, financial regulation
    Date: 2008–12–01
  14. By: Koetter, Michael; Poghosyan, Tigran
    Abstract: We investigate the relationship between real estate markets and bank distress among German universal and specialized mortgage banks between 1995 and 2004. Higher house prices increase the value of collateral, which reduces the probability of bank distress (PDs). But higher prices at given rents may also indicate excessive expectations regarding the present value of real estate assets, which can increase PDs. Increasing price-to-rent ratios are positively related to PDs and larger real estate exposures amplify this effect. Rising real estate price levels alone reduce bank PDs, but only for banks with large real estate market exposure. This suggests a positive, but relatively small 'collateral' eect for banks with more expertise in specialized mortgage lending. Likewise, lower price-to-rent ratios are estimated to reduce the riskiness of banks. The multilevel logit model used here further shows that real estate markets are regionally segmented and location-specific effects contribute significantly to predicted bank PDs.
    Keywords: Real estate, distress, universal vs. specialized banks
    JEL: C25 G21 G3
    Date: 2008
  15. By: Alejandro Balbas
    Abstract: General risk functions are becoming very important in finance and insurance. Many risk functions are interpreted as initial capital requirements that a manager must add and invest in a risk-free security in order to protect his clients wealth. Nevertheless, until now it has not been proved that an alternative investment will be outperformed by the riskless asset. This paper deals with a complete arbitrage free market and a general expectation bounded risk measure and analyzes whether the investment in the riskless asset of the capital requirements is optimal. It is shown that it is not optimal in many important cases. For instance, if the risk measure is the CVaR and we consider the assumptions of the CAPM or the Black and Scholes model. Furthermore, the Black and Scholes model the explicit expression of the optimal strategy is provided, and it is composed of several put options. If the confidence level of the CVaR is close to 100% then the optimal strategy becomes a classical portfolio insurance strategy. This may be a surprising and important finding for both researchers and practitioners. In particular, managers can discover how to reduce the level of initial capital requirements by trading options.
    Keywords: Risk measure, Capital requirement, Optimal strategy, Portfolio insurance
    JEL: G11 G13 G22 G23
    Date: 2008–12
  16. By: Peter Gordon; Harry W. Richardson
    Abstract: National security is a basic responsibility of national governments, but it is also intangible. What can economic analysis contribute? Benefit-cost analysis has rarely been applied because of the ambiguous and commons nature of the benefits. Our group at the University of Southern California’s Center for Risk and Economic Analysis of Terrorism (CREATE) has worked to elaborate and apply economic impact analysis to describe the expected losses from various hypothetical terrorist attacks. Our innovation has been to add a spatial dimension to operational inter-industry models.
    Date: 2008–11

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