New Economics Papers
on Risk Management
Issue of 2009‒01‒17
eleven papers chosen by

  1. Applying Basel II Requirements in Romania By Miru, Oana Maria; Hetes-Gavra , Roxana; Nicolescu, Ana Cristina
  2. Basel II Capital Requirements, Firms' Heterogeneity, and the Business Cycle By Ines Drumond; José Jorge
  3. Stages of the 2007/2008 Global Financial Crisis: Is There a Wandering Asset-Price Bubble? By Orlowski, Lucjan T
  4. Buy-and-Hold Strategies and Comonotonic Approximations By M. Bosch-Princep; J. Dhaene; J. Marin-Solano; C. Ribas; O. Roch; S. Vanduffel
  5. Information, Liquidity, and the (Ongoing) Panic of 2007 By Gary B. Gorton
  6. Basel II, External Ratings and Adverse Selection By Akhtar, S.; Bannier, C.; Tyrell, M.; Elizalde, A.; Janda, K.; Lind, G.
  7. Compatibility between pricing rules and risk measures: The CCVaR By Alejandro Balbás; Raquel Balbás
  8. Yield-Curve Based Probit Models for Forecasting U.S. Recessions: Stability and Dynamics By Heikki Kauppi
  9. Implied Market Price of Weather Risk By Wolfgang Härdle; Brenda López Cabrera
  10. On the Systemic Nature of Weather Risk By Guenther Filler; Martin Odening; Ostap Okhrin; Wei Xu
  11. The Spread of the Credit Crisis: View from a Stock Correlation Network By Smith, Reginald

  1. By: Miru, Oana Maria; Hetes-Gavra , Roxana; Nicolescu, Ana Cristina
    Abstract: The Basel II Agreement is a new stage in the development of prudential regulations. Compared to the initial agreement, Basel I, this one allows a more large and precise analysis of banking risks. The European approach of Basel II requirements aims to offer some common conditions for all the credit institutions. Secondly, in order to achieve the objectives of Basel II, an active implication of the supervisory authorities is needed, as well as a tighter cooperation between them in order to increase the financial integration at the European Union level. In what concerns Romania, that has recently joined the European Union, the implementation of Basel II requirements imply a new series of challenges both for credit institutions and for the Central Bank. These challenges, for the commercial banks, reside in adjusting the risk management techniques and the informational system, training the staff, obtaining the databases, etc. and for the Central Bank in both adapting the surveillance process and elaborating new regulations. This paper tries to analyze the main implications of implementing these requirements, both for the Romanian commercial banks and for the National Bank.
    Keywords: banking; prudential regulations; supervision; capital requirements
    JEL: E5 E50
    Date: 2008
  2. By: Ines Drumond (CEMPRE and Faculdade de Economia, Universidade do Porto); José Jorge (CEMPRE and Faculdade de Economia, Universidade do Porto)
    Abstract: This paper assesses the potential procyclical effects of Basel II capital requirements by evaluating to what extent those effects depend on the composition of banks' asset portfolios and on how borrowers' credit risk evolves over the business cycle. By developing a heterogeneous-agent general equilibrium model, in which firms' access to credit depends on their financial position, we find that regulatory capital requirements, by forcing banks to finance a fraction of loans with costly bank capital, have a negative effect on firms' capital accumulation and output in steady state. This effect is amplified with the changeover from Basel I to Basel II, in a stationary equilibrium characterized by a significant fraction of small and highly leveraged firms. In addition, to the extent that it is more costly to raise bank capital in bad times, the introduction of an aggregate technology shock into a partial equilibrium version of the model supports the Basel II procyclicality hypothesis: Basel II capital requirements accentuate the bank loan supply effect underlying the bank capital channel of propagation of exogenous shocks.
    Keywords: Business Cycles, Procyclicality, Financial Constraints, Bank Capital Channel, Basel II, Heterogeneity
    JEL: E44 E32 G28 E10
    Date: 2009–01
  3. By: Orlowski, Lucjan T
    Abstract: This study identifies five distinctive stages of the current global financial crisis: the meltdown of the subprime mortgage market; spillovers into broader credit market; the liquidity crisis epitomized by the fallout of Northern Rock, Bear Stearns and Lehman Brothers with counterparty risk effects on other financial institutions; the commodity price bubble, and the ultimate demise of investment banking in the U.S. The study argues that the severity of the crisis is influenced strongly by changeable allocations of global savings coupled with excessive credit creation, which lead to over-pricing of varied types of assets. The study calls such process a “wandering asset-price bubble”. Unstable allocations elevate market, credit and liquidity risks. Monetary policy responses aimed at stabilizing financial markets are proposed.
    Keywords: subprime mortgage crisis; credit crisis; liquidity crisis; market risk; credit risk; default risk; counterparty risk; collateralized debt obligations; Level 3 Assets; Basel II
    JEL: G12 G15 E44 G21
    Date: 2008–12–10
  4. By: M. Bosch-Princep; J. Dhaene; J. Marin-Solano; C. Ribas; O. Roch; S. Vanduffel (Universitat de Barcelona)
    Abstract: We investigate optimal buy-and-hold strategies for terminal wealth problems in a multi-period framework. As terminal wealth is a sum of dependent random variables, each of these variables corresponding to an amount of capital that has been invested in a particular asset at a particular date, we first consider approximations that reduce the multivariate randomness to univariate randomness. Next, these approximations are used to determine buy-and-hold strategies that optimize, for a given probability level, the Value at Risk and the Conditional Left Tail Expectation of the distribution function of final wealth. This paper complements Dhaene et al. (2005), where the case of continuous rebalancing is considered.
    Keywords: comonotonicity, lower bounds, optimal portfolios, risk measures, lognormal variables
    JEL: C63 G11 C61
    Date: 2009
  5. By: Gary B. Gorton
    Abstract: The credit crisis was sparked by a shock to fundamentals, housing prices failed to rise, which led to a collapse of trust in credit markets. In particular, the repurchase agreement market in the U.S., estimated to be about $12 trillion, larger than the total assets in the U.S. banking system ($10 trillion), became very illiquid during the crisis due to the fear of counterparty default, leaving lenders with illiquid bonds that they did not want, believing that they could not be sold. As a result, there was an increase in repo haircuts (the initial margin), causing massive deleveraging. I investigate this indirectly, by looking at the breakdown in the arbitrage foundation of the ABX.HE indices during the panic. The ABX.HE indices of subprime mortgage-backed securities are derivatives linked to the underlying subprime bonds. Introduced in 2006, the indices aggregated and revealed information about the value of the subprime mortgage-backed securities and allowed parties to buy protection against declines in subprime value via credit derivatives written on the index or tranches of the index. When the ABX prices plummeted, the arbitrage relationships linking the credit derivatives linked to the index and the underlying bonds broke down because liquidity evaporated in the repo market. This breakdown allows a glimpse of the information problems that led to illiquidity in the repo markets, and the extent of the demand for protection against subprime risk.
    JEL: G1 G13 G21
    Date: 2009–01
  6. By: Akhtar, S.; Bannier, C.; Tyrell, M.; Elizalde, A.; Janda, K.; Lind, G.
    Abstract: This paper will describe and analyse the development of Basel II Capital Accord and will focus on the use of external ratings in the Standardized Approach in Basel II. Furthermore it will examine the problem of adverse selection which appears in Basel II as a result from the proposal for the use of external ratings in determining the risk weights in the standardized approach. The paper will also attempt to find possible solutions to the adverse selection problem by discussing two similar models, and derive implications from them.
    Keywords: Basel II; external ratings; adverse selection; rating agencies; standardized approach
    JEL: E51 E5 G24
    Date: 2008–09–30
  7. By: Alejandro Balbás; Raquel Balbás
    Abstract: This paper has considered a risk measure ρ and a (maybe incomplete and/or imperfect) arbitrage-free market with pricing rule π. They are said to be compatible if there are no reachable strategies y such that π (y) remains bounded and ρ(y) is close to - ∞. We show that the lack of compatibility leads to meaningless situations in financial or actuarial applications. The presence of compatibility is characterized by properties connecting the Stochastic Discount Factor of π and the sub-gradient of ρ . Consequently, several examples pointing out that the lack of compatibility may occur in very important pricing models are yielded. For instance the CVaR and the DPT are not compatible with the Black and Scholes model or the CAPM. We prove that for a given incompatible couple (π,ρ) we can construct a minimal risk measure ρπ compatible with π and such that ρπ ≥ ρ . This result is particularized for the CVaR and the CAPM and the Black and Scholes model. Therefore we construct the Compatible Conditional Value at Risk (CCVaR). It seems that the CCVaR preserves the good properties of the CVaR and overcomes its shortcomings.
    Keywords: Risk Measure, Pricing Rule, Compatibility, Compatible Conditional Value at Risk
    JEL: G11 G13 G22 G23
    Date: 2009–01
  8. By: Heikki Kauppi (Department of Economics, University of Turku)
    Abstract: Recent research provides controversial evidence on the stability of yield-curve based binary probit models for forecasting U.S. recessions. This paper reviews so far applied specifications and presents new procedures for examining the stability of selected probit models. It finds that a yield-curve based probit model that treats the binary response (a recession dummy) as a nonhomogeneous Markov chain produces superior in-sample and out-of-sample probability forecasts for U.S. recessions and that this model specification is stable over time. Thus, the failure of yieldcurve based forecasts to signal the 1990-1991 and 2001 recessions should not be attributed to parameter instability, instead the evidence suggests that these events were inherently uncertain.
    Keywords: recession forecast, yield curve, dynamic probit models, parameter stability
    JEL: C22 C25 E32 E37
    Date: 2008–05
  9. By: Wolfgang Härdle; Brenda López Cabrera
    Abstract: Weather influences our daily lives and choices and has an enormous impact on cooperate revenues and earnings. Weather derivatives differ from most derivatives in that the underlying weather cannot be traded and their market is relatively illiquid. The weather derivative market is therefore incomplete. This paper implements a pricing methodology for weather derivatives that can increase the precision of measuring weather risk. We applied continous autoregressive models (CAR) with seasonal variation to model the temperature in Berlin and with that to get explicite nature of non-arbitrage prices for temperature derivatives. We infer the implied market price from Berlin cumulative monthly temperature futures that are traded at the Chicago Mercantile Exchange (CME), which is an important parameter of the associated equivalent martingale measures used to price and hedge weather future/options in the market. We propose to study the market price of risk, not only as a piecewise constant linear function, but also as a time dependent. In any of the previous cases, we found that the market price of weather risk is different from zero and shows a seasonal structure. With the extract information we price other exotic options, such as cooling/heating degree day temperatures and non standard contract with crazy maturities.
    Keywords: Weather derivatives, weather risk, weather forecasting, seasonality, continuous autoregressive model, stochastic variance, CAT index, CDD index, HDD index, market price of risk, risk premium, CME
    JEL: G19 G29 N26 N56 Q29 Q54
    Date: 2009–01
  10. By: Guenther Filler; Martin Odening; Ostap Okhrin; Wei Xu
    Abstract: Systemic weather risk is a major obstacle for the formation of private (non- subsidized) crop insurance. This paper explores the possibility of spatial diversification of insurance by estimating the joint occurrence of unfavorable weather conditions in different locations. For that purpose copula methods are employed that allow an adequate description of stochastic dependencies between multivariate random variables. The estimation procedure is applied to weather data in Germany. Our results indicate that indemnity payments based on temperature as well as on cumulative rainfall show strong stochastic dependence even at a national scale. Thus the possibility to reduce risk exposure by increasing the trading area of the insurance is limited. Irrespective of their economic implications our results pinpoint the necessity of a proper statistical modeling of the dependence structure of multivariate random variables. The usual approach of measuring stochastic dependence with linear correlation coefficients turned out to be questionable in the context of weather insurance as it may overestimate diversification effects considerably.
    Keywords: weather risk, crop insurance, copula
    JEL: C14 Q19
    Date: 2009–01
  11. By: Smith, Reginald
    Abstract: The credit crisis roiling the world's financial markets will likely take years and entire careers to fully understand and analyze. A short empirical investigation of the current trends, however, demonstrates that the losses in certain markets, in this case the US equity markets, follow a cascade or epidemic flow like model along the correlations of various stocks. A few images and explanation here will suffice to show the phenomenon. Also, whether the idea of "epidemic" or a "cascade" is a metaphor or model for this crisis will be discussed. Animations of the spread of the crisis are available at editcrisis
    Keywords: networks; econophysics; equities; stock market; correlation; credit crisis
    JEL: G15 G10
    Date: 2008–11–11

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