nep-rmg New Economics Papers
on Risk Management
Issue of 2009‒04‒05
twelve papers chosen by
Stan Miles
Thompson Rivers University

  1. La Gestión de Riesgo de Liquidez en Economías Emergentes: Un Modelo Valor-en-Riesgo (VaR) Paramétrico de Calibración Indirecta y una Aplicación al Sistema Financiero Boliviano By Gonzales-Martínez, Rolando
  2. A Liquidity Risk Stress-Testing Framework with Interaction between Market and Credit Risks By Eric Wong; Cho-Hoi Hui
  3. Uncertainty of Multiple Period Risk Measures By Lönnbark, Carl
  4. The pricing of subprime mortgage risk in good times and bad: evidence from the ABX.HE indices By Ingo Fender; Martin Scheicher
  5. Towards New Technical Indicators for Trading Systems and Risk Management By Michel Fliess; Cédric Join
  6. Modelling intra-daily volatility by functional data analysis: an empirical application to the spanish stock market By Kenedy Alva; Juan Romo; Esther Ruiz
  7. Extreme Value GARCH modelling with Bayesian Inference By Les Oxley; Marco Reale; Carl Scarrott; Xin Zhao
  8. A Unified Theory of Tobin’s q, Corporate Investment, Financing, and Risk Management By Patrick Bolton; Hui Chen; Neng Wang
  9. Value at Risk for Large Portfolios By Lönnbark, Carl; Holmberg, Ulf; Brännäs, Kurt
  10. Banking Stability Measures By Charles Goodhart; Miguel Segoviano
  11. Cross-Border Exposures and Financial Contagion By Degryse, H.A.; Elahi, M.A.; Penas, M.F.
  12. Banking-on-the-Average Rules By Hans Gersbach; Volker Hahn

  1. By: Gonzales-Martínez, Rolando
    Abstract: Time series of obligations with the public are important to liquidity risk management in emerging economies, but a traditional parametric VaR model could give imprecise measures of liquidity risk if the series do not approach a normal (Gaussian) distribution. To overcome this flaw of parametric gaussian VaR models, this study suggest a parametric VaR model with indirect calibration (VaR-i) with a beta-parameter calibrated to be successful in backtesting tests, according to the empirical distribution of the data and not necessarily to the Gaussian distribution.
    Keywords: Valor-en-Riesgo; Value-at-Risk; riesgo de liquidez; VaR; medición de riesgos; medidas de riesgo
    JEL: C40 G32 G21
    Date: 2009–01
  2. By: Eric Wong (Research Department, Hong Kong Monetary Authority); Cho-Hoi Hui (Research Department, Hong Kong Monetary Authority)
    Abstract: This study develops a stress-testing framework to assess liquidity risk of banks, where liquidity and default risks can stem from the crystallisation of market risk arising from a prolonged period of negative asset price shocks. In the framework, exogenous asset price shocks increase banks¡¯ liquidity risk through three channels. First, severe mark-to-market losses on the banks¡¯ assets increase banks¡¯ default risk and thus induce significant deposits outflows. Secondly, the ability to generate liquidity from asset sales continues to evaporate due to the shocks. Thirdly, banks are exposed to contingent liquidity risk, as the likelihood of drawdowns on their irrevocable commitments increases in such stressful financial environments. In the framework, the linkage between market and default risks of banks is implemented using a Merton-type model, while the linkage between default risk and deposit outflows is estimated econometrically. Contagion risk is also incorporated through banks¡¯ linkage in the interbank and capital markets. Using the Monte Carlo method, the framework quantifies liquidity risk of individual banks by estimating the expected cash-shortage time and the expected default time. Based on publicly available data as at the end of 2007, the framework is applied to a group of banks in Hong Kong. The simulation results suggest that liquidity risk of the banks would be contained in the face of a prolonged period of asset price shocks. However, some banks would be vulnerable when such shocks coincide with interest rate hikes due to monetary tightening. Such tightening is, however, relatively unlikely in a context of such shocks.
    Keywords: Liquidity risk, stress testing, default risk, banks
    JEL: C60 G13 G28
    Date: 2009–03
  3. By: Lönnbark, Carl (Department of Economics, Umeå University)
    Abstract: In general, the properties of the conditional distribution of multiple period returns do not follow easily from the one-period data generating process. This renders computation of Value-at-Risk and Expected Shortfall for multiple period returns a non-trivial task. In this paper we consider some approximation approaches to computing these measures. Based on the results of a simulation experiment we conclude that among the studied analytical approaches the one based on approximating the distribution of the multiple period shocks by a skew-t was the best. It was almost as good as the simulation based alternative. We also found that the uncertainty due to the estimation risk can be quite accurately estimated employing the delta method. In an empirical illustration we computed ve day V aR0s for the S&P 500 index. The approaches performed about equally well.
    Keywords: Asymmetry; Estimation Error; Finance; GJR-GARCH; Prediction; Risk Management
    JEL: C16 C46 C52 C53 C63 G10
    Date: 2009–04–01
  4. By: Ingo Fender; Martin Scheicher
    Abstract: This paper investigates the market pricing of subprime mortgage risk on the basis of data for the ABX.HE family of indices, which have become a key barometer of mortgage market conditions during the recent financial crisis. After an introduction into ABX index mechanics and a discussion of historical pricing patterns, we use regression analysis to establish the relationship between observed index returns and macroeconomic news as well as market-based proxies of default risk, interest rates, liquidity and risk appetite. The results imply that declining risk appetite and heightened concerns about market illiquidity - likely due in part to significant short positioning activity - have provided a sizeable contribution to the observed collapse in ABX prices since the summer of 2007. In particular, while fundamental factors, such as indicators of housing market activity, have continued to exert an important influence on the subordinated ABX indices, those backed by AA and AAA exposures have tended to react more to the general deterioration of the financial market environment. This provides further support for the inappropriateness of pricing models that do not sufficiently account for factors such as risk appetite and liquidity risk, particularly in periods of heightened market pressure. In addition, as related risk premia can be captured by unconstrained investors, ABX pricing patterns appear to lend support to government measures aimed at taking troubled assets off banks' balance sheets - such as the US Troubled Asset Relief Program (TARP).
    Keywords: ABX index, mortgage-backed securities, pricing, risk premia
    Date: 2009–03
  5. By: Michel Fliess (LIX - Laboratoire d'informatique de l'école polytechnique - CNRS : UMR7161 - Polytechnique - X, INRIA Saclay - Ile de France - ALIEN - INRIA - Polytechnique - X - CNRS : UMR - Ecole Centrale de Lille); Cédric Join (INRIA Saclay - Ile de France - ALIEN - INRIA - Polytechnique - X - CNRS : UMR - Ecole Centrale de Lille, CRAN - Centre de recherche en automatique de Nancy - CNRS : UMR7039 - Université Henri Poincaré - Nancy I - Institut National Polytechnique de Lorraine - INPL)
    Abstract: We derive two new technical indicators for trading systems and risk management. They stem from trends in time series, the existence of which has been recently mathematically demonstrated by the same authors (A mathematical proof of the existence of trends in financial time series, Proc. Int. Conf. Systems Theory: Modelling, Analysis and Control, Fes, 2009), and from higher order quantities which replace the familiar statistical tools. Recent fast estimation techniques of algebraic flavor are utilized. The first indicator tells us if the future price will be above or below the forecasted trendline. The second one predicts abrupt changes. Several promising numerical experiments are detailed and commented.
    Keywords: Quantitative Finance, technical analysis, trading systems, risk management, trends, technical indicators, time series
    Date: 2009
  6. By: Kenedy Alva; Juan Romo; Esther Ruiz
    Abstract: We propose recent functional data analysis techniques to study the intra-daily volatility. In particular, the volatility extraction is based on functional principal components and the volatility prediction on functional AR(1) models. The estimation of the corresponding parameters is carried out using the functional equivalent to OLS. We apply these ideas to the empirical analysis of the IBEX35 returns observed each _ve minutes. We also analyze the performance of the proposed functional AR(1) model to predict the volatility along a given day given the information in previous days for the intra-daily volatility for the firms in the IBEX35 Madrid stocks index
    Keywords: Market microstructure, Ultra-high frequency data, Functional data analysis,Functional AR(1) model
    Date: 2009–03
  7. By: Les Oxley (University of Canterbury); Marco Reale; Carl Scarrott; Xin Zhao
    Abstract: Extreme value theory is widely used financial applications such as risk analysis, forecasting and pricing models. One of the major difficulties in the applications to finance and economics is that the assumption of independence of time series observations is generally not satisfied, so that the dependent extremes may not necessarily be in the domain of attraction of the classical generalised extreme value distribution. This study examines a conditional extreme value distribution with the added specification that the extreme values (maxima or minima) follows a conditional autoregressive heteroscedasticity process. The dependence has been modelled by allowing the location and scale parameters of the extreme distribution to vary with time. The resulting combined model, GEV-GARCH, is developed by implementing the GARCH volatility mechanism in these extreme value model parameters. Bayesian inference is used for the estimation of parameters and posterior inference is available through the Markov Chain Monte Carlo (MCMC) method. The model is firstly applied to relevant simulated data to verify model stability and reliability of the parameter estimation method. Then real stock returns are used to consider evidence for the appropriate application of the model. A comparison is made between the GEV-GARCH and traditional GARCH models. Both the GEV-GARCH and GARCH show similarity in the resulting conditional volatility estimates, however the GEV-GARCH model differs from GARCH in that it can capture and explain extreme quantiles better than the GARCH model because of more reliable extrapolation of the tail behaviour.
    Keywords: Extreme value distribution, dependency, Bayesian, MCMC, Return quantile
    JEL: C11 G12
    Date: 2009–04–01
  8. By: Patrick Bolton; Hui Chen; Neng Wang
    Abstract: This paper proposes a simple homogeneous dynamic model of investment and corporate risk management for a financially constrained firm. Following Froot, Scharfstein, and Stein (1993), we define a corporation’s risk management as the coordination of investment and financing decisions. In our model, corporate risk management involves internal liquidity management, financial hedging, and investment. We determine a firm’s optimal cash, investment, asset sales, credit line, external equity finance, and payout policies as functions of the following key parameters: 1) the firm’s earnings growth and cash-flow risk; 2) the external cost of financing; 3) the firm’s liquidation value; 4) the opportunity cost of holding cash; 5) investment adjustment and asset sales costs; and 6) the return and covariance characteristics of hedging assets the firm can invest in. The optimal cash inventory policy takes the form of a double-barrier policy where i) cash is paid out to shareholders only when the cash-capital ratio hits an endogenous upper barrier, and ii) external funds are raised only when the firm has depleted its cash. In between the two barriers, the firm adjusts its capital expenditures, asset sales, and hedging policies. Several new insights emerge from our analysis. For example, we find an inverse relation between marginal Tobin’s q and investment when the firm draws on its credit line. We also find that financially constrained firms may have a lower equity beta in equilibrium because these firms tend to hold higher precautionary cash inventories.
    JEL: E22 G12 G32 G35
    Date: 2009–04
  9. By: Lönnbark, Carl (Department of Economics, Umeå University); Holmberg, Ulf (Department of Economics, Umeå University); Brännäs, Kurt (Department of Economics, Umeå University)
    Abstract: We argue that the practise of valuing the portfolio is important for the calculation of the V aR. In particular, the seller (buyer) of an asset does not face horizontal demand (supply) curves. We propose a partially new approach for incorporating this fact in the V aR and in an empirical illustration we compare it to a competing approach. We find substantial differences.
    Keywords: Demand; Supply; Liquidity Risk; Limit Order Book; Bank; Sweden
    JEL: C22 C51 C53 D40 G00 G10
    Date: 2009–04–01
  10. By: Charles Goodhart; Miguel Segoviano
    Abstract: The recent crisis underlined that proper estimation of distress-dependence amongst banks in a global system is essential for financial stability assessment. We present a set of banking stability measures embedding banks’ linear (correlation) and nonlinear distress-dependence, and their changes through the economic cycle, thereby allowing analysis of stability from three complementary perspectives: common distress in the system, distress between specific banks, and cascade effects associated with a specific bank. Our approach defines the banking system as a portfolio of banks and infers its multivariate density from which the proposed measures are estimated. These can be provided for developed and developing countries.
    Date: 2009–01
  11. By: Degryse, H.A.; Elahi, M.A.; Penas, M.F. (Tilburg University, Center for Economic Research)
    Abstract: Integrated financial markets provide opportunities for expansion and improved risk sharing, but also pose threats of contagion risk through cross-border exposures. This paper examines cross-border contagion risk over the period 1999-2006. To that purpose we use aggregate cross-border exposures of seventeen countries as reported in the BIS Consolidated Banking Statistics. We find that a shock which affects the liabilities of one country may undermine the stability of the entire financial system. Particularly, a shock wiping out 25% (35%) of US (UK) cross-border liabilities against non-US (non-UK) banks could lead to bank contagion eroding at least 94% (45%) of the recipient countries’ banking assets. We also find that since 2006 a shock to Eastern Europe, Turkey and Russia affects most countries. Our simulations also reveal that the “speed of propagation of contagion†has increased in recent years resulting in a higher number of directly exposed banking systems. Finally we find that contagion is more widespread in geographical proximities.
    Keywords: Cross-border contagion;financial integration;financial stability.
    JEL: G15 G20 G29
    Date: 2009
  12. By: Hans Gersbach (CER-ETH - Center of Economic Research at ETH Zurich, Switzerland); Volker Hahn (CER-ETH - Center of Economic Research at ETH Zurich, Switzerland)
    Abstract: In this paper, we argue for a regulatory framework under which a bank’s required level of equity capital depends on the equity capital of its peers. Such bankingon- the-average rules are transparent and could also be combined with the current regulatory framework. In addition, we argue that banking-on-the-average rules ensure the build-up of bank equity capitals in booms and thus avoid excessive leverage. Prudent banks can impose prudency on other banks. In a simple model of a banking system, we show that a banking-on-the-average framework can deliver the socially optimal solution because it induces banks to abstain from gambling. Moreover, it alleviates socially harmful consequences of conventional equity-capital rules, which may induce banks to excessively cut back on lending or liquidate desirable long-term investment projects in downturns.
    Keywords: banking on the average, equity-capital requirements, banking system, banking crisis
    JEL: G21 G28
    Date: 2009–03

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