New Economics Papers
on Risk Management
Issue of 2009‒04‒18
five papers chosen by

  1. How the Subprime Crisis Went Global: Evidence from Bank Credit Default Swap Spreads By Barry Eichengreen; Ashoka Mody; Milan Nedeljkovic; Lucio Sarno
  2. CDO Pricing with Copulae By Barbara Choros; Wolfgang Härdle; Ostap Okhrin
  3. On the Determinants of the Implied Default Barrier By Georges Dionne; Sadok Laajimi
  4. Risk Shifting and Mutual Fund Performance By Jennifer Huang; Clemens Sialm; Hanjiang Zhang
  5. Stochastic Mortality, Macroeconomic Risks, and Life Insurer Solvency By Katja Hanewald; Thomas Post; Helmut Gründl

  1. By: Barry Eichengreen; Ashoka Mody; Milan Nedeljkovic; Lucio Sarno
    Abstract: How did the Subprime Crisis, a problem in a small corner of U.S. financial markets, affect the entire global banking system? To shed light on this question we use principal components analysis to identify common factors in the movement of banks' credit default swap spreads. We find that fortunes of international banks rise and fall together even in normal times along with short-term global economic prospects. But the importance of common factors rose steadily to exceptional levels from the outbreak of the Subprime Crisis to past the rescue of Bear Stearns, reflecting a diffuse sense that funding and credit risk was increasing. Following the failure of Lehman Brothers, the interdependencies briefly increased to a new high, before they fell back to the pre-Lehman elevated levels – but now they more clearly reflected heightened funding and counterparty risk. After Lehman's failure, the prospect of global recession became imminent, auguring the further deterioration of banks' loan portfolios. At this point the entire global financial system had become infected.
    JEL: F36 G15 G18
    Date: 2009–04
  2. By: Barbara Choros; Wolfgang Härdle; Ostap Okhrin
    Abstract: Modeling the portfolio credit risk is one of the crucial issues of the last years in the financial problems. We propose the valuation model of Collateralized Debt Obligations based on a one- and two-parameter copula and default intensities estimated from market data. The presented method is used to reproduce the spreads of the iTraxx Europe tranches. The two-parameter model incorporates the fact that the risky assets of the CDO pool are chosen from six different industry sectors. The dependency among the assets from the same group is described with the higher value of the copula parameter, otherwise the lower value of the parameter is ascribed. Our approach outperforms the standard market pricing procedure based on the Gaussian distribution.
    Keywords: CDO, CDS, multifactor models, multivariate distributions, Copulae, correlation smile
    JEL: C14 G12 G13
    Date: 2009–03
  3. By: Georges Dionne; Sadok Laajimi
    Abstract: We use the maximum likelihood (ML) estimation approach to estimate the default barriers from market values of equities for a sample of 762 public industrial Canadian firms. The ML approach allows us to estimate the asset instantaneous drift, volatility and barrier level simultaneously, when the firm's equity is priced as a Down-and-Out European call (DOC) option. We find that the estimated barrier is positive and significant in our sample. Moreover, we compare the default prediction accuracy of the DOC framework with the KMV-Merton approach. Using probit estimation, we find that the default probability from the two structural models provides similar in-sample fits, but the barrier option framework achieves better out-of-sample forecasts. Regression analysis shows that leverage is not the only determinant of the default barrier. The implied default threshold is also positively related to financing costs, and negatively to liquidity, asset volatility and firm size. We also find that liquidation costs, renegotiation frictions and equity holders' bargaining power increase the implied default barrier level.
    Keywords: Barrier option, default barrier, bankruptcy prediction, maximum likelihood estimation, strategic default
    JEL: G32 G33
    Date: 2009
  4. By: Jennifer Huang; Clemens Sialm; Hanjiang Zhang
    Abstract: Mutual funds change their risk levels significantly over time. This paper investigates the performance consequences of risk shifting, as well as the economic motivations and the mechanisms of risk shifting. Using a holdings-based measure of risk shifting, we find that funds that increase risk perform worse than funds that keep stable risk levels over time. In addition, funds that expect higher benefits from risk shifting are more likely to increase risk and perform particularly poorly after increasing risk. Our results are consistent with the notion that agency problems, rather than the ability to take advantage of changing investment opportunities, are the likely motivation behind risk shifting behavior.
    JEL: G11 G12 G23
    Date: 2009–04
  5. By: Katja Hanewald; Thomas Post; Helmut Gründl
    Abstract: Motivated by a recent demographic study establishing a link between macroeconomic fluctuations and the mortality index kt in the Lee-Carter model, we assess the impact of macroeconomic fluctuations on the solvency of a life insurance company. Liabilities in our stochastic simulation framework are driven by a GDP-linked variant of the Lee-Carter mortality model. Furthermore, interest rates and stock prices are allowed to react to changes in GDP, which itself is modeled as a stochastic process. Our results show that insolvency probabilities are significantly higher when the reaction of mortality rates to changes in GDP is incorporated.
    Keywords: Life insurance, asset-liability management, stochastic mortality, Lee-Carter model, business cycle
    JEL: G22 G23 G28 G32 E32 J11
    Date: 2009–03

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