nep-rmg New Economics Papers
on Risk Management
Issue of 2009‒05‒02
fifteen papers chosen by
Stan Miles
Thompson Rivers University

  1. Levy Density Based Intensity Modeling of the Correlation Smile By Balakrishna, B S
  2. A Framework for Assessing the Systemic Risk of Major Financial Institutions By Xin Huang; Hao Zhou; Haibin Zhu
  3. The Use (and Abuse) of CDS Spreads During Distress By Carolyne Spackman; Manmohan Singh
  4. Performance and Merton-Type Default Risk of Listed Banks in EU: a panel VAR approach By Anastasia Koutsomanoli-Filippaki; Emmanuel Mamatzakis
  5. Relevancy of the cost-of-capital rate for the insurance companies. By Mathieu Gatumel
  6. Financial Stability Frameworks and the Role of Central Banks: Lessons from the Crisis By Erlend Nier
  7. A Dynamic Correlation Modelling Framework with Consistent Stochastic Recovery By Li, Yadong
  8. Do I Need Crop Insurance? Self Evaluating Crop Insurance as a Risk Management Tool in New York State By Richards, Steve
  9. Why Do Foreign Firms Have Less Idiosyncratic Risk than U.S. Firms? By Söhnke M. Bartram; Gregory Brown; René M. Stulz
  10. On the Systemic Nature of Weather Risk By Xu, Wei; Filler, Guenther; Odening, Martin; Okhrin, Ostap
  11. Case Studies on the Use of Crop Insurance in Managing Risk By Gloy, Brent A.; Staehr, A. Edward
  12. Risk Management Policies for Dynamic Capacity Control By Matthias Koenig; Joern Meissner
  13. The Time-Varying Systematic Risk of Carry Trade Strategies By Paul Soderlind; Angelo Ranaldo; Charlotte Christiansen
  14. Note on new prospects on vines. By Dominique Guegan; Pierre-André Maugis
  15. Private Pensions and Policy Responses to the Financial and Economic Crisis By Pablo Antolín; Fiona Stewart

  1. By: Balakrishna, B S
    Abstract: The jump distribution for the default intensities in a reduced form framework is modeled and calibrated to provide reasonable fits to CDX.NA.IG and iTraxx Europe CDOs, to 5, 7 and 10 year maturities simultaneously. Calibration is carried out using an efficient Monte Carlo simulation algorithm suitable for both homogeneous and heterogeneous collections of credit names. The underlying jump process is found to relate closely to a maximally skewed stable Levy process with index of stability alpha ~ 1.5.
    Keywords: Default Risk; Default Correlation; Default Intensity; Intensity Model; Levy Density; CDO; Monte Carlo
    JEL: G13
    Date: 2008–07–16
  2. By: Xin Huang; Hao Zhou; Haibin Zhu
    Abstract: In this paper we propose a framework for measuring and stress testing the systemic risk of a group of major financial institutions. The systemic risk is measured by the price of insurance against financial distress, which is based on ex ante measures of default probabilities of individual banks and forecasted asset return correlations. Importantly, using realized correlations estimated from high-frequency equity return data can significantly improve the accuracy of forecasted correlations. Our stress testing methodology, using an integrated micro-macro model, takes into account dynamic linkages between the health of major US banks and macro-financial conditions. Our results suggest that the theoretical insurance premium that would be charged to protect against losses that equal or exceed 15 % of total liabilities of 12 major US financial firms stood at $110 billion in March 2008 and had a projected upper bound of $250 billion in July 2008.
    Keywords: systemic risk, stress testing, portfolio credit risk, credit default swap, high-frequency data
    Date: 2009–04
  3. By: Carolyne Spackman; Manmohan Singh
    Abstract: Credit Default Swap spreads have been used as a leading indicator of distress. Default probabilities can be extracted from CDS spreads, but during distress it is important to take account of the stochastic nature of recovery value. The recent episodes of Landbanski, WAMU and Lehman illustrate that using the industry-standard fixed recovery rate assumption gives default probabilities that are low relative to those extracted from stochastic recovery value as proxied by the cheapest-to-deliver bonds. Financial institutions using fixed rate recovery assumptions could have a false sense of security, and could be faced with outsized losses with potential knock-on effects for other institutions. To ensure effective oversight of financial institutions, and to monitor the stability of the global financial system especially during distress, the stochastic nature of recovery rates needs to be incorporated.
    Keywords: Credit risk , Financial institutions , Risk premium , Bond markets , Asset prices , Bankruptcy ,
    Date: 2009–03–19
  4. By: Anastasia Koutsomanoli-Filippaki (Council of Economic Advisors, Ministry of Economy and Finance, Greece); Emmanuel Mamatzakis (Department of Economics, University of Macedonia)
    Abstract: This paper provides empirical evidence that sheds new light into the dynamic interactions between risk and efficiency, a highly debated issue in the literature. Using a large panel data set that includes 251 listed banks operating in the enlarged European Union over the period 1998 to 2006 this study exploits a three-step procedure. First, we estimate three alternative measures of bank performance, based on alternative efficiency definitions, by employing a directional distance function framework, along with a cost frontier and a profit function. As a second step, we calculate a Merton type bank default risk, based on the Black and Scholes (1973) option pricing theory. Then, we employ a Panel-VAR analysis, which allows the examination of the underlying relationships between efficiency and risk without applying any a-priori restrictions. Most evidence shows that the effect of a one standard deviation shock of the distance to default on inefficiency is negative and substantial. There is some evidence of a reverse causation, but the impact of a shock in bank inefficiency on risk is small and lasts for a short period of time. As part of a sensitivity analysis, we extent our study to investigate the relationship between efficiency and default risk for banks with different types of ownership structures and across financial systems with different levels of development.
    Keywords: bank inefficiency, default risk, panel VAR, causality.
    JEL: G21 G28 D21
    Date: 2009–04
  5. By: Mathieu Gatumel (Centre d'Economie de la Sorbonne)
    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.
    JEL: G12 G20 G22 G32
    Date: 2008–11
  6. By: Erlend Nier
    Abstract: This paper sets out general principles for the design of financial stability frameworks, starting from an analysis of the objectives and tools of financial regulation. The paper then offers a comprehensive analysis of the costs and benefits of the two main models that have emerged for modern financial systems: the integrated model, with a single supervisor outside of the central bank, and the twin-peaks model, with a systemic risk regulator (central bank) on the one hand and a conduct of business regulator on the other. The paper concludes that the twin-peaks model may become more attractive when regulatory structures are geared more explicitly towards the mitigation of systemic risk-including through the introduction of new macroprudential tools that could be used alongside monetary policy to contain macro-systemic risks; through enhanced regulation and special resolution regimes for systemically important institutions; and a more holistic approach to the oversight of clearing and settlement systems. Since the optimal solution may well be path-dependent and specific to the development of financial markets in any given country, a number of hybrid models are also discussed.
    Keywords: Central banks , Financial crisis , Monetary policy , Financial stability , Financial systems , Financial sector , Bank supervision , Bank regulations , Bank resolution , Credit risk , Risk management ,
    Date: 2009–04–10
  7. By: Li, Yadong
    Abstract: This paper describes a flexible and tractable bottom-up dynamic correlation modelling framework with a consistent stochastic recovery specification. In this modelling framework, only the joint distributions of default indicators are determined from the calibration to the index tranches; and the joint distribution of default time and spread dynamics can be changed independently from the CDO tranche pricing by applying one of the existing top-down methods to the common factor process. Numerical results showed that the proposed modelling method achieved good calibration to the index tranches across multiple maturities under the current market conditions. This modelling framework offers a practical approach to price and risk manage the exotic correlation products.
    Keywords: Credit; Correlation; CDO; Dynamic; Copula; Stochastic Recovery; Bottom-up; Top-down
    JEL: C02 D40
    Date: 2009–02–26
  8. By: Richards, Steve
    Keywords: Crop insurance, Agribusiness, Crop Production/Industries,
    Date: 2009–02
  9. By: Söhnke M. Bartram; Gregory Brown; René M. Stulz
    Abstract: Using a large panel of firms across the world from 1991-2006, we show that the median foreign firm has lower idiosyncratic risk than a comparable U.S. firm. Country characteristics help explain variation in the level of idiosyncratic risk, but less so than firm characteristics. Idiosyncratic risk falls as government stability and respect for the rule of law improve. Idiosyncratic risk is positively related to stock market development but negatively related to bond market development. Surprisingly, we find that idiosyncratic risk is generally negatively related to corporate disclosure quality. Finally, idiosyncratic risk generally increases with shareholder protection. Though there is evidence that R<sup>2</sup> increases with creditor rights and falls with the quality of disclosure, these results are driven by the relations between these variables and systematic risk rather than by the impact of these variables on idiosyncratic risk.
    JEL: E44 G12 G14 G15 G32
    Date: 2009–04
  10. By: Xu, Wei; Filler, Guenther; Odening, Martin; Okhrin, Ostap
    Abstract: Systemic weather risk is a major obstacle for the formation of private (nonsubsidized) crop insurance. This paper explores the possibility of spatial diversication of insurance by estimating the joint occurrence of unfavorable weather conditions in dierent 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 coeffcients turned out to be questionable in the context of weather insurance as it may overestimate diversfication effects considerably.
    Keywords: weather risk, crop insurance, copula, Risk and Uncertainty, C14, Q19,
    Date: 2009
  11. By: Gloy, Brent A.; Staehr, A. Edward
    Abstract: Managing the risk associated with farming is challenging. Fortunately, farmers have a variety of risk management tools at their disposal. This series of case studies examines how crop insurance can be used to manage some of the risks faced by farmers. The examples illustrate how crop insurance purchases would impact the returns generated to a farming enterprise. While the examples cover a variety of commodities and insurance products, they do not consider every possible risk that might arise. Likewise, they do not consider all of the possible financial situations that might be experienced by a farmer. Instead, they focus on highlighting how crop insurance impacts the profitability of the farm. Companion spreadsheets are available for all of the examples so that readers can examine a wider range of scenarios than those discussed in the examples. These spreadsheets and other related materials are available for download at: pIns.html
    Keywords: Managing Risk, Crop insurance, Apple production, grape production, soybeans, forage production, Agribusiness, Crop Production/Industries, Financial Economics,
    Date: 2009–02
  12. By: Matthias Koenig (Department of Management Science, Lancaster University Management School); Joern Meissner (Department of Management Science, Lancaster University Management School)
    Abstract: Consider a dynamic decision making model under risk with a fixed planning horizon, namely the dynamic capacity control model. The model describes a firm, operating in a monopolistic setting and selling a range of products consuming a single resource. Demand for each product is time-dependent and modeled by a random variable. The firm controls the revenue stream by allowing or denying customer requests for product classes. We investigate risk-sensitive policies in this setting, for which risk concerns are important for many non-repetitive events and short-time considerations. Analyzing several numerically risk-averse capacity control policies in terms of standard deviation and conditional-value-at-risk, our results show that only a slight modification of the risk-neutral solution is needed to apply a risk-averse policy. In particular, risk-averse policies which decision rules are functions depending only on the marginal values of the risk-neutral policy perform well. The risk sensitivity of a policy only depends on the current state but it does not matter whether risk-neutral or risk-averse decisions led to the state. From a practical perspective, the advantage is that a decision maker does not need to compute any risk-averse dynamic program. Risk sensitivity can be easily achieved by implementing risk-averse functional decision rules based on a risk-neutral solution.
    Keywords: dynamic decisions, capacity control, revenue management, risk
    JEL: C61
    Date: 2009–04
  13. By: Paul Soderlind; Angelo Ranaldo; Charlotte Christiansen
    Abstract: To capture time-variation in the risk exposure of exchange rates, this paper suggests a factor model with stock and bond markets as the explanatory factors - but where the betas are allowed to depend on the exchange rate volatility. Empirical results on daily data from 1995 to 2008 show that a typical carry trade strategy based on 10 currencies from major industrialized countries has much higher exposure to the stock market and also more mean reversion in volatile periods. The findings are robust to various extensions, including adding more currencies and other regime variables.
    Keywords: carry trade, factor model, smooth transition regression, time-varying betas
    JEL: F31 G15 G11
    Date: 2009–04
  14. By: Dominique Guegan (Paris School of Economics - Centre d'Economie de la Sorbonne); Pierre-André Maugis (Centre d'Economie de la Sorbonne)
    Abstract: We present here a new way of building vine copulas that allows us to create a vast number of new vine copulas, allowing for more precise modeling in high dimensions. To deal with this great number of copulas we present a new efficient selection methodology using a lattice structure on the vine set. Our model allows for a lot of degrees of freedom, but further improvements face numerous problems caused by vines' complexity as an estimator in a statistical and computational way, problems that we will expose in this paper. Robust n-variate models would be a great breakthrough for asset risk management in banks and insurance companies.
    Keywords: Vines, multivariate copulas, model selection.
    JEL: D81 C10 C40 C52
    Date: 2008–12
  15. By: Pablo Antolín; Fiona Stewart
    Abstract: This paper discusses responses to current financial and economic crisis by regulators, supervisors and policy makers in the area of private pensions. These responses are examined in the light of international guidelines, best practices and recommendations to improve the design of private pensions.<P>Pensions privées et réponses politiques à la crise financière et économique<BR>Ce document examine les réponses apportées à la crise financière et économique par les régulateurs, les superviseurs et les responsables politiques dans le domaine des pensions privées. Ces réponses sont examinées à la lumière des meilleures pratiques, des recommandations et des principes internationaux en vue d‘améliorer la conception des systèmes de pensions privées.
    Keywords: pensions de retraite, regulation, supervision, supervision, régulation, private pensions, pensions privées, risk management, gestion des risques, defined benefit, defined contribution, funding and solvency rules, plans de retraite à cotisations définies et à prestations définies, règles de financement et de solvabilité
    JEL: D14 D91 E21 G11 G38 J14 J26
    Date: 2009–04

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