New Economics Papers
on Risk Management
Issue of 2009‒06‒03
nine papers chosen by

  1. Risk Transfer with CDOs By Jan Pieter Krahnen; Christian Wilde
  2. A Risk Management Approach for Portfolio Insurance Strategies By Benjamin Hamidi; Bertrand Maillet; Jean-Luc Prigent
  3. Funding liquidity risk in a quantitative model of systemic stability By Aikman, David; Alessandri, Piergiorgio; Eklund, Bruno; Gai, Prasanna; Kapadia, Sujit; Martin, Elizabeth; Mora, Nada; Sterne, Gabriel; Willison, Matthew
  4. The information content of Hungarian sovereign CDS spreads By Lóránt Varga
  5. An Empirical Analysis of Alternative Portfolio Selection Criteria By Manfred GILLI; Enrico SCHUMANN
  6. A Meta-Distribution for Non-Stationary Samples By Dominique Guégan
  7. Predicting Stock Returns in a Cross-Section : Do Individual Firm chatacteristics Matter ? By Kateryna Shapovalova; Alexander Subbotin
  8. Forecasting Expected Shortfall with a Generalized Asymmetric Student-t Distribution By Dongming Zhu; John Galbraith
  9. Determinants of interest rate exposure of Spanish banking industry By Gloria M. Soto Pacheco; Cristóbal González; Laura Ballester; Román Ferrer

  1. By: Jan Pieter Krahnen (Goethe Uniyversity Frankfurt); Christian Wilde (Goethe University Frankfurt)
    Abstract: Modern bank management comprises both classical lending business and transfer of asset risk to capital markets through securitization. Sound knowledge of the risks involved in securitization transactions is a prerequisite for solid risk management. This paper aims to resolve a part of the opaqueness surrounding credit-risk allocation to tranches that represent claims of different seniority on a reference portfolio. In particular, this paper analyzes the allocation of credit risk to different tranches of a CDO transaction when the underlying asset returns are driven by a common macro factor and an idiosyncratic component. Junior and senior tranches are found to be nearly orthogonal, motivating a search for the whereabout of systematic risk in CDO transactions. We propose a metric for capturing the allocation of systematic risk to tranches. First, in contrast to a widely-held claim, we show that (extreme) tail risk in standard CDO transactions is held by all tranches. While junior tranches take on all types of systematic risk, senior tranches take on almost no non-tail risk. This is in stark contrast to an untranched bond portfolio of the same rating quality, which on average suffers substantial losses for all realizations of the macro factor. Second, given tranching, a shock to the risk of the underlying asset portfolio (e.g. a rise in asset correlation or in mean portfolio loss) has the strongest impact, in relative terms, on the exposure of senior tranche CDO-investors. Our findings can be used to explain major stylized facts observed in credit markets.
    Keywords: Credit Risk, Risk Transfer, Systematic Risk
    JEL: G21 G28
    Date: 2008–04–28
  2. By: Benjamin Hamidi (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Panthéon-Sorbonne - Paris I, A.A.Advisors-QCG - ABN AMRO); Bertrand Maillet (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Panthéon-Sorbonne - Paris I, A.A.Advisors-QCG - ABN AMRO, EIF - EIF); Jean-Luc Prigent (THEMA - Théorie économique, modélisation et applications - CNRS : UMR8184 - Université de Cergy Pontoise)
    Abstract: Controlling and managing potential losses is one of the main objectives of the Risk Management. Following Ben Ameur and Prigent (2007) and Chen et al. (2008), and extending the first results by Hamidi et al. (2009) when adopting a risk management approach for defining insurance portfolio strategies, we analyze and illustrate a specific dynamic portfolio insurance strategy depending on the Value-at-Risk level of the covered portfolio on the French stock market. This dynamic approach is derived from the traditional and popular portfolio insurance strategy (Cf. Black and Jones, 1987 ; Black and Perold, 1992) : the so-called "Constant Proportion Portfolio Insurance" (CPPI). However, financial results produced by this strategy crucially depend upon the leverage - called the multiple - likely guaranteeing a predetermined floor value whatever the plausible market evolutions. In other words, the unconditional multiple is defined once and for all in the traditional setting. The aim of this article is to further examine an alternative to the standard CPPI method, based on the determination of a conditional multiple. In this time-varying framework, the multiple is conditionally determined in order to remain the risk exposure constant, even if it also depends upon market conditions. Furthermore, we propose to define the multiple as a function of an extended Dynamic AutoRegressive Quantile model of the Value-at-Risk (DARQ-VaR). Using a French daily stock database (CAC 40) and individual stocks in the period 1998-2008), we present the main performance and risk results of the proposed Dynamic Proportion Portfolio Insurance strategy, first on real market data and secondly on artificial bootstrapped and surrogate data. Our main conclusion strengthens the previous ones : the conditional Dynamic Strategy with Constant-risk exposure dominates most of the time the traditional Constant-asset exposure unconditional strategies.
    Keywords: CPPI, Portfolio insurance, VaR, CAViaR, quantile regression, dynamic quantile model.
    Date: 2009–05
  3. By: Aikman, David (Bank of England); Alessandri, Piergiorgio (Bank of England); Eklund, Bruno (Bank of England); Gai, Prasanna (Australian National University); Kapadia, Sujit (Bank of England); Martin, Elizabeth (Bank of England); Mora, Nada (Federal Reserve Bank of Kansas City); Sterne, Gabriel (Bank of England); Willison, Matthew (Bank of England)
    Abstract: We demonstrate how the introduction of liability-side feedbacks affects the properties of a quantitative model of systemic risk. The model is known as RAMSI and is still in its development phase. It is based on detailed balance sheets for UK banks and encompasses macro-credit risk, interest and non-interest income risk, network interactions, and feedback effects. Funding liquidity risk is introduced by allowing for rating downgrades and incorporating a simple framework in which concerns over solvency, funding profiles and confidence may trigger the outright closure of funding markets to particular institutions. In presenting results, we focus on aggregate distributions and analysis of a scenario in which large losses at some banks can be exacerbated by liability-side feedbacks, leading to system-wide instability.
    Keywords: Systemic risk; financial stability models; funding liquidity risk; contagion
    JEL: G10 G21 G32
    Date: 2009–06–15
  4. By: Lóránt Varga (Magyar Nemzeti Bank)
    Abstract: In our paper we present how the Hungarian credit default swap (CDS) market functions, and indicate its position in the global credit derivatives markets. Our primary goals are to glean some information from the CDS spreads about Hungary’s credit risk, and to determine the role of the Hungarian sovereign CDS market in different market periods, as well as its long-term relationship with other Hungarian financial markets. Our findings suggest that the Hungarian market has low liquidity compared to the average liquidity of credit derivatives markets. However, relative to the outstanding stock of Hungarian sovereign foreign currency bonds, the daily average turnover of the market and the outstanding stock of Hungarian sovereign CDS contracts at the end of 2007 were substantial, estimated to be around EUR 10-20 million and EUR 7-20 billion respectively. Even though the Hungarian sovereign CDS spread and foreign currency bond credit spread tend to move in tandem in the long run, the two rates may temporarily deviate from one another due to micro structural factors. Hungary’s credit risk premium is primarily defined in the Hungarian sovereign CDS market, which means that any new information pertaining to Hungary’s credit risk is captured in the CDS spreads first. In contrast, the Hungarian foreign currency bond market is not an effective market, given that foreign currency bond credit spreads merely adjust to the changes of CDS spreads afterwards. During particularly turbulent market periods Hungarian sovereign CDS spreads tend to rise higher than is fundamentally justified.
    Keywords: credit derivatives markets, credit default swap, sovereign foreign currency bond markets, sovereign credit risk, credit rating, price discovery.
    JEL: F34 G12 G14 G15
    Date: 2009
  5. By: Manfred GILLI (University of Geneva and Swiss Finance Institute); Enrico SCHUMANN (University of Geneva)
    Abstract: In modern portfolio theory, financial portfolios are characterised by a desired property, the ‘reward’, and something undesirable, the ‘risk’. While these properties are commonly identified with mean and variance of returns, respectively, we test alternative specifications like partial and conditional moments, quantiles, and drawdowns. More specifically, we analyse the empirical performance of portfolios selected by optimising risk–reward ratios constructed from these alternative functions. We find that these portfolios in many cases outperform our benchmark (minimum-variance), in particular when long-run returns are concerned. However, we also find that all the strategies tested seem quite sensitive to relatively small changes in the data. The main theme throughout our results is that minimising risk, as opposed to maximising reward, often leads to good out-of-sample performance. In contrast, adding a reward-function to the selection criterion improves a given strategy often only marginally.
    Keywords: Portfolio optimisation, Optimisation heuristics, Partial moments, Downside risk, Expected Shortfall, Value-at-Risk, Risk measures, Performance measures, Threshold Accepting
    JEL: G11 C61 C63
    Date: 2009–03
  6. By: Dominique Guégan (PSE, Centre d’Economie de la Sorbonne, University Paris1 Panthéon-Sorbonne)
    Abstract: In this paper, we focus on the building of an invariant distribution function associated to a non-stationary sample. After discussing some specific problems encountered by non-stationarity inside samples like the "spurious" long memory effect, we build a sequence of stationary processes permitting to define the concept of meta-distribution for a given non-stationary sample. We use this new approach to discuss some interesting econometric issues in a non-stationary setting, namely forecasting and risk management strategy.
    Keywords: Non-Stationarity, Copula, Long-memory, Switching, Cumulants, Estimation theory
    JEL: C32 C51 G12
    Date: 2009–06–01
  7. By: Kateryna Shapovalova (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Panthéon-Sorbonne - Paris I); Alexander Subbotin (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Panthéon-Sorbonne - Paris I)
    Abstract: It is a common wisdom that individual stocks' returns are difficult to predict, though in many situations it is important to have such estimates at our disposal. In particular, they are needed to determine the cost of capital. Market equilibrium models posit that expected returns are proportional to the sensitivities to systematic risk factors. Fama and French (1993) three-factor model explains the stock returns premium as a sum of three components due to different risk factors : the traditional CAPM market beta, and the betas to the returns on two portfolios, "Small Minus Big" (the differential in the stock returns for small and big companies) and "High Minus Low" (the differential in the stock returns for the companies with high and low book-to-price ratio). The authors argue that this model is sufficient to capture the impact on returns of companies' accounting fundamentals, such as earnings-to-price, cash flow-to-price, past sales growth, long term and short-term past earnings. Using a panel of stock returns and accounting data from 1979 to 2008 for the companies listed on NYSE, we show that this is not the case, at least at individual stocks' level. According to our findings, fundamental characteristics of companies' performance are of higher importance to predict future expected returns than sensitivities to the Fama and French risk factors. We explain this finding within the rational pricing paradigm : contemporaneous accounting fundamentals may be better proxies for the future sensitivity to risk factors, than the historical covariance estimates.
    Keywords: Accounting fundamentals, equity performance, style analysis, value and growth, cost of capital.
    Date: 2009–05
  8. By: Dongming Zhu; John Galbraith
    Abstract: Financial returns typically display heavy tails and some skewness, and conditional variance models with these features often outperform more limited models. The difference in performance may be especially important in estimating quantities that depend on tail features, including risk measures such as the expected shortfall. Here, using a recent generalization of the asymmetric Student-t distribution to allow separate parameters to control skewness and the thickness of each tail, we fit daily financial returns and forecast expected shortfall for the S&P 500 index and a number of individual company stocks; the generalized distribution is used for the standardized innovations in a nonlinear, asymmetric GARCH-type model. The results provide empirical evidence for the usefulness of the generalized distribution in improving prediction of downside market risk of financial assets. <P>De façon générale, les rendements financiers sont caractérisés par des queues épaisses et une certaine asymétrie. Ainsi, les modèles à variance conditionnelle dotés de ces caractéristiques donnent de meilleurs résultats que les modèles plus limités. La différence dans les résultats obtenus peut être particulièrement importante lorsqu’il s’agit d’évaluer des quantités qui dépendent des caractéristiques des queues, y compris les mesures du risque, tel que le manque à gagner prévu. Dans le cas actuel, en recourant à une généralisation récente de la distribution asymétrique suivant la loi t de Student, de sorte que des paramètres distincts limitent l’asymétrie et l’épaisseur de chaque queue, nous intégrons les rendements financiers quotidiens et estimons le manque à gagner prévu dans le cas de l’indice S&P 500 et de certaines actions de compagnies individuelles. La distribution généralisée est utilisée pour les innovations normalisées contenues dans un modèle asymétrique non linéaire de type GARCH. Les résultats démontrent de façon empirique l’utilité de la distribution généralisée pour améliorer les prévisions au sujet du risque de perte en cas de baisse du marché des actifs financiers.
    Keywords: asymmetric distribution, expected shortfall, NGARCH model, distribution asymétrique, manque à gagner prévu, modèle NGARCH (Nonlinear Generalized AutoRegressive Conditional Heteroscedasticity)
    JEL: C16 G10
    Date: 2009–05–01
  9. By: Gloria M. Soto Pacheco (Universidad de Murcia); Cristóbal González (Universitat de València); Laura Ballester (Universidad de Castilla-La Mancha); Román Ferrer (Universitat de València)
    Abstract: Interest rate risk represents one of the key forms of financial risk faced by banks. It has given rise to an extensive body of research, mainly focused on the estimation of sensitivity of bank stock returns to changes in interest rates. However, the analysis of the sources of bank interest rate risk has received much less attention in the literature. The aim of this paper is to empirically investigate the main determinants of the interest rate exposure of Spanish commercial banks by using panel data methodology. The results indicate that interest rate exposure is systematically related to some bank-specific characteristics. In particular, a significant positive association is found between bank size, derivative activities, and proportion of loans to total assets and banks¿ interest rate exposure. In contrast, the proportion of deposits to total assets is significantly and negatively related to the level of bank¿s interest rate risk. El riesgo de interés representa una de las principales fuentes de riesgo financiero a las que se enfrentan las entidades bancarias. Este riesgo ha dado lugar a un extenso cuerpo de investigación, centrado básicamente en la estimación de la sensibilidad del rendimiento de las acciones bancarias ante las variaciones de los tipos de interés. Sin embargo, el análisis de los determinantes del riesgo de interés ha recibido mucha menos atención en la literatura.El objetivo de este trabajo es investigar empíricamente los principales determinantes de la exposición al riesgo de interés de las entidades bancarias españolas utilizando metodología de datos de panel. Los resultados obtenidos indican que la exposición al riesgo de interés se encuentra sistemáticamente relacionada con varias características bancarias. En particular, se ha constatado una significativa asociación positiva entre el tamaño de la entidad, el volumen de operaciones con activos derivados y el ratio de préstamos sobre activos bancarios totales y el grado de exposición al riesgo de interés. Por el contrario, se ha observado una relación negativa significativa entre el ratio de depósitos sobre activos bancarios totales y el nivel del riesgo de interés de las entidades bancarias.
    Keywords: riesgo de interés, entidades bancarias, acciones, características bancarias. interest rate risk, banking firms, stocks, balance sheet characteristics.
    JEL: G12 G21 C52
    Date: 2009–04

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