nep-rmg New Economics Papers
on Risk Management
Issue of 2009‒06‒10
nine papers chosen by
Stan Miles
Thompson Rivers University

  1. Assessing the risk-return trade-off in loans portfolios By Javier Mencía
  3. Financial and Economic Determinants of Firm Default By Giulio Bottazzi; Marco Grazzi; Angelo Secchi; Federico Tamagni
  4. Forest Management Under Fire Risk When Forest Carbon Sequestration Has Value By Stéphane Couture; Arnaud Reynaud
  5. The impact of climate change on catastrophe risk models : implications for catastrophe risk markets in developing countries By Seo, John; Mahul, Olivier
  6. Competing Risk Proportional Hazard Models of Farm Service Agency Direct Operating Loans By Dixon, Bruce L.; Ahrendsen, Bruce L.; Foianini, Monica; Hamm, Sandy; Danforth, Diana
  7. Who is afraid of political risk? Multinational firms and their choice of capital structure By Kesternich, Iris; Schnitzer, Monika
  8. Entrepreneurial Finance and Non-diversifiable Risk By Hui Chen; Jianjun Miao; Neng Wang
  9. Investment Risk and Pensions: Measuring Uncertainty in Returns By Anna Christina d'Addio; José Seisdedos; Edward R. Whitehouse

  1. By: Javier Mencía (Banco de España)
    Abstract: This paper analyses the risk and return of loans portfolios in a joint setting. I develop a model to obtain the distribution of loans returns. I use this model to describe the investment opportunity set of lenders using mean-variance analysis with a Value at Risk constraint. I also obtain closed form expressions for the interest rates that banks should set in compensation for borrowers' credit risk under absence of arbitrage opportunities and I use these rates as a benchmark to interpret actual loans' prices. Finally, I study the risk-return trade-off in an empirical application to the Spanish banking system.
    Keywords: Credit risk, Probability of default, Asset Pricing, Mean-Variance allocation, Stochastic Discount Factor, Value at Risk
    JEL: G21 G12 G11 C32 D81 G28
    Date: 2009–06
  2. By: Raymond BRUMMELHUIS; Jules Sadefo-Kamdem
    Abstract: This paper is concerned with the e±cient analytical computation of Value-at-Risk (VaR) for portfolios of assets depending quadratically on a large number of joint risk factors that follows a multivariate Generalized Laplace Distribution. Our approach is designed to supplement the usual Monte-Carlo techniques, by providing an asymptotic formula for the quadratic portfolio's cumulative distribution function, together with explicit error-estimates. The application of these methods is demonstrated using some financial applications examples.
    Date: 2009–06
  3. By: Giulio Bottazzi; Marco Grazzi; Angelo Secchi; Federico Tamagni
    Abstract: This paper investigates the relevance of financial and economic variables on firm defaults. Our analysis is not limited to publicly traded companies but extends to a large sample of limited liability firms. We consider size, growth, profitability and productivity together with a standard set of financial indicators. Non parametric tests allow to asses to what extent defaulting firms differ from the non-defaulting group. Bootstrap probit regressions confirm that economic variables play both a long and short term effect. Our findings are robust with respect to the inclusion of Distance to Deafult and risk ratings among the regressors.
    Keywords: firm default, financial indicators, selection and growth dynamics, kernel densities, stochastic equality, bootstrap probit regressions, distance to default
    JEL: C14 C25 D20 G30 L11
    Date: 2009–06–09
  4. By: Stéphane Couture; Arnaud Reynaud
    Date: 2009–05
  5. By: Seo, John; Mahul, Olivier
    Abstract: Catastrophe risk models allow insurers, reinsurers and governments to assess the risk of loss from catastrophic events, such as hurricanes. These models rely on computer technology and the latest earth and meteorological science information to generate thousands if not millions of simulated events. Recently observed hurricane activity, particularly in the 2004 and 2005 hurricane seasons, in conjunction with recently published scientific literature has led risk modelers to revisit their hurricane models and develop climate conditioned hurricane models. This paper discusses these climate conditioned hurricane models and compares their risk estimates to those of base normal hurricane models. This comparison shows that the recent 50 year period of climate change has potentially increased North Atlantic hurricane frequency by 30 percent. However, such an increase in hurricane frequency would result in an increase in risk to human property that is equivalent to less than 10 years’ worth of US coastal property growth. Increases in potential extreme losses require the reinsurance industry to secure additional risk capital for these peak risks, resulting in the short term in lower risk capacity for developing countries. However, reinsurers and investors in catastrophe securities may still have a long-term interest in providing catastrophe coverage in middle and low-income countries as this allows reinsurers and investors to better diversify their catastrophe risk portfolios.
    Keywords: Natural Disasters,Hazard Risk Management,Insurance&Risk Mitigation,Disaster Management,Insurance Law
    Date: 2009–06–01
  6. By: Dixon, Bruce L.; Ahrendsen, Bruce L.; Foianini, Monica; Hamm, Sandy; Danforth, Diana
    Abstract: The USDA Farm Service Agency (FSA) direct farm loan program is designed to provide credit to family-sized farms unable to obtain credit from conventional sources at reasonable rates and terms despite having sufficient cash flow to repay and an ability to fully securitize the loan. FSA policy encourages borrowers to exit the program as soon as possible. This study uses Cox proportional hazard models in a competing risks framework to identify predictive factor of: (1) loan success or default, and (2) length of time to loan termination. Survey data from 1925 direct loans originated in federal fiscal years 1994-95 are used for analysis. Only data available to FSA at time of origination were collected. Since these data are all the information FSA has at time of loan origination, the competing risk models provide an alternative method for measuring priori relative riskiness indicated by borrower and loan characteristics. Results indicate that borrower financial strength, intensity of borrowers' current relationship with FSA and loan characteristics are significant measures of loan risk.
    Keywords: duration, Farm Service Agency, direct loans, competing risks, Agricultural Finance, Risk and Uncertainty, C29, G28, Q12, Q14,
    Date: 2008
  7. By: Kesternich, Iris; Schnitzer, Monika
    Abstract: This paper investigates how multinational firms choose the capital structure of their foreign affiliates in response to political risk. We focus on two choice variables, the leverage and the ownership structure of the foreign affiliate, and we distinguish different types of political risk, such as expropriation, unreliable intellectual property rights and confiscatory taxation. In our theoretical analysis we find that, as political risk increases, the ownership share tends to decrease, whereas leverage can both increase or decrease, depending on the type of political risk. Using the Microdatabase Direct Investment of the Deutsche Bundesbank, we find supportive evidence for these different effects.
    Keywords: Multinational firms, political risk, capital structure, leverage, ownership structure, foreign affiliates
    JEL: F21 F23 G32
    Date: 2009
  8. By: Hui Chen (MIT Sloan School of Management); Jianjun Miao (Department of Economics, Boston University); Neng Wang (Columbia Business School and National Bureau of Economic Research)
    Abstract: Entrepreneurs face significant non-diversifiable business risks. We build a dynamic incompletemarkets model of entrepreneurial finance to demonstrate the important implications of nondiversifiable risks for entrepreneurs’ interdependent consumption, portfolio allocation, financing, investment, and business exit decisions. The optimal capital structure is determined by a generalized tradeoff model where leverage via risky non-recourse debt provides significant diversification benefits. More risk-averse entrepreneurs default earlier, but also choose higher leverage, even though leverage makes his equity more risky. Non-diversified entrepreneurs demand both systematic and idiosyncratic risk premium. Cash-out option and external equity further improve diversification and raise the entrepreneur’s valuation of the firm. Finally, entrepreneurial risk aversion can overturn the risk-shifting incentives induced by risky debt.
    Keywords: Default, diversification benefits, entrepreneurial risk aversion, incomplete markets, private equity premium, hedging, capital structure, cash-out option, precautionary saving
    JEL: G11 G31 E2
    Date: 2009–03
  9. By: Anna Christina d'Addio; José Seisdedos; Edward R. Whitehouse
    Abstract: This paper explores how uncertainty over investment returns affects pension systems. This issue is becoming more important because of the dramatic spread of defined-contribution pension provision around the world. It has also been highlighted by the recent financial crisis: the OECD estimates that pension funds lost 23% of their value in 2008, worth a heady USD 5.4 trillion. The scale of investment risk is measured in this paper using historical data on returns on equities and bonds in major OECD economies over the past quarter century. The results show a median real return of 7.3% a year on a portfolio equally weighted between equities and bonds (averaging across the countries studied). It might be expected that, over a very long period, the degree of uncertainty in investment returns is small. After all, a few bad years in the market are likely to be offset by boom years. Nevertheless, the degree of uncertainty, even with the relatively long investment horizons of pensions, is found to be large. In 10% of cases, an annual return of less than 5.5% would be expected, while in 10% of cases, this should exceed 9.0%. Compounded over the time horizon for pension savings of 40 years or more, such differences in rates of return amount to enormous sums of money. However, there is a series of reasons why returns achieved by individuals on their pension funds are less than the market return (as measured by conventional indices). These factors include administrative charges, agency and governance effects and demographic change, depressing investment returns below the high levels recorded over the past two decades. As a result, a more conservative assumption for future investment returns than the record over the past quarter century is appropriate. Settling on a median of 5.0% annual real return net of charges implies that 80% of the time, the investment return on pension savings should be between 3.2% and 6.7% a year.<BR>Ce document mesure l’impact de l’incertitude des rendements d’investissement sur les systèmes de retraite. Ce sujet devient de plus en plus important en raison de la propagation spectaculaire des systèmes de retraite à cotisations définies. Le degré du risque d'investissement est mesuré à l’aide de données historiques sur le rendement des actions et des obligations dans un nombre de pays de l’OCDE au cours du dernier quart de siècle. Les résultats montrent, en moyenne dans les pays étudiés, un rendement réel médian de 7,3 % annuel d’un portefeuille composé en parties égales d’actions et d’obligations. On pourrait s’attendre à ce que, sur une très longue période, le degré d’incertitude du rendement des investissements soit faible. Après tout, quelques mauvaises années sont susceptibles d’être compensées par des années de prospérité. Néanmoins, le degré d’incertitude, même en prenant le très long horizon temporel sur lequel se fait l’investissement des pensions, se trouve à être grand. Dans 10 % des cas, on devrait s’attendre à un rendement annuel de moins de 5,5 %, tandis que dans 10 % des cas, il devrait dépasser 9,0 %. Les calculs des rendements composés de l’épargne-retraite sur une période de 40 ans, montrent que de telles différences sont équivalentes à d’énormes sommes d’argent. Toutefois, il existe une série de facteurs qui peuvent expliquer pourquoi les rendements obtenus par les individus sur leurs fonds de pension sont inférieurs aux rendements du marché (tels que ceux mesurés par les indices classiques). Ces facteurs qui incluent les frais administratifs, les effets d’agence et de gouvernance et ceux liés au changement démographique, ont contribué à la baisse des rendements en dessous du niveau élevé enregistré au cours des deux dernières décennies. Par conséquent, une hypothèse plus conservatrice sur le rendement des investissements futurs est appropriée. En fixant la médiane du rendement annuel net de charges à 5 % implique que dans 80 % des cas, le rendement sur l’investissement de l’épargne-retraite devrait se situer entre 3,2 % et 6,7 % par an.
    JEL: D14 G11 G23
    Date: 2009–06–09

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