nep-rmg New Economics Papers
on Risk Management
Issue of 2009‒06‒17
eighteen papers chosen by
Stan Miles
Thompson Rivers University

  1. Risk management by the Basel Committee: evaluating progress made from the 1988 Basel Accord to recent developments By Ojo, Marianne
  2. A Risk Management Approach for Portfolio Insurance Strategies. By Benjamin Hamidi; Bertrand Maillet; Jean-Luc Prigent
  3. A Dynamic Correlation Modelling Framework with Consistent Stochastic Recovery By Li, Yadong
  4. Financial regulation and risk management: addressing risk challenges in a changing financial environment By Ojo, Marianne
  5. CREDIT RISK IN FINANCING SME IN ROMANIA By Vorniceanu, Marius; Covaci, Brindusa; Cocosatu, Cristinel Claudiu
  6. Fiscal behaviour in the European Union: rules, fiscal decentralization and government indebtedness. By Ingo Fender; Martin Scheicher
  7. Predicting Stock Returns in a Cross-Section : Do Individual Firm Characteristics Matter ?. By Kateryna Shapovalova; Alexander Subbotin
  8. De copulis non est disputandum - Copulae: An Overview By Wolfgang Härdle; Ostap Okhrin
  9. Measuring and managing credit risk in SMEs: a quantitative and qualitative rating model By Ivan DE NONI; Antonio LORENZON; Luigi ORSI
  10. D'un multiple conditionnel en assurance de portefeuille : CAViaR pour les gestionnaires ?. By Benjamin Hamidi; Emmanuel Jurczenko; Bertrand Maillet
  11. Evaluarea expunerii firmelor la riscul valutar; consideratii generale (General remarks on the assessment of foreign exchange risk exposure of firms) By Arnaldo MAURI; Claudia Gabriela BAICU
  12. Bailouts, the Incentive to Manage Risk, and Financial Crises By Stavros Panageas
  13. Asset Liability Management in Insurance Company By Giandomenico, Rossano
  14. A New Capital Regulation For Large Financial Institutions By Hart, Oliver; Zingales, Luigi
  15. Systemic Risk: Amplification Effects, Externalities, and Policy Responses. By Anton Korinek
  16. "'Enforced Indebtedness' and Capital Adequacy Requirements" By Jan Toporowski
  17. Crash Risk in Currency Markets By Emmanuel Farhi; Samuel Paul Fraiberger; Xavier Gabaix; Romain Ranciere; Adrien Verdelhan
  18. Multi-Factor Model of Correlated Commodity - Forward Curves for Crude Oil and Shipping Markets By Paul D. Sclavounos; Per Einar Ellefsen

  1. By: Ojo, Marianne
    Abstract: This paper traces developments from the inception of the 1988 Basel Capital Accord to its present form (Basel II). In highlighting the flaws of the 1988 Accord, an evaluation is made of the Basel Committee’s efforts to address such weaknesses through Basel II. Whilst considerable progress has been achieved, the paper concludes, based on one of the principal aims of these Accords, namely the management of risk, that more work is still required particularly in relation to hedge funds and those risks attributed to non bank financial institutions.
    Keywords: risk;management;regulation;banks;Basel;Committee
    JEL: K2
    Date: 2008–08
  2. By: Benjamin Hamidi (Centre d'Economie de la Sorbonne et A.A.Advisors-QCG (ABN AMRO)Variances); Bertrand Maillet (Centre d'Economie de la Sorbonne, A.A.Advisors-QCG (ABN AMRO)Variances et IEF); Jean-Luc Prigent (THEMA - Université de Cergy)
    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.
    JEL: G11 C13 C14 C22 C32
    Date: 2009–05
  3. 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
  4. By: Ojo, Marianne
    Abstract: Amongst other things, this paper aims to address complexities and challenges faced by regulators in identifying and assessing risk, problems arising from different perceptions of risk, and solutions aimed at countering problems of risk regulation. It will approach these issues through an assessment of explanations put forward to justify the growing importance of risks, well known risk theories such as cultural theory, risk society theory and governmentality theory. In addressing the problems posed as a result of the difficulty in quantifying risks, it will consider a means whereby risks can be quantified reasonably without the consequential effects which result from the dual nature of risk that is, risks emanating from the management of institutional risks. Current attempts by the European Union to regulate risks will also be discussed. This discussion will be facilitated through a consideration of recent developments in the EU which are aimed at addressing risks posed by hedge funds. The results obtained from a consultation process on hedge funds, and which will be discussed in the concluding section of this paper, reveal whether the systemic relevance of hedge funds and prime brokerage regulation need to be reviewed. Questions also addressed during the consultation process, which include whether indirect prudential regulation is inadequate to shield the financial system from hedge funds’ failure and whether prudential authorities have necessary tools to monitor exposures of the core financial system to hedge funds, will also be discussed.
    Keywords: risk;regulation;banks;regulators;audit;financial
    JEL: K2
    Date: 2009–04
  5. By: Vorniceanu, Marius (Universitatea Spiru Haret, Facultatea de Finante si Banci); Covaci, Brindusa (Universitatea Spiru Haret, Facultatea de Finante si Banci); Cocosatu, Cristinel Claudiu (Universitatea Spiru Haret, Facultatea de Finante si Banci)
    Abstract: Romania's integration in the European Union brought about some major changes in our banking system. One of the direct consequences is the fierce competition between banks for supremacy on the market. According to this, the Romanian banks saw in the SMEs sector a true potential for reaching their goal and they proceeded to conquer it by conceiving unique products, specially designed to reach the financial needs of this segment. Moreover, banks often come up with new attractive offers and cost reductions for the SMEs (Small and Medium Sized Enterprises) sector. In this context, some answers need to be done: the effective risk banks accept to take by providing the offers, specific risks in financing this sector, the problem of the balance between risk and profit return (or market share increase).
    Keywords: credit risk; risk management; financing SME; bank policies
    JEL: C61 G11
    Date: 2009–06–04
  6. By: Ingo Fender (Bank for International Settlements (BIS), Monetary and Economic Department, Centralbahnplatz 2, 4002 Basel, Switzerland.); Martin Scheicher (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany.)
    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 macroeco-nomic 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) in its original form. JEL Classification: E43, G12, G13, G14.
    Keywords: ABX index, mortgage-backed securities, pricing, risk premia.
    Date: 2009–05
  7. By: Kateryna Shapovalova (Centre d'Economie de la Sorbonne); Alexander Subbotin (Centre d'Economie de la Sorbonne et Higher School of Economics)
    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.
    JEL: E44 G11 E32
    Date: 2009–05
  8. By: Wolfgang Härdle; Ostap Okhrin
    Abstract: Normal distribution of the residuals is the traditional assumption in the classical multivariate time series models. Nevertheless it is not very often consistent with the real data. Copulae allows for an extension of the classical time series models to nonelliptically distributed residuals. In this paper we apply different copulae to the calculation of the static and dynamic Value-at-Risk of portfolio returns and Profit-and-Loss function. In our findings copula based multivariate model provide better results than those based on the normal distribution.
    Keywords: copula, multivariate distribution, value-at-risk, multivariate dependence
    JEL: C13 C14 C50
    Date: 2009–05
  9. By: Ivan DE NONI; Antonio LORENZON; Luigi ORSI
    Abstract: The main aim of this paper is to develop a qualitative and quantitative credit risk rating model for SMEs. The scope of this model is to assign, through a discriminant function (see Altman,1969), a synthetic judgment of the firm management ( ). First of all it must characterize variables that multiplied for a weighted coefficient allow us to determine a score of the analyzed enterprises. The classification is based on a discriminating function that maximize the variance of the variables among the firms of two groups and to minimize the variance among the firms of the same group. An important aspect of the model is its ability to enclose in the judgment of rating also the qualitative part. The objective is to modify the quantitative score including the qualitative judgments that emerge from a qualitative questionnaire. The final rating, therefore, is constructed assigning the final score (quantitative plus qualitative) to the class of rating that it includes such value. So a synthetic judgment of the solvency, the solidity and the forecasts is supplied about the firm analysis. In conclusion we can say that the obtained results confirm the reliability of the model. The error percentage, in fact, is only of 13.65% for the performing firm and 8.91% for the non performing. Further analyses have demonstrated that the model turns out reliable also in relation to possible distortions generated from dimensional (analysis for number of employers) and geographical (analysis for province) effects. Contrarily a surveying on industry does not give the same results. Various industry are characterize from different variability coefficients and it implies a meaningful sectorial effect
    Keywords: SMEs, Rating Model, Competitiveness, Networking
    JEL: M14 G32 G33
    Date: 2007–10–15
  10. By: Benjamin Hamidi (Centre d'Economie de la Sorbonne et A.A.Advisors-QCG (ABN AMRO)Variances); Emmanuel Jurczenko (ESCP-EAP); Bertrand Maillet (Centre d'Economie de la Sorbonne, A.A.Advisors-QCG (ABN AMRO)Variances et IEF)
    Abstract: In a Constant Proportion Portfolio Insurance (CPPI) framework, a constant risk exposure is defined by the multiple of the strategy. This article proposes an alternative conditional multiple estimation model, which is based on an autoregressive quantile regression dynamic approach. We estimate several specifications of the conditional multiple model on the American equity market, and we compare relative performances of cushioned portfolios using conditional and unconditional multiples.
    Keywords: Portfolio insurance, CPPI, quantile regression.
    JEL: G11 C13 C14 C22 C32
    Date: 2009–05
  11. By: Arnaldo MAURI; Claudia Gabriela BAICU
    Abstract: The paper deals firstly with the assessment of nonfinancial firm’s risk exposure which has been deeply affected in the last two decades by the trend of market globalization and increased competition. In this new scenario we can note the weakening of the traditional separation between risks voluntary accepted by the firm as a chance to improve its profitability and risks which unavoidably lay on the overall business activity of the firm itself and have to be adequately covered by means of risk management. Secondly, within the frame of financial risks, particular attention is given to exchange rate fluctuations and to issues dealing with measurement and analysis of qualitative as well as quantitative aspects of foreign exchange risks affecting nonfinancial firms and chiefly those extensively involved in international activities. The focus then shifts to the assessment of foreign currency risk exposure by the firm as well as to managing foreign eschange risks and to the intruments and techniques involved.
    Keywords: Risk, financial risk, foreign exchange risk,foreign exchange exposure, risk management
    JEL: G30 G28 G32
    Date: 2008–02–01
  12. By: Stavros Panageas
    Abstract: A firm's termination leads to bankruptcy costs. This may create an incentive for outside stakeholders or the firm's debtholders to bail out the firm as bankruptcy looms. Because of this implicit guarantee, firm shareholders have an incentive to increase volatility in order to exploit the implicit protection. However, if they increase volatility too much they may induce the guarantee-extending parties to "walk away". I derive the optimal risk management rule in such a framework and show that it allows high volatility choices, while net worth is high. However, risk limits tighten abruptly when the firm's net worth declines below an endogenously determined threshold. Hence, the model reproduces the qualitative features of existing risk management rules, and can account for phenomena such as "flight to quality".
    JEL: G32 G33
    Date: 2009–06
  13. By: Giandomenico, Rossano
    Abstract: The model, by using the option theory, determines the fair value of the policies life with different time of maturity and shows that the effective liabilities duration of an Insurance Company exposed to the default-risk is different from the duration of a default-free zero coupon bond with the same time of maturity. Furthermore, it shows that the value of equity can be immunized in a dynamic way with respect to the movement of the spot-rate by selling and purchasing the default-free bonds in the firm asset. Moreover, the equity value, by the right bond allocation, can be immunized without varying continually the weight of the bonds on the firm asset. Furthermore, it considers the surrender option and the mortally issue such that it corrects some pitfalls that are commonly encountered in the insurance industry.
    Keywords: Contingent Claim; Duration; Immunization
    JEL: G22 G13
    Date: 2006–06
  14. By: Hart, Oliver; Zingales, Luigi
    Abstract: We design a new, implementable capital requirement for large financial institutions (LFIs) that are too big to fail. Our mechanism mimics the operation of margin accounts. To ensure that LFIs do not default on either their deposits or their derivative contracts, we require that they maintain a capital cushion sufficiently great that their own credit default swap price stays below a threshold level. If this level is violated the LFI regulator forces the LFI to issue equity until the CDS price moves back below the threshold. If this does not happen within a predetermined period of time, the regulator intervenes. We show that this mechanism ensures that LFIs are solvent with probability one, while preserving the disciplinary effects of debt.
    Keywords: banks; Capital requirement; too big to fail
    JEL: G21 G28
    Date: 2009–06
  15. By: Anton Korinek (4118F Tydings Hall, University of Maryland, College Park, MD 20742,USA,)
    Abstract: The worst financial crises since the Great Depression has forced central bankers and policymakers across Europe and around the globe to take unprecedented policy measures to deal with systemic risk, i.e. the risk that the financial system ceases to perform its function of allocating capital to the most productive use because of financial difficulties among a significant number of financial institutions. This paper develops a parsimonious model of systemic risk in the form of amplification effects whereby adverse developments in financial markets and in the real economy mutually reinforce each other and lead to a feedback cycle of falling asset prices, deteriorating balance sheets and tightening financing conditions. The paper shows that the free market equilibrium in such an environment is generically inefficient because constrained market participants do not internalize that their actions entail amplification effects. Therefore they undervalue the social benefits of liquidity during crises and take on too much systemic risk. We use our framework to shed light on a number of current policy issues. We show that banks face socially insufficient incentives to raise more capital during systemic crises, that bailouts which are anticipated can be ineffective, and that expectational errors are considerably more costly during crises than in normal times. Furthermore we develop an analytical framework for macro-prudential capital adequacy requirements that take into account systemic risk. We also analyze a new channel of financial contagion and explain why private agents will take insufficient precautions against contagion from other sectors in the economy.
    Keywords: financial crises, amplification effects, liquidity, systemic risk, systemic externalities, social pricing kernel, macroprudential regulation.
    JEL: E31 E32 E24 J51
    Date: 2009–05–14
  16. By: Jan Toporowski
    Abstract: The capital adequacy requirements for banks, enshrined in international banking regulations, are based on a fallacy of composition--namely, the notion that an individual firm can choose the structure of its financial liabilities without affecting the financial liabilities of other firms. In practice, says author Jan Toporowski, capital adequacy regulations for banks are a way of forcing nonfinancial companies into debt. "Enforced indebtedness" then reduces the quality of credit in the economy. In an international context, the present system of capital adequacy regulation reinforces this indebtedness. Proposals for "dynamic provisioning" to increase capital requirements during an economic boom would simply accelerate the boom's collapse. Contingent commitments to lend to governments in the event of private-sector lending withdrawals, alongside lending to foreign private-sector borrowers, are a much more viable alternative.
    Date: 2009–05
  17. By: Emmanuel Farhi; Samuel Paul Fraiberger; Xavier Gabaix; Romain Ranciere; Adrien Verdelhan
    Abstract: How much of carry trade excess returns can be explained by the presence of disaster risk? To answer this question, we propose a simple structural model that includes both Gaussian and disaster risk premia and can be estimated even in samples that do not contain disasters. The model points to a novel estimation procedure based on currency options with potentially different strikes. We implement this procedure on a large set of countries over the 1996--2008 period, forming portfolios of hedged and unhedged carry trade excess returns by sorting currencies based on their forward discounts. We find that disaster risk premia account for about 25% of expected carry trade excess returns in advanced countries.
    JEL: E44 F31
    Date: 2009–06
  18. By: Paul D. Sclavounos; Per Einar Ellefsen
    Abstract: An arbitrage free multi-factor model is developed of the correlated forward curves of the crude oil, gasoline, heating oil and tanker shipping markets. Futures contracts trading on public exchanges are used as the primary underlying securities for the development of a multi-factor Gaussian Heath-Jarrow-Morton (HJM) model for the dynamic evolution of the correlated forward curves. An intra- and inter-commodity Principal Component Analysis (PCA) is carried out in order to isolate seasonality and identify a small number of independent factors driving each commodity market. The cross-commodity correlation of the factors is estimated by a two step PCA. The factor volatilities and cross-commodity factor correlations are studied in order to identify stable parametric models, heteroskedasticity and seasonality in the factor volatilities and correlations. The model leads to explicit stochastic differential equations governing the short term and long term factors driving the price of the spot commodity under the risk neutral measure. Risk premia are absent, consistently with HJM arbitrage free framework, as they are imbedded in the factor volatilities and correlations estimated by the PCA. The use of the model is described for the pricing of derivatives written on inter- and intra-commodity futures spreads, Asian options, the valuation and hedging of energy and shipping assets, the fuel efficient navigation of shipping fleets and use in corporate risk management.
    Date: 2009–03

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