New Economics Papers
on Risk Management
Issue of 2009‒10‒17
fourteen papers chosen by

  1. Hedging residual value risk using derivatives By Sylvain Prado
  2. Are Banking Systems Increasingly Fragile ? Investigating Financial Institutions’ CDS Returns Extreme Co-Movements By Dima Rahman
  3. Implied Multi-Factor Model for Bespoke CDO Tranches and other Portfolio Credit Derivatives By Igor Halperin
  4. Some New Evidence on the Role of Collateral: Lazy Banks or Diligent Banks? By Amedeo Argentiero
  5. Risk Concentration and Diversification: Second-Order Properties By Matthias Degen; Dominik D. Lambrigger; Johan Segers
  6. BSDEs with random default time and their applications to default risk By Shige Peng; Xiaoming Xu
  7. Transfer Pricing Risk Awareness of Multinational Corporations - Evidence from a Global Survey By Sven P. Jost
  8. Ethical vs. Non-Ethical – Is There a Difference? Analyzing Performance of Ethical and Non-Ethical Investment Funds By Linnéa Lundberg; Jiri Novak; Maria Vikman
  9. Pricing of Asian temperature risk By Fred Benth; Wolfgang Karl Härdle; Brenda López Cabrera
  10. "Government Intervention to Prevent Bankruptcy: The Effect of Blind-Bidding Laws on Movie Theaters" By James G. Mulligan; Daniel J. Wedzielewski
  11. Stress testing French banks' income subcomponents By Coffinet, J.; Lin, S.; Martin, C.
  12. Signals from housing and lending booms. By Irina Bunda; Michele Ca’ Zorzi
  13. Measuring the Quality of Banking Regulation in Egypt By Silvia Rashad Gad Tadros
  14. Multifractal analysis and instability index of prior-to-crash market situations By M. Piacquadio; F. O. Redelico

  1. By: Sylvain Prado
    Abstract: Abstract: In the leasing industry the lessor faces a risk, at the end of the contract, in not recovering sufficient capital value from resale of the asset. We propose a model to hedge residual value risk using the Gaussian copula methodology. After discussing residual value risk and credit risk modelization, a new derivative product is introduced and analyzed; the Collateralized Residual Values (CRV). The model is applied to an European auto lease portfolio of operating lease contracts pertaining to a major company. Our results indicate that the financial product is easy to customize, and to implement through the contract characteristics and the level of correlation.
    Keywords: Residual value risk, credit risk, credit derivatives, factor modeling, copula
    JEL: C10 G13
    Date: 2009
  2. By: Dima Rahman
    Abstract: This paper investigates potential contagion among the major financial institutions in developed economies. Using Credit Default Swaps (CDS) premia as a measure of credit or counterparty risk, our analysis focuses on the extreme co-movements of Financial Institutions' default contracts during the high level of stress undergone by the CDS markets in the aftermath of the 2007 sub-prime crisis. Our approach is twofold: first, under different tail dependence scenarios, we calibrate several multivariate linear propagation models of constant correlation. Our Monte Carlo simulation study finds evidence of contagion for Financial Institutions- notably in the US-and captures a non-normal dependence structure in the tails for the traded contracts. Second, we estimate a multivariate Dynamic Conditional Correlation-GARCH (DCC-GARCH) model, and demonstrate significant ARCH and GARCH effects, as well as time-varying correlations in CDS spreads variations. Our overall analysis rejects the assumption of constant correlation. More importantly, it advocates changing structures in tail dependence for CDS series during times of financial turmoil as an important feature of banks’ increased fragility.
    Keywords: Bank fragility, Counterparty risk, Financial crises, Extreme co-movements, Conditional correlation, Multivariate GARCH, Monte Carlo simulation
    Date: 2009
  3. By: Igor Halperin
    Abstract: This paper introduces a new semi-parametric approach to the pricing and risk management of bespoke CDO tranches, with a particular attention to bespokes that need to be mapped onto more than one reference portfolio. The only user input in our framework is a multi-factor model (a "prior" model hereafter) for index portfolios, such as CDX.NA.IG or iTraxx Europe, that are chosen as benchmark securities for the pricing of a given bespoke CDO. Parameters of the prior model are fixed, and not tuned to match prices of benchmark index tranches. Instead, our calibration procedure amounts to a proper reweightening of the prior measure using the Minimum Cross Entropy method. As the latter problem reduces to convex optimization in a low dimensional space, our model is computationally efficient. Both the static (one-period) and dynamic versions of the model are presented. The latter can be used for pricing and risk management of more exotic instruments referencing bespoke portfolios, such as forward-starting tranches or tranche options, and for calculation of credit valuation adjustment (CVA) for bespoke tranches.
    Date: 2009–10
  4. By: Amedeo Argentiero (University of Rome Tor Vergata - Dept. of Economics and ISAE - Institute for Studies and Economic Analyses)
    Abstract: In the banking literature (Manove et al. (2001)) "Lazy Banks" are defined as those banks that substitute project screening with collateral. This paper aims to test for Italy some empirical implications of the theoretical model of "Lazy Banks": the negative relationship between collateral and project screening, whether collateral is posted by safer borrowers and law enforcement is able to increase the degree of collateralization. Empirical evidence presented here suggests that, both for long-term loans and short-term ones, when project screening increases, the amount of real guarantees with respect to the credit granted increases. Moreover, the data show that collateral seems to be posted by high-risk borrowers and law enforcement does not matter in explaining the presence of real guarantees for long-term loans, whereas it represents a further risk component that generates an increase in collateral for short-term loans. Therefore, a model of "Lazy Banks" does not seem to be verified on the data, suggesting the results rather a sort of "diligence" in the banks' behavior. Furthermore, the empirical findings on our data reveal that the presence of real guarantees is not able to lower ex-post default credit risk. These results are consistent with a view of collateral as a credible mechanism for commitment against informative asymmetries and not as a convenient hedge against realized ex-post credit default risk.
    Keywords: Collateral, Screening, Lazy Banks, Default Risk.
    JEL: D82 G21 H42
    Date: 2009–07
  5. By: Matthias Degen; Dominik D. Lambrigger; Johan Segers
    Abstract: The quantification of diversification benefits due to risk aggregation plays a prominent role in the (regulatory) capital management of large firms within the financial industry. However, the complexity of today's risk landscape makes a quantifiable reduction of risk concentration a challenging task. In the present paper we discuss some of the issues that may arise. The theory of second-order regular variation and second-order subexponentiality provides the ideal methodological framework to derive second-order approximations for the risk concentration and the diversification benefit.
    Date: 2009–10
  6. By: Shige Peng; Xiaoming Xu
    Abstract: In this paper we are concerned with backward stochastic differential equations with random default time and their applications to default risk. The equations are driven by Brownian motion as well as a mutually independent martingale appearing in a defaultable setting. We show that these equations have unique solutions and a comparison theorem for their solutions. As an application, we get a saddle-point strategy for the related zero-sum stochastic differential game problem.
    Date: 2009–10
  7. By: Sven P. Jost
    Abstract: This paper investigates the transfer pricing risk awareness of multinational firms using cross-sectional data of more than 350 firms located in 24 countries and classified in 12 industries. Moving beyond the sole tax optimization motives of multinational firms, we extend the existing literature by using unique firm-level information such as that the transfer pricing risk awareness is assessed and reported by the person ultimately responsible for transfer pricing. We find that the level of transfer pricing risk awareness of multinational companies predominantly depends on (i) the industry a firm operates in, (ii) a country's risk classification with respect to its transfer pricing regulations (e.g. penalty regimes in case of non-compliance with transfer pricing regulations), (iii) firm size and (iv) the interaction effect of the first two factors. By way of contrast, the time of introduction of transfer pricing regulations and also tax considerations do not seem to play a crucial role for transfer pricing risk perceptions.
    Keywords: Transfer pricing; International taxation; Multinational firms; Tax risk management
    JEL: F23 H25
    Date: 2009–09
  8. By: Linnéa Lundberg (Stockholm University School of Business, Sweden); Jiri Novak (Institute of Economic Studies, Faculty of Social Sciences, Charles University, Prague, Czech Republic); Maria Vikman (Stockholm University School of Business, Sweden)
    Abstract: Ethical investments have become increasingly popular over the past years. Ethical funds restrict their investment based on environmental, social and/or ethical criteria. Prior research on the performance of ethical versus non-ethical funds yields mixed results. This paper investigates the differences in risk profiles and realized returns between ethical and non-ethical funds. A sample of 23 ethical funds and 152 non-ethical funds covering the time period between 2000 and 2007 is investigated. The analysis of the portfolio composition shows that there are small differences in the structure of portfolios concerning industry composition and company size. However, the ethical funds tend to hold more stocks in their portfolios than non-ethical ones. The results provide some evidence on the underperformance of ethical funds; this underperformance is stronger in years of poor stock market performance, which indicates that systematic risk of ethical funds may be higher.
    Keywords: ethical, social responsible investment, SRI, investment, funds, portfolio, returns, risk, screening, Sweden
    JEL: G12 C21
    Date: 2009–09
  9. By: Fred Benth; Wolfgang Karl Härdle; Brenda López Cabrera
    Abstract: Weather derivatives (WD) are different from most financial derivatives because the underlying weather cannot be traded and therefore cannot be replicated by other financial instruments. The market price of risk (MPR) is an important parameter of the associated equivalent martingale measures used to price and hedge weather futures/options in the market. The majority of papers so far have priced non-tradable assets assuming zero MPR, but this assumption underestimates WD prices. We study the MPR structure as a time dependent object with concentration on emerging markets in Asia. We find that Asian Temperatures (Tokyo, Osaka, Beijing, Teipei) are normal in the sense that the driving stochastics are close to a Wiener Process. The regression residuals of the temperature show a clear seasonal variation and the volatility term structure of CAT temperature futures presents a modified Samuelson effect. In order to achieve normality in standardized residuals, the seasonal variation is calibrated with a combination of a fourier truncated series with a GARCH model and with a local linear regression. By calibrating model prices, we implied the MPR from Cumulative total of 24- hour average temperature futures (C24AT) for Japanese Cities, or by knowing the formal dependence of MPR on seasonal variation, we price derivatives for Kaohsiung, where weather derivative market does not exist. The findings support theoretical results of reverse relation between MPR and seasonal variation of temperature process.
    Keywords: Weather derivatives, continuous autoregressive model, CAT, CDD, HDD, risk premium
    JEL: G19 G29 G22 N23 N53 Q59
    Date: 2009–10
  10. By: James G. Mulligan (Department of Economics,University of Delaware); Daniel J. Wedzielewski (JPMorganChase)
    Abstract: In the 1970s motion picture studios used blind bidding and non-refundable guarantees to reduce the risks of producing large budget films. However, theater owners claimed that blind bidding and guarantees shifted the risk to them and increased the likelihood of bankruptcy. In response to lobbying by theater owners, twenty-four states passed laws banning blind bidding between 1978 and 1984, while seven states also banned non-refundable guarantees. We find that the laws were not only ineffective in keeping theater owners from exiting the market; they may have been detrimental to theater owners converting to multiplexes at that time.
    Keywords: bankruptcy, blind bidding, vertical contractual relationships, government intervention.
    JEL: L1 L2
    Date: 2009
  11. By: Coffinet, J.; Lin, S.; Martin, C.
    Abstract: Using a broad dataset of individual consolidated data of French banks over the period 1993-2007, we seek to evaluate the sensitivity to adverse macroeconomic scenarios of the three main sources of banking income, namely interest margins, fees and commissions, and trading income. First, we show that the determinants of banking income subcomponents are highly specific: whereas interest rates spread plays a significant role in determining net interest income, stock market measures are significant determinants of trading income. GDP growth impacts significantly on fees and commissions. Second, our macroeconomic stress testing exercises tend to show that fees and commission and to a lesser extent trading incomes are much more sensitive to some adverse macroeconomic shocks than interest income. This could support the view that income diversification is associated with higher banking revenue resilience.
    Keywords: Banking income , Interest margins , Fees and commissions , Trading income , Dynamic panel estimation.
    JEL: C23 G21 L2
    Date: 2009
  12. By: Irina Bunda (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Michele Ca’ Zorzi (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: The contribution of this paper is to revisit the Early Warning System (EWS) literature by analysing selected episodes of financial market crisis, i.e. those preceded by a spell of credit and real estate expansions. The aim is to disentangle instances when this constitutes a natural phenomenon associated with a process of financial development and innovation from those where it constitutes a worrisome signal. We identify economic variables that have leading indicator properties, thus helping to distinguish between “benign” episodes from those likely ending with downward pressures on the exchange rate or even a fully-fledged banking crisis. We find that a large current account deficit, a fall in price competitiveness, strong real growth and high public debt-to-GDP ratio increase the probability that a lending or housing boom would be accompanied by financial market tensions shortly after the peak. JEL Classification: E32, F31, F37.
    Keywords: Early warning system, financial crises, house prices, credit booms.
    Date: 2009–09
  13. By: Silvia Rashad Gad Tadros (Faculty of Management Technology, The German University in Cairo)
    Abstract: The free market economy most countries pursue nowadays is never entirely free from government intervention. Policy makers devote special attention to the regulation of financial markets and with the current financial crisis, the quality of the banking regulations need to be reconsidered. This paper aims to provide a tool to measure the quality of banking regulation and supervision. This is usually a difficult task because it is a qualitative analysis and is arbitrary. However, a regulation index has been modelled that is similar to the concept of a cost-benefit analysis. The input index resembles the cost signifying the efforts made by governments and supervisors to measure the intensity of the regulation. The output index resembles the benefit which shows the outcome of the governments’ efforts. Finally, applying this index on Egypt filled a research gap in this area.
    Keywords: Banking regulation, Quality index, Egypt
    JEL: G28 G21 L51
    Date: 2009–10
  14. By: M. Piacquadio; F. O. Redelico
    Abstract: We take prior-to-crash market prices (NASDAQ, Dow Jones Industrial Average) as a signal, a function of time, we project these discrete values onto a vertical axis, thus obtaining a Cantordust. We study said cantordust with the tools of multifractal analysis, obtaining spectra by definition and by lagrangian coordinates. These spectra have properties that typify the prior-to-crash market situation. Any of these spectra entail elaborate processing of the raw signal data. With the unprocessed raw data we obtain an instability index, also with properties that typify the prior-to-crisis market situation. Both spectra and the instability index agree in characterizing such crashes, and in giving an early warning of them.
    Date: 2009–10

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