nep-rmg New Economics Papers
on Risk Management
Issue of 2009‒12‒19
eleven papers chosen by
Stan Miles
Thompson Rivers University

  1. The growing importance of risk in financial regulation By Ojo, Marianne
  2. Systematic risk of CDOs and CDO arbitrage By Hamerle, Alfred; Liebig, Thilo; Schropp, Hans-Jochen
  3. Credit Default Swap Calibration and Counterparty Risk Valuation with a Scenario based First Passage Model By Damiano Brigo; Marco Tarenghi
  4. Credit Default Swap Calibration and Equity Swap Valuation under Counterparty Risk with a Tractable Structural Model By Damiano Brigo; Marco Tarenghi
  5. Containing Systemic Risk By Karl Whelan
  6. Climate Change and Risk Management: Challenges for Insurance, Adaptation, and Loss Estimation By Kousky, Carolyn; Cooke, Roger
  7. Multiple defaults and contagion risks By Ying Jiao
  8. Beyond the Financial Crisis: Addressing risk challenges in a changing financial environment By Ojo, Marianne
  9. Capital requirements and business cycles with credit market imperfections By Agénor, P.-R.; Alper, K.; Pereira da Silva, L.
  10. A duality approach to the worst case value at risk for a sum of dependent random variables with known covariances By Brice Franke; Michael Stolz
  11. Financial Stability: Overcoming the Crisis and Improving the Efficiency of the Banking Sector By Randall S. Jones; Masahiko Tsutsumi

  1. By: Ojo, Marianne
    Abstract: This paper traces the developments that have contributed to the importance of risk in regulation. Not only does it consider theories associated with risk, it also discusses explanations as to why risk has become so important within regulatory and governmental circles. Two forms of risk regulation, namely risk based regulation and meta regulation are considered. As well as considering the application of both in jurisdictions such as the UK, the paper places greater focus in discussing the importance of meta regulation in jurisdictions such as Germany, Italy and the US. The preference for meta regulation is based on the premises, not only of the advantages considered in this paper but also on the application of Basel II in several jurisdictions. Whilst meta regulation also has its disadvantages, the impact of risk based regulation on the use of external auditors plays a part in the preference for meta regulation.
    Keywords: risk; regulation; meta; Basel II; financial
    JEL: K2
    Date: 2009–12
  2. By: Hamerle, Alfred; Liebig, Thilo; Schropp, Hans-Jochen
    Abstract: “Arbitrage CDOs” have recorded an explosive growth during the years before the outbreak of the financial crisis. In the present paper we discuss potential sources of such arbitrage opportunities, in particular arbitrage gains due to mispricing. For this purpose we examine the risk profiles of Collateralized Debt Obligations (CDOs) in some detail. The analyses reveal significant differences in the risk profile between CDO tranches and corporate bonds, in particular concerning the considerably increased sensitivity to systematic risks. This has farreaching consequences for risk management, pricing and regulatory capital requirements. A simple analytical valuation model based on the CAPM and the single-factor Merton model is used in order to keep the model framework simple. Then, the conditional expected loss curve (EL profile) is studied in some detail. In the next step, the asset correlation associated with a CDO tranche is estimated treating the structured instrument as a single-name credit instrument (i.e., a loan equivalent). While tractable, the loan-equivalent approach requires appropriate parameterization to achieve a reasonable approximation of the tranche´s risk profile. We consider the tranche as a “virtual” borrower or bond for which a single-factor model holds. Then, the correlation parameter is calculated via a non-linear optimization. This “bond representation” allows to approximate the risk profile (expressed by the EL profile) using a single-factor model and to express the dependence on the systematic risk factor via the corresponding asset correlation. It turns out that the resulting asset correlation is many times higher than that of straight bonds. Then, the Merton type valuation model for the corresponding bond representations is applied for valuation of the CDO tranches. Using a sample CDO portfolio, some opportunities for “CDO arbitrage” are described where it is assumed that investors are guided solely by the tranches’ rating and ignore the increased systematic risk for pricing. In the next section we discuss how tranches with high systematic risk can be generated and how CDO arrangers can exploit this to their advantage. It comes as no surprise that precisely these types of structures featured in many of the CDOs issued prior to the outbreak of the financial crisis. --
    Keywords: Collateralized debt obligations (CDO),arbitrage CDOs,credit rating,expected loss profile,bond representation,systematic risk of CDO tranches,CDO pricing
    JEL: C13 G12 G24
    Date: 2009
  3. By: Damiano Brigo; Marco Tarenghi
    Abstract: In this work we develop a tractable structural model with analytical default probabilities depending on a random default barrier and possibly random volatility ideally associated with a scenario based underlying firm debt. We show how to calibrate this model using a chosen number of reference Credit Default Swap (CDS) market quotes. In general this model can be seen as a possible extension of the time-varying AT1P model in Brigo and Tarenghi (2004). The calibration capability of the Scenario Volatility/Barrier model (SVBAT1P), when keeping time-constant volatility, appears inferior to the one of AT1P with time-varying deterministic volatility. The SVBAT1P model, however, maintains the benefits of time-homogeneity and can lead to satisfactory calibration results, as we show in a case study where we compare different choices on scenarios and parameters. Similarly to AT1P, SVBAT1P is suited to pricing hybrid equity/credit derivatives and to evaluate counterparty risk in equity payoffs, and more generally to evaluate hybrid credit/equity payoffs. We consider the equity return swap in Brigo and Tarenghi (2004) and show its valuation under SVBAT1P with the same CDS and equity calibration input used earlier for AT1P, and further we hint at equity default swap valuation in the conclusions.
    Date: 2009–12
  4. By: Damiano Brigo; Marco Tarenghi
    Abstract: In this paper we develop a tractable structural model with analytical default probabilities depending on some dynamics parameters, and we show how to calibrate the model using a chosen number of Credit Default Swap (CDS) market quotes. We essentially show how to use structural models with a calibration capability that is typical of the much more tractable credit-spread based intensity models. We apply the structural model to a concrete calibration case and observe what happens to the calibrated dynamics when the CDS-implied credit quality deteriorates as the firm approaches default. Finally we provide a typical example of a case where the calibrated structural model can be used for credit pricing in a much more convenient way than a calibrated reduced form model: The pricing of counterparty risk in an equity swap.
    Date: 2009–12
  5. By: Karl Whelan (University College Dublin)
    Abstract: Systemic risk refers to the risk of financial system breakdown due to linkages between institutions. This risk cannot be assessed by looking at how individual institutions manage risks but instead requires a full understanding of how the system as a whole operates. At present, the data available to central banks and financial regulators are not at all adequate for the task of assessing systemic risk and the new European Systemic Risk Board needs to address this issue. There is a lot of exciting ongoing research devoted to measuring systemic risk and providing signals to regulators as to when and where they should intervene. However, the tools being developed are still limited in their usefulness. More pressing than the development of these tools is the development and implementation of policy measures to make the financial system more robust. These measures should include higher capital ratios, limits on non-core funding and redesigning financial systems to be less complex.
    Keywords: Financial Risk,Systemic Risk,Banking
    Date: 2009–12–01
  6. By: Kousky, Carolyn (Resources for the Future); Cooke, Roger (Resources for the Future)
    Abstract: Adapting to climate change will not only require responding to the physical effects of global warming, but will also require adapting the way we conceptualize, measure, and manage risks. Climate change is creating new risks, altering the risks we already face, and also, importantly, impacting the interdependencies between these risks. In this paper we focus on three particular phenomena of climate related risks that will require a change in our thinking about risk management: global micro-correlations, fat tails, and tail dependence. Consideration of these phenomena will be particularly important for natural disaster insurance, as they call into question traditional methods of securitization and diversification.
    Keywords: tail dependence, micro-correlations, fat tails, damage distributions, climate change
    JEL: Q54 G22 C02
    Date: 2009–02–03
  7. By: Ying Jiao (PMA)
    Abstract: We study multiple defaults where the global market information is modelled as progressive enlargement of filtrations. We shall provide a general pricing formula by establishing a relationship between the enlarged filtration and the reference default-free filtration in the random measure framework. On each default scenario, the formula can be interpreted as a Radon-Nikodym derivative of random measures. The contagion risks are studied in the multi-defaults setting where we consider the optimal investment problem in a contagion risk model and show that the optimization can be effectuated in a recursive manner with respect to the default-free filtration.
    Date: 2009–12
  8. By: Ojo, Marianne
    Abstract: The Financial Crisis has not only highlighted the importance of addressing issues such as liquidity risk – it has also brought to the fore the need to focus on unregulated instruments such as hedge funds, which are of systemic importance to the financial industry. Risk is an area which, owing to its increasing significance, requires greater focus. A move to risk based strategies is evidenced by the growing popularity of risk based regulation and meta regulatory strategies. Given the presence of an unregulated hedge fund industry however, such attempts do not suffice on their own. Further, the systemic nature of risk exacerbates the problem of such unregulated institutions. 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. These theories will be considered against a background of themes such as dynamism, evolutionism, developments in science and industry, cultural attitudes to risk, and the need to be responsive and reflexive to changes which have arisen in modern society. Theoretical models and hybrids of a responsive model of regulation such as Enforced self regulation and meta regulation, which have the potential to address the problems relating to risk will be addressed. By virtue of the pro cyclical nature of risk, the inability of Basel 2 to address risk cycles were revealed during the Northern Rock Crisis. Other flaws and deficiencies inherent in Basel 2, a form of meta regulation, will be highlighted. The relevance of internal control systems to an efficient system of regulation, the reasons for which meta regulation is not only considered to be the most responsive form of regulation, but also one which assigns central role to internal control systems will be discussed. The contested nature of risk and the difficulties attributed to its quantification, raise questions about its ability to function effectively as a regulatory tool. If risks could be eliminated in their entirety however, then regulation would serve no purpose. This paper aims generally therefore to direct attention to those areas which could be addressed, namely institutional risks, and measures whereby such risks, even though impossible to eliminate, could be minimized.
    Keywords: risk; theories; financial; regulation; Financial; Crisis
    JEL: K2 K0 M42
    Date: 2009–12
  9. By: Agénor, P.-R.; Alper, K.; Pereira da Silva, L.
    Abstract: The business cycle effects of bank capital regulatory regimes are examined in a New Keynesian model with credit market imperfections and a cost channel of monetary policy. Key features of the model are that bank capital increases incentives for banks to monitor borrowers, thereby reducing the probability of default, and excess capital generates benefits in terms of reduced regulatory scrutiny. Basel I and Basel II-type regulatory regimes are defined, and the model is calibrated for a middle-income country. Simulations of supply and demand shocks show that, depending on the elasticity that relates the repayment probability to the capital-loan ratio, a Basel II-type regime may be less procyclical than a Basel I-type regime.
    Keywords: Banks&Banking Reform,Debt Markets,Access to Finance,Economic Theory&Research,Emerging Markets
    Date: 2009–12–01
  10. By: Brice Franke; Michael Stolz
    Abstract: We propose an approach to the aggregation of risks which is based on estimation of simple quantities (such as covariances) associated to a vector of dependent random variables, and which avoids the use of parametric families of copulae. Our main result demonstrates that the method leads to bounds on the worst case Value at Risk for a sum of dependent random variables. Its proof applies duality theory for infinite dimensional linear programs.
    Date: 2009–12
  11. By: Randall S. Jones; Masahiko Tsutsumi
    Abstract: The crisis that originated in mid-2007 in the United States and deepened in September 2008 is the largest peace-time disruption of financial markets since the Great Depression. It was triggered by a number of factors, namely the large amount of lending to subprime borrowers, the expansion of securitisation resulting in a disconnect between loan originators and final investors, the questionable assessments of credit rating agencies and the unprecedented resort to off-balance sheet vehicles. These developments took place during a traditional credit boom and reinforced the skyrocketing of asset prices, erosion of lending standards and under-pricing of risk. The crisis had serious repercussions worldwide, particularly in Europe, given the global nature of financial markets. This paper begins by considering why the Japanese banking system was initially relatively resilient to the deterioration in the global financial system, although there were some secondary effects that are discussed in the following section. The third section outlines the emergency response of the Japanese authorities to the financial crisis, including quantitative measures by the central bank and other institutions and regulatory changes by the Financial Services Agency (FSA). At the same time, the authorities have taken steps to improve the regulatory framework. The fourth section goes beyond the crisis to consider policies to boost chronically low profitability in the banking sector. Measures to promote efficiency in the financial sector by upgrading capital markets and improving the range and quality of financial products are discussed in the following section.<P>Stabilité financière : surmonter la crise et améliorer l'efficience du secteur bancaire au Japon<BR>Les banques japonaises ont été en grande partie épargnées par les effets directs de la crise financière mondiale, grâce à leur exposition limitée aux actifs toxiques étrangers, au cadre réglementaire en place au Japon et au rôle modeste de la titrisation. Néanmoins, la forte contraction de la production et la chute des cours des actions ont indéniablement eu des répercussions préjudiciables sur le secteur bancaire. Les autorités ont réagi en prenant des mesures pour stabiliser le marché financier, injecter des capitaux dans les établissements de dépôts et préserver le crédit aux petites entreprises. Ces mesures d'urgence devraient être démantelées progressivement afin de limiter les effets de distorsion qui en découlent, une fois que la reprise sera ancrée. Il est essentiel de moderniser le cadre réglementaire en améliorant la transparence des produits titrisés, le fonctionnement des agences de notation financières et les règles relatives aux fonds propres. Il importe également de remédier à des problèmes chroniques, dont la faible rentabilité des établissements financiers, en particulier des banques régionales, et de renforcer l'efficience du secteur financier. Cela passe par diverses mesures, notamment par la privatisation des établissements financiers publics, l'amélioration de l'efficacité des services bancaires, et le renforcement de la diversité et de la qualité des produits financiers.
    Keywords: Bank of Japan, bank, Basel II, capital adequacy regulation, capital injections, capital markets, credit rating agencies, financial sector, FSA, global financial crisis, Japan, Japanese economy, regional banks, reverse mortgages, securitisation, agences de notation financières, Bâle II, Banque du Japon, banque, banques régionales, crise financière mondiale, économie japonaise, FSA, injections de capitaux, Japon, marchés de capitaux, prêts viagers hypothécaires, règles relatives aux fonds propres, secteur financier, titrisation
    JEL: Q28 Q54 Q56 Q58
    Date: 2009–12–04

This nep-rmg issue is ©2009 by Stan Miles. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.