New Economics Papers
on Risk Management
Issue of 2010‒01‒10
nineteen papers chosen by

  1. Evaluation of Hedge Fund Returns Value at Risk Using GARCH Models By Sabrina Khanniche
  2. Credit risk analysis in microcredit: How does gender matter? By Helena Marrez; Mathias Schmit
  3. The Janus-Headed Salvation: Sovereign and Bank Credit Risk Premia during 2008-09. By Jacob W. Ejsing; Wolfgang Lemke
  4. Empirical Risk Factors in Realized Stock Returns By Jiri Novak; Dalibor Petr
  5. Multiple defaults and contagion risks By Ying Jiao
  6. When liquidity risk becomes a macro-prudential issue: Empirical evidence of bank behaviour By Jan Willem van den End; Mostafa Tabbae
  7. Balance Sheet Interlinkages and Macro-Financial Risk Analysis in the Euro Area. By Olli Castrén; Ilja Kristian Kavonius
  8. Optimal risk in marketing resource allocation By Alejandro Balbas; Mercedes Esteban Bravo; Jose M. Vidal-Sanz
  9. Liquidity Hoarding and Interbank Market Spreads: The Role of Counterparty Risk. By Florian Heider; Marie Hoerova; Cornelia Holthausen
  10. Broker-dealer risk appetite and commodity returns By Erkko Etula
  11. The Dark Side of Global Integration: Increasing Tail Dependence By Antonio Cosma;; Michel Beine; Robert Vermeulen
  12. Modelling the Volatility-Return Trade-off when Volatility may be Nonstationary By Christian M. Dahl; Emma M. Iglesias
  13. International Financial competition and bank risk-taking in emerging economies By Arnaud Bourgain; Patrice Pieretti; Skerdilajda Zanaj
  14. Asian Sovereign Debt and Country Risk By Johansson, Anders C.
  15. Financial leverage, corporate investment, and stock returns By Ali K. Ozdagli
  16. Crop Insurance: Security for Farmers and Agricultural Stakeholders in the Face of Seasonal Climate Variability By Reyes, Celia M; Domingo, Sonny N.
  17. Too much right can make a wrong: Setting the stage for the financial crisis By Richard J. Rosen
  18. An institutional evaluation of pension funds and life insurance companies By Dirk Broeders; An Chen; Birgit Koos
  19. What factors affect the Oslo Stock Exchange? By Næs, Randi; Skjeltorp, Johannes; Ødegaard, Bernt Arne

  1. By: Sabrina Khanniche
    Abstract: The aim of this research paper is to evaluate hedge fund returns Value-at-Risk by using GARCH models. To perform the empirical analysis, one uses the HFRX daily performance hedge fund strategy subindexes and spans the period March 2003 – March 2008. I found that skewness and kurtosis are substantial in the hedge fund returns distribution and the clustering phenomenon is pointed out. These features suggest the use of GARCH models to model the volatility of hedge fund return indexes. Hedge fund return conditional variances are estimated by using linear models (GARCH) and non-linear asymmetric models (EGARCH and TGARCH). Performance of several Value at Risk models is compared; the Gaussian VaR, the student VaR, the cornish fisher VaR, the normal GARCH-type VaR, the student GARCH-type VaR and the cornish fisher GARCH-type VaR. Our results demonstrate that the normal VaR underestimates accurate hedge fund risks while the student and the cornish fisher GARCH-type VaR are more reliable to estimate the potential maximum loss of hedge funds.
    Keywords: Hedge Fund, Value at Risk, GARCH models.
    JEL: G11 G12 G23
    Date: 2009
  2. By: Helena Marrez (Solvay Brussels School of Economics and Management, Université Libre de Bruxelles, Brussels); Mathias Schmit (Centre Emile Bernheim, Solvay Brussels School of Economics and Management, Université Libre de Bruxelles, Brussels)
    Abstract: This paper is the first to analyze the credit risk of a microfinance institution based on the loan portfolio of a leading Maghrebian microfinance institution, both in terms of number of clients served and of portfolio size. This allows us to work with a proprietary data set of 1,144,770 contracts issued between 1997 and 2007. Using a resampling technique, we estimate the probability density function of losses and value-at-risk measures for a portfolio of loans granted to female and male microfinance clients separately. Results show that loss rates are higher for a male client population than for a female client population, both on average as for percentiles 95 to 99.99. We find that this difference is due to lower default probabilities for female clients, while recovery rates for male and female clients are similar. We also analyze diversification effects, where we find that the proportion of diversifiable risk in total risk is bigger for portfolios of loans granted to female clients than for portfolios of loans granted to male clients. Finally we show that capital requirements determined by the 99.9 percentile remain below those required by the Basel 2 Accords, which opens perspectives for a specific treatment of microfinance if financial regulation becomes applicable to the sector.
    Keywords: Microfinance; Credit risk; Gender study; Bank regulation; Capital requirement
    JEL: G21 G28 O16
    Date: 2009–04
  3. By: Jacob W. Ejsing (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Wolfgang Lemke (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: As the global banking crisis intensified in the fall of 2008, governments announced comprehensive rescue packages for financial institutions. In this paper, we put the joint response of euro area bank and sovereign CDS premia under the microscope. We find that the bank rescue packages led to a clear structural break in these premia's comovement, which had been rather tight and stable in the weeks preceding the in-tensification of the crisis. Firstly, the packages induced a decrease in risk spreads for banks at the expense of a marked increase in risk spreads for governments. Secondly, we show that in addition to this one-off jump in the levels of CDS spreads, the packages strongly increased the sensitivity of sovereign risk spreads to any further aggravation of the crisis. At the same time, the sensitivity of bank credit risk premia declined and became more sovereign-like, reflecting the extensive government guarantees of banking sector liabilities. JEL Classification: G15, G21.
    Keywords: Financial crisis, risk transfer, credit default swaps.
    Date: 2009–12
  4. By: Jiri Novak (Institute of Economic Studies, Faculty of Social Sciences, Charles University, Prague, Czech Republic); Dalibor Petr (Palacky University, Olomouc)
    Abstract: Measuring risk in the stock market context is one of the key challenges of modern finance. Despite of the substantial significance of the topic to investors and market regulators, there is a controversy over what risk factors should be used to price the assets or to determine the cost of capital. We empirically investigate the ability of several commonly proposed risk factors to predict Swedish stock returns. We consider the sensitivity of an asset returns to the variation in market returns, the market value of equity, the ratio of market value of equity to book value of equity and the short-term historical stock returns. We conclude that none of these factors is clearly significant for explaining stock returns at the Stockholm Stock Exchange, which casts doubt on their use as universal risk factors in various corporate governance contexts. It seems that the previously documented relationship is contingent on the data sample used and on the time period.
    Keywords: stock returns, asset pricing, risk, multifactor models, CAPM, size, book-to-market, momentum, Sweden
    JEL: G12 C21
    Date: 2009–12
  5. By: Ying Jiao (PMA - Laboratoire de Probabilités et Modèles Aléatoires - CNRS : UMR7599 - Université Pierre et Marie Curie - Paris VI - Université Paris-Diderot - Paris VII)
    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: 2009–12–16
  6. By: Jan Willem van den End; Mostafa Tabbae
    Abstract: This paper provides empirical evidence of behavioural responses by banks and their contribution to system-wide liquidity stress. Using firm-specific balance sheet data, we construct aggregate indicators of macro-prudential risk. Measures of size and herding show that balance sheet adjustments have been pro-cyclical in the crisis, while responses became increasingly dependent across banks and concentrated on certain market segments. Banks' reactions were shaped by decreased risk tolerance and limited flexibility in risk management. Regression analysis confirms that their behaviour contributed to financial sector stress. The behavioural measures are useful tools for monetary and macro prudential analyses and can improve the micro foundations of financial stability models. 
    Keywords: banking; financial stability; stress-tests; liquidity risk.
    JEL: C15 E44 G21 G32
    Date: 2009–12
  7. By: Olli Castrén (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Ilja Kristian Kavonius (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: The financial crisis has highlighted the need for models that can identify counterparty risk exposures and shock transmission processes at the systemic level. We use the euro area financial accounts (flow of funds) data to construct a sector-level network of bilateral balance sheet exposures and show how local shocks can propagate throughout the network and affect the balance sheets in other, even seemingly remote, parts of the financial system. We then use the contingent claims approach to extend this accounting-based network of interlinked exposures to risk-based balance sheets which are sensitive to changes in leverage and asset volatility. We conclude that the bilateral cross-sector exposures in the euro area financial system constitute important channels through which local risk exposures and balance sheet dislocations can be transmitted, with the financial intermediaries playing a key role in the processes. High financial leverage and high asset volatility are found to increase a sector’s vulnerability to shocks and contagion. JEL Classification: C22, E01, E21, E44, F36, G01, G12, G14.
    Keywords: Balance sheet contagion, financial accounts, network models, contingent claims analysis, systemic risk, macro-prudential analysis.
    Date: 2009–12
  8. By: Alejandro Balbas; Mercedes Esteban Bravo; Jose M. Vidal-Sanz
    Abstract: Marketing resource allocation is increasingly based on the optimization of expected returns on investment. If the investment is implemented in a large number of repetitive and relatively independent simple decisions, it is an acceptable method, but risk must be considered otherwise. The Markowitz classical mean-deviation approach to value marketing activities is of limited use when the probability distributions of the returns are asymmetric (a common case in marketing). In this paper we consider a unifying treatment for optimal marketing resource allocation and valuation of marketing investments in risky markets where returns can be asymmetric, using coherent risk measures recently developed in finance. We propose a set of first order conditions for the solution, and present a numerical algorithm for the computation of the optimal plan. We use this approach to design optimal advertisement investments in sales response management
    Keywords: Resource allocation, Coherent risk measures, Optimization, Sales response models
    Date: 2009–10
  9. By: Florian Heider (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Marie Hoerova (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Cornelia Holthausen (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: We study the functioning and possible breakdown of the interbank market in the presence of counterparty risk. We allow banks to have private information about the risk of their assets. We show how banks’ asset risk affects funding liquidity in the interbank market. Several interbank market regimes can arise: i) normal state with low interest rates; ii) turmoil state with adverse selection and elevated rates; and iii) market breakdown with liquidity hoarding. We provide an explanation for observed developments in the interbank market before and during the 2007-09 financial crisis (dramatic increases of unsecured rates and excess reserves banks hold, as well as the inability of massive liquidity injections by central banks to restore interbank activity). We use the model to discuss various policy responses. JEL Classification: G01, G21, D82.
    Keywords: Financial crisis, Interbank market, Liquidity, Counterparty risk, Asymmetric information.
    Date: 2009–12
  10. By: Erkko Etula
    Abstract: This paper shows that the risk-bearing capacity of securities brokers and dealers is a strong determinant of risk premia and the volatility of returns in commodity markets. I measure risk-bearing capacity as the fraction of broker-dealer financial assets relative to the total financial assets of broker-dealers and households. This variable has particularly strong power to forecast energy returns, both in sample and out of sample: It forecasts approximately 30 percent of the variation in quarterly crude oil returns. These findings are rationalized in a simple asset-pricing model where the economic role of broker-dealers is to provide insurance against commodity price fluctuations. I estimate cross-sectional prices of risk using an arbitrage-free asset-pricing approach and show that broker-dealer risk-bearing capacity forecasts commodity returns because of its association with the price of risk.
    Keywords: Commodity futures ; Brokers ; Risk ; Rate of return ; Asset pricing ; Intermediation (Finance) ; Households
    Date: 2009
  11. By: Antonio Cosma; (Luxembourg School of Finance, University of Luxembourg); Michel Beine (CREA, University of Luxembourg and CES-info); Robert Vermeulen (CREA, University of Luxembourg and Department of Economics, Maastricht University)
    Abstract: We measure stock market coexceedances using the methodology of Cappiello, Gerard and Manganelli (2005, ECB Working Paper 501). This method enables us to measure comovement at each point of the return distribution. First, we construct annual coexceedance probabilities for both lower and upper tail return quantiles using daily data from 1974-2006. Next, we explain these probabilities in a panel gravity model framework. Results show that macroeconomic variables asymmetrically impact stock market comovement across the return distribution. Financial liberalization significantly increases left tail comovement, whereas trade integration significantly increases comovement across all quantiles.
    Keywords: stock market comovement; trade integration; financial integration
    JEL: F15 F36 F41 G15
    Date: 2009
  12. By: Christian M. Dahl (University of Aarhus and CREATES); Emma M. Iglesias (Department of Economics, Michigan State University and University of Essex)
    Abstract: In this paper a new GARCH–M type model, denoted the GARCH-AR, is proposed. In particular, it is shown that it is possible to generate a volatility-return trade-off in a regression model simply by introducing dynamics in the standardized disturbance process. Importantly, the volatility in the GARCH-AR model enters the return function in terms of relative volatility, implying that the risk term can be stationary even if the volatility process is nonstationary. We provide a complete characterization of the stationarity properties of the GARCH-AR process by generalizing the results of Bougerol and Picard (1992b). Furthermore, allowing for nonstationary volatility, the asymptotic properties of the estimated parameters by quasi-maximum likelihood in the GARCH-AR process are established. Finally, we stress the importance of being able to choose correctly between AR-GARCH and GARCH-AR processes: First, it is shown, by a small simulation study, that the estimators for the parameters in an ARGARCH model will be seriously inconsistent if the data generating process actually is a GARCH-AR process. Second, we provide an LM test for neglected GARCH-AR effects and discuss its finite sample size properties. Third, we provide an empirical illustration showing the empirical relevance of the GARCH-AR model based on modelling a wide range of leading US stock return series.
    Keywords: Quasi-Maximum Likelihood, GARCH-M Model, Asymptotic Properties, Risk-return Relation.
    JEL: C12 C13 C22 G12
    Date: 2009–10–02
  13. By: Arnaud Bourgain; Patrice Pieretti; Skerdilajda Zanaj (CREA, University of Luxembourg)
    Abstract: In this paper, we analyze the risk taking behavior of banks in emerging economies, in a context of international bank competition. In the spirit of Vives (2002 and 2006) who has developed the notion of "external market discipline", our paper introduces a new channel through which depositors can exercise pressure to control risk taking. They can reallocate their savings away from their home country to a more protective system of a developed economy. In such a frame- work, we show that there is no univoque relationship between the information disclosure of risk management and excessive risk taking. This relationship depends on the degree of financial openness of the emergent country, which ultimately defines how e¤ective the market discipline is. Furthermore, we analyze the risk taking choice of banks in emergent economies in presence of deposit insurance. We find no monotone relationship between the likeliness of excessive risk taking of banks in the emerging country and the level of deposit insurance.
    JEL: G21 G28 F39 L60
    Date: 2009
  14. By: Johansson, Anders C. (China Economic Research Center)
    Abstract: This paper analyzes systematic risk of sovereign bonds in four East Asian countries: China, Malaysia, Philippines, and Thailand. A bivariate stochastic volatility model that allows for time-varying correlation is estimated with Markov Chain Monte Carlo simulation. The volatilities and correlation are then used to calculate the time-varying betas. The results show that country-specific systematic risk in Asian sovereign bonds varies over time. When adjusting for inherent exchange rate risk, the pattern of systematic risk is similar, even though the level is generally lower. The findings have important implications for international portfolio managers that invest in emerging sovereign bonds and those who need benchmark instruments to analyze risk in assets such as corporate bonds in the emerging Asian financial markets.
    Keywords: Asia; sovereign bonds; systematic risk; stochastic volatility; Markov Chain Monte Carlo
    JEL: C32 F31 G12 G15
    Date: 2009–12–01
  15. By: Ali K. Ozdagli
    Abstract: This paper presents a dynamic model of the firm with risk-free debt contracts, investment irreversibility, and debt restructuring costs. The model fits several stylized facts of corporate finance and asset pricing: First, book leverage is constant across different book-to-market portfolios, whereas market leverage differs significantly. Second, changes in market leverage are mainly caused by changes in stock prices rather than by changes in debt. Third, when the model is calibrated to fit the cross-sectional distribution of book-to-market ratios, it explains the return differences across different firms. The model also shows that investment irreversibility alone cannot generate the cross-sectional patterns observed in stock returns and that leverage is the main source of the value premium.
    Keywords: Corporations - Finance ; Stocks - Rate of return
    Date: 2009
  16. By: Reyes, Celia M; Domingo, Sonny N.
    Abstract: Crop insurance is a risk management tool designed to even out agricultural risks and address the consequences of natural disasters to make losses more bearable, especially to the marginalized farmers. In the Philippines, the Philippine Crop Insurance Corporation (PCIC) implements and manages the government program on agricultural insurance. This paper provides a comprehensive review of the crop insurance program in the Philippines--its history, operationalization, performance, and a number of challenges. Some of the identified constraints in operating the program are high overhead cost, need for larger investment fund, and question of sustainability. The results of secondary data assessment and key informant interviews revealed that PCIC has captured only a small segment of its target clientele, particularly the subsistence farmers, due to logistical and marketing constraints. Moreover, farmer dependence on informal credit, particularly in rural farming communities, seems to have also created a nonviable setting for a crop insurance program.
    Keywords: seasonal climate forecast (SCF), agricultural credit, crop insurance, Philippine Crop Insurance Corporation (PCIC)
    Date: 2009
  17. By: Richard J. Rosen
    Abstract: The financial crisis that started in 2007 exposed a number of flaws in the financial system. Many of these flaws were associated with financial instruments that were issued by the shadow banking system, especially securitized assets. The volume and complexity of securitized assets grew rapidly during runup to the financial crisis that began in 2007. The paper discusses how the financial crisis can be viewed as a possible but logical outcome of a system where investors are overconfident, busy, and investing other peoples’ money and intermediaries are set up to take advantage of investors’ tendencies. The investor-intermediary risk cycle in this crisis is common to other crises. However, there are a number of factors that may have made the 2007 crisis more severe. Among them are the length of the pre-crisis period, the shift from financial intermediaries to the shadow banking system, the increasing interconnectedness among financial firms, and the increased leverage at some financial firms.
    Date: 2009
  18. By: Dirk Broeders; An Chen; Birgit Koos
    Abstract: This paper compares two different types of annuity providers, i.e. defined benefit pension funds and life insurance companies. One of the key differences is that the residual risk in pension funds is collectively borne by the beneficiaries and the sponsor while in the case of life insurers, it is borne by the external shareholders. This paper employs a contingent claim approach to evaluate the risk return trade-off for annuitants.For that, we take into account the differences in contract specifications and in regulatory regimes. Mean-variance analysis is conducted to determine annuity choices of consumers with different preferences. Using realistic parameters we find that under linear and quadratic utility, life insurance companies always dominate pension funds, while under other utility specifications this is only true for low default probabilities. Furthermore, we find that power utility consumers are indifferent if the long term default probability of pension funds exceeds that of life insurers by 2 to 4%. 
    Keywords: Pension plans; barrier options; contingent claim approach; mean-variance analysis.
    JEL: G11 G23
    Date: 2009–12
  19. By: Næs, Randi (Ministry of Trade and Industry); Skjeltorp, Johannes (Norges Bank); Ødegaard, Bernt Arne (University of Stavanger)
    Abstract: This paper analyzes return patterns and determinants at the Oslo Stock Exchange (OSE) in the period 1980--2006. We find that a three-factor model containing the market, a size factor and a liquidity factor provides a reasonable fit for the cross-section of Norwegian stock returns. As expected, oil prices significantly affect cash flows of most industry sectors at the OSE. Oil is, however, not a priced risk factor in the Norwegian stock market. As the case in many other countries, we find that macroeconomic variables affect stock prices, but since we find only weak evidence of these variables being priced in the market, the most reasonable channel for these effects is through company cash flows.
    Keywords: Stock Market Valuation; Asset Pricing; Factor Models; Generalized Method of Moments
    JEL: E44 G12
    Date: 2009–11–30

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