nep-rmg New Economics Papers
on Risk Management
Issue of 2010‒01‒23
thirteen papers chosen by
Stan Miles
Thompson Rivers University

  1. Factor models and the credit risk of a loan portfolio By Palombini, Edgardo
  2. Downturn LGD: A Spot Recovery Approach By Li, Hui
  3. Extending the scope of prudential supervision: Regulatory developments during and beyond the “effective” periods of the Post BCCI and the Capital Requirements directives. By Ojo, Marianne
  4. "Observations on the Problem of 'Too Big to Fail/Save/Resolve'" By Jan Kregel
  5. The companies financial architecture and the market values: is there an interlinkage ? The case of Bucharest Stock Exchange By Pirtea , Marilen; Dima, Bogdan; Milos, Laura Raisa
  6. Risk Premiums and Macroeconomic Dynamics in a Heterogeneous Agent Model By Ferre de Graeve; Maarten Dossche; Marina Emiris; Henri Sneessens; Raf Wouters
  7. Consolidation in banking and financial stability in Europe: empirical evidence By Uhde, André; Heimeshoff, Ulrich
  8. Regulation of Systemic Liquidity Risk By Cao, Jin; Illing, Gerhard
  9. VOLATILITY RISK By Zhiguang (Gerald) Wang
  10. Lessons from the global financial crisis for regulators and supervisors By Willem Buiter
  11. Using Financial Ratios to Identify Romanian Distressed Companies By Madalina Ecaterina Andreica; Mugurel Ionut Andreica; Marin Andreica
  12. Asymptotics of the probability minimizing a "down-side" risk By Hiroaki Hata; Hideo Nagai; Shuenn-Jyi Sheu
  13. "Crude Oil Hedging Strategies Using Dynamic Multivariate GARCH" By Roengchai Tansuchat; Chia-Lin Chang; Michael McAleer

  1. By: Palombini, Edgardo
    Abstract: Factor models for portfolio credit risk assume that defaults are independent conditional on a small number of systematic factors. This paper shows that the conditional independence assumption may be violated in one-factor models with constant default thresholds, as conditional defaults become independent only including a set of observable (time-lagged) risk factors. This result is confirmed both when we consider semi-annual default rates and if we focus on small firms. Maximum likelihood estimates for the sensitivity of default rates to systematic risk factors are obtained, showing how they may substantially vary across industry sectors. Finally, individual risk contributions are derived through Monte Carlo simulation.
    Keywords: Asset correlation; factor models; loss distribution; portfolio credit risk; risk contributions.
    JEL: C13 C15 G21
    Date: 2009–10
  2. By: Li, Hui
    Abstract: Basel II suggests that banks estimate downturn loss given default (DLGD) in capital requirement calculation. There have been studies that focused on the dependence of default rates and loss given defaults through economic cycles. However, the models proposed are still not satisfactory. In this paper, we propose a new model framework based on our recent work of stochastic spot recovery for Gaussian copula. We also compare our model with the previous approaches.
    Keywords: Basel II; Downturn Loss Given Default; Stochastic Recovery; Spot Recovery; Factor Credit Models; Default Time Copula; Gaussian Copula; Large Homogeneous Pool; Credit VaR; Expected Shortfall
    JEL: G32 G13
    Date: 2010–01–13
  3. By: Ojo, Marianne
    Abstract: The main argument of this paper is, namely, the need for greater emphasis on disclosure requirements and measures – particularly within the securities markets. This argument is justified on the basis of lessons which have been drawn from the recent Financial Crises, one of which is the inability of bank capital requirements on their own to address funding and liquidity problems. The engagement of market participants in the corporate reporting process, a process which would consequently enhance market discipline, constitutes a fundamental means whereby greater measures aimed at facilitating prudential supervision could be extended to the securities markets. Auditors, in playing a vital role in financial reporting, as tools of corporate governance, contribute to the disclosure process and towards engaging market participants in the process. This paper will however consider other means whereby transparency and disclosure of financial information within the securities markets could be enhanced, and also the need to accord greater priority to prudential supervision within the securities markets. Furthermore, the paper draws attention to the need to focus on Pillar 3 of Basel II, namely, market discipline. It illustrates how through Pillar 3, market participants like credit agencies can determine the levels of capital retained by banks – hence their potential to rectify or exacerbate pro cyclical effects resulting from Pillars 1 and 2. The challenges encountered by Pillars 1 and 2 in addressing credit risk is reflected by problems identified with pro cyclicality, which are attributed to banks’ extremely sensitive internal credit risk models, and the level of capital buffers which should be retained under Pillar Two. Such issues justify the need to give greater prominence to Pillar 3. As a result of the influence and potential of market participants in determining capital levels, such market participants are able to assist regulators in managing more effectively, the impact of systemic risks which occur when lending criteria is tightened owing to Basel II's procyclical effects. Regulators are able to respond and to manage with greater efficiency, systemic risks to the financial system during periods when firms which are highly leveraged become reluctant to lend. This being particularly the case when such firms decide to cut back on lending activities, and the decisions of such firms cannot be justified in situations where such firms’ credit risk models are extremely sensitive – hence the level of capital being retained is actually much higher than minimum regulatory Basel capital requirements. In elaborating on Basel II's pro cyclical effects, the gaps which exist with internal credit risk model measurements will be considered. Gaps which exist with Basel II's risk measurements, along with the increased prominence and importance of liquidity risks - as revealed by the recent financial crisis, and proposals which have been put forward to mitigate Basel II's procyclical effects will also be addressed.
    Keywords: Capital Requirements Directive (CRD); Post BCCI Directive; prudential supervision; liquidity; capital; maturity mismatches; regulation
    JEL: K2 G3 D82 D53 G2 F3 F21
    Date: 2010–01
  4. By: Jan Kregel
    Abstract: Past experience suggests that multifunctional banking is the leading source of financial crisis, while large bank size contributes to contagion and systemic risk. This indicates that resolving large banks will not solve the problems associated with multifunctional banking--a conclusion reached after every financial crisis, and one that should apply to the present crisis as well. Senior Scholar Jan Kregel observes that it is important to recognize that past solutions may not be appropriate for present conditions. The approach to the current financial crisis has been to resolve small- and medium-size banks through the FDIC, while banks considered "too big to fail" are given direct and indirect government support. Many of these large government-supported banks have been allowed to absorb smaller banks through FDIC resolution, creating even larger banks. As these institutions repay their direct government support, the problem of "too big to fail" is simply aggravated. Thus, the current thrust of government regulatory reform--increased capital and liquidity requirements, and further legislation--is unlikely to lessen the systemic risks these institutions pose.
    Date: 2009–12
  5. By: Pirtea , Marilen; Dima, Bogdan; Milos, Laura Raisa
    Abstract: Nowadays there is a large debate on whether the financial information proves any relevance for the investors´ prediction of the securities market values/stock prices. The paper focuses, besides reviewing some important literature concerning this issue, on an empirical analysis taking into consideration 44 companies listed on Bucharest Stock Exchange based on pool data linear regressions. It is true that the most recent research state that there is an important evidence of a deterioration of the relationship between accounting information and stock prices. Although, the main findings of this paper consist in that there are certain aspects which should be further examined for a more reliable conceptual approach. In addition, it concludes that - even in the case of an emergent capital market as Bucharest Stock Exchange - it can be found mixed evidences to support the importance of financial information in portfolio’ management decisions. In a sense or another, the paper state overall that the financial information matter for market determination of financial assets’ values.
    Keywords: capital markets; financial information; financial assets’ valuation
    JEL: C32 G14 D82
    Date: 2009–09–01
  6. By: Ferre de Graeve; Maarten Dossche; Marina Emiris; Henri Sneessens; Raf Wouters (CREA, University of Luxembourg)
    Abstract: We analyze financial risk premiums and real economic dynamics in a DSGE model with three types of agents - shareholders, bondholders and workers - that differ in participation in the capital market and in attitude towards risk and intertemporal sub- stitution. Aggregate productivity and distribution risks are transferred across these agents via the bond market and via an efficient labor contract. The result is a combi- nation of volatile returns to capital and a highly cyclical consumption process for the shareholders, which are two important ingredients for generating high and counter- cyclical risk premiums. These risk premiums are consistent with a strong propagation mechanism through an elastic supply of labor, rigid real wages and a countercyclical la- bor share. Based on the empirical estimates for the two sources of real macroeconomic risk, the model generates significant and plausible time variation in both bond and equity risk premiums. Interestingly, the single largest jump in both the risk premium and the price of risk is observed during the current recession.
    JEL: E32 E44 G12
    Date: 2009
  7. By: Uhde, André; Heimeshoff, Ulrich
    Abstract: Using aggregate balance sheet data from banks across the EU-25 over the period from 1997 to 2005 this paper provides empirical evidence that national banking market concentration has a negative impact on European banks' financial soundness as measured by the Z-score technique while controlling for macroeconomic, bank-specific, regulatory, and institutional factors. Furthermore, we find that Eastern European banking markets exhibiting a lower level of competitive pressure, fewer diversification opportunities and a higher fraction of government-owned banks are more prone to financial fragility whereas capital regulations have supported financial stability across the entire European Union. --
    Keywords: Market structure,Financial stability,Banking regulation
    JEL: G21 G28 G34 L16
    Date: 2009
  8. By: Cao, Jin; Illing, Gerhard
    Abstract: The paper provides a baseline model for regulatory analysis of systemic liquidity shocks. We show that banks may have an incentive to invest excessively in illiquid long term projects. In the prevailing mixed strategy equilibrium the allocation is inferior from the investor’s point of view since some banks free-ride on the liquidity provision as a result of limited liability. The paper compares different regulatory mechanisms to cope with the externalities. It is shown that the combination of liquidity regulation ex ante and lender of last resort policy ex post is able to implement the outcome maximizing investor’s payoff. In contrast, both “narrow banking” and imposing equity requirements as buffer are inferior mechanisms for coping with systemic liquidity risk.
    Keywords: Liquidity Regulation; Systemic risk; Lender of last resort; Financial Stability
    JEL: E5 G21 G28
    Date: 2010–01
  9. By: Zhiguang (Gerald) Wang (Deparment of Economics, South Dakota State University)
    Abstract: Classical capital asset pricing theory tells us that riskaverse investors would require higher returns to compensate for higher risk on an investment. One type of risk is price (return) risk, which reflects uncertainty in the price level and is measured by the volatility (standard deviation) of asset returns. Volatility itself is also known to be random and hence is perceived as another type of risk. Investors can bear price risk in exchange for a higher return. But are investors willing to pay a premium to enjoy lower volatility? In this essay, I try to answer this question by (1) introducing two different measures of volatility, (2) summarizing findings about volatility risk and its premiums in financial equity markets and (3) presenting preliminary research on volatility risk premiums in the markets for corn, wheat and soybeans, which are relevant to the South Dakota economy.
    Date: 2009–12
  10. By: Willem Buiter
    Abstract: This lecture is a tour d’horizon of the financial crisis aimed at extracting lessons for future financial regulation. It combines normative recommendations based on conventional welfare economics with positive assessments of the kind of measures likely to be adopted based on political economy considerations.
    Date: 2009–07
  11. By: Madalina Ecaterina Andreica; Mugurel Ionut Andreica; Marin Andreica
    Abstract: In the context of the current financial crisis, when more companies are facing bankruptcy or insolvency, the paper aims to find methods to identify distressed firms by using financial ratios. The study will focus on identifying a group of Romanian listed companies, for which financial data for the year 2008 were available. For each company a set of 14 financial indicators was calculated and then used in a principal component analysis, followed by a cluster analysis, a logit model, and a CHAID classification tree.
    Date: 2010–01
  12. By: Hiroaki Hata; Hideo Nagai; Shuenn-Jyi Sheu
    Abstract: We consider a long-term optimal investment problem where an investor tries to minimize the probability of falling below a target growth rate. From a mathematical viewpoint, this is a large deviation control problem. This problem will be shown to relate to a risk-sensitive stochastic control problem for a sufficiently large time horizon. Indeed, in our theorem we state a duality in the relation between the above two problems. Furthermore, under a multidimensional linear Gaussian model we obtain explicit solutions for the primal problem.
    Date: 2010–01
  13. By: Roengchai Tansuchat (Faculty of Economics, Maejo University); Chia-Lin Chang (Department of Applied Economics, National Chung Hsing University); Michael McAleer (Erasmus School of Economics, Erasmus University Rotterdam and Tinbergen Institute)
    Abstract: The paper examines the performance of four multivariate volatility models, namely CCC, VARMA-GARCH, DCC and BEKK, for the crude oil spot and futures returns of two major benchmark international crude oil markets, Brent and WTI, to calculate optimal portfolio weights and optimal hedge ratios, and to suggest a crude oil hedge strategy. The empirical results show that the optimal portfolio weights of all multivariate volatility models for Brent suggest holding futures in larger proportions than spot. For WTI, however, DCC and BEKK suggest holding crude oil futures to spot, but CCC and VARMA-GARCH suggest holding crude oil spot to futures. In addition, the calculated optimal hedge ratios (OHRs) from each multivariate conditional volatility model give the time-varying hedge ratios, and recommend to short in crude oil futures with a high proportion of one dollar long in crude oil spot. Finally, the hedging effectiveness indicates that DCC (BEKK) is the best (worst) model for OHR calculation in terms of reducing the variance of the portfolio.
    Date: 2010–01

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