New Economics Papers
on Risk Management
Issue of 2010‒05‒15
thirteen papers chosen by

  1. Systemic risk analysis using forward-looking distance-to-default series By Martin Saldías Zambrana
  2. What "triggers" mortgage default? By Ronel Elul; Nicholas S. Souleles; Souphala Chomsisengphet; Dennis; Glennon; Robert Hunt
  3. A structural model of contingent bank capital By George Pennacchi
  4. Analyzing and Forecasting Volatility Spillovers, Asymmetries and Hedging in Major Oil Markets By Chia-Lin Chang,; Michael McAleer; Roengchai Tansuchat
  5. Simulation and Estimation of Loss Given Default By Stefan Hlawatsch; Sebastian Ostrowski
  6. What determines euro area bank CDS spreads ? By Jan Annaert; Marc De Ceuster; Patrick Van Roy; Cristina Vespro
  7. Risk-based classification of financial instruments in the Finnish statutory pension scheme TyEL By Tanskanen , Antti J; Niininen , Petri; Vatanen, Kari
  8. Determining The Value-at-risk In The Shadow Of The Power Law: The Case Of The SP-500 Index By Dominique, C-Rene; Rivera-Solis, Luis Eduardo; Des Rosiers, Francois
  9. Default Risk Premia on Government Bonds in a Quantitative Macroeconomic Model By Falko Juessen; Ludger Linnemann; Andreas Schabert
  10. Simulating copula-based distributions and estimating tail probabilities by means of Adaptive Importance Sampling By Marco Bee
  11. Maturity, indebtedness, and default risk By Satyajit Chatterjee; Burcu Eyigungor
  12. Reining in Excessive Risk Taking by Executives : Experimental Evidence By Mathieu Lefebvre; Ferdinand M. Vieider
  13. On the fractional Black-Scholes market with transaction costs By Ehsan Azmoodeh

  1. By: Martin Saldías Zambrana
    Abstract: Based on contingent claims theory, this paper develops a method to monitor systemic risk in the European banking system. Aggregated Distance-to-Default series are generated using option prices information from systemically important banks and the DJ STOXX Banks Index. These indicators provide methodological advantages in monitoring vulnerabilities in the banking system over time: 1) they capture interdependences and joint risk of distress in systemically important banks; 2) their forward-looking feature endow them with early signaling properties compared to traditional approaches in the literature and other market-based indicators; and 3) they produce simultaneously both smooth and informative long-term signals and quick and clear reaction to market distress.
    Keywords: Systemic risk ; Banks and banking - Europe
    Date: 2010
  2. By: Ronel Elul; Nicholas S. Souleles; Souphala Chomsisengphet; Dennis; Glennon; Robert Hunt
    Abstract: This paper assesses the relative importance of two key drivers of mortgage default: negative equity and illiquidity. To do so, the authors combine loan-level mortgage data with detailed credit bureau information about the borrower's broader balance sheet. This gives them a direct way to measure illiquid borrowers: those with high credit card utilization rates. The authors find that both negative equity and illiquidity are significantly associated with mortgage default, with comparably sized marginal effects. Moreover, these two factors interact with each other: The effect of illiquidity on default generally increases with high combined loan-to-value ratios (CLTV), though it is significant even for low CLTV. County-level unemployment shocks are also associated with higher default risk (though less so than high utilization) and strongly interact with CLTV. In addition, having a second mortgage implies significantly higher default risk, particularly for borrowers who have a first-mortgage LTV approaching 100 percent.
    Keywords: Mortgages ; Default (Finance)
    Date: 2010
  3. By: George Pennacchi
    Abstract: This paper develops a structural credit risk model of a bank that issues deposits, shareholders' equity, and fixed or floating coupon bonds in the form of contingent capital or subordinated debt. The return on the bank's assets follows a jump-diffusion process, and default-free interest rates are stochastic. The equilibrium pricing of the bank's deposits, contingent capital, and shareholders' equity is studied for various parameter values haracterizing the bank's risk and the contractual terms of its contingent capital. Allowing for the possibility of jumps in the bank's asset value, as might occur during a financial crisis, has distinctive implications for valuing contingent capital. Credit spreads on contingent capital are higher the lower is the value of shareholders' equity at which conversion occurs and the larger is the conversion discount from the bond's par value. The effect of requiring a decline in a financial stock price index for conversion (dual price trigger) is to make contingent capital more similar to non-convertible subordinated debt. The paper also examines the bank's incentive to increase risk when it issues different forms of contingent capital as well as subordinated debt. In general, a bank that issues contingent capital has a moral hazard incentive to raise its assets' risk of jumps, particularly when the value of equity at the conversion threshold is low. However, moral hazard when issuing contingent capital tends to be less than when issuing subordinated debt. Because it reduces effective leverage and the pressure for government bailouts, contingent capital deserves serious consideration as part of a package of reforms that stabilize the financial system and eliminate "Too-Big-to-Fail."
    Keywords: Bank capital ; Risk ; Bank failures
    Date: 2010
  4. By: Chia-Lin Chang,; Michael McAleer (University of Canterbury); Roengchai Tansuchat
    Abstract: Crude oil price volatility has been analyzed extensively for organized spot, forward and futures markets for well over a decade, and is crucial for forecasting volatility and Value-at-Risk (VaR). There are four major benchmarks in the international oil market, namely West Texas Intermediate (USA), Brent (North Sea), Dubai/Oman (Middle East), and Tapis (Asia-Pacific), which are likely to be highly correlated. This paper analyses the volatility spillover and asymmetric effects across and within the four markets, using three multivariate GARCH models, namely the constant conditional correlation (CCC), vector ARMA-GARCH (VARMA-GARCH) and vector ARMA-asymmetric GARCH (VARMA-AGARCH) models. A rolling window approach is used to forecast the 1-day ahead conditional correlations. The paper presents evidence of volatility spillovers and asymmetric effects on the conditional variances for most pairs of series. In addition, the forecast conditional correlations between pairs of crude oil returns have both positive and negative trends. Moreover, the optimal hedge ratios and optimal portfolio weights of crude oil across different assets and market portfolios are evaluated in order to provide important policy implications for risk management in crude oil markets.
    Keywords: Volatility spillovers; multivariate GARCH; conditional correlation; asymmetries; hedging
    JEL: C22 C32 G32
    Date: 2010–04–01
  5. By: Stefan Hlawatsch (Faculty of Economics and Management, Otto-von-Guericke University Magdeburg); Sebastian Ostrowski (Faculty of Economics and Management, Otto-von-Guericke University Magdeburg)
    Abstract: The aim of our paper is the development of an adequate estimation model for the loss given default, which incorporates the empirically observed bimodality and bounded nature of the distribution. Therefore we introduce an adjusted Expectation Maximization algorithm to estimate the parameters of a univariate mixture distribution, consisting of two beta distributions. Subsequently these estimations are compared with the Maximum Likelihood estimators to test the efficiency and accuracy of both algorithms. Furthermore we analyze our derived estimation model with estimation models proposed in the literature on a synthesized loan portfolio. The simulated loan portfolio consists of possibly loss-influencing parameters that are merged with loss given default observations via a quasi-random approach. Our results show that our proposed model exhibits more accurate loss given default estimators than the benchmark models for different simulated data sets comprising obligor-specific parameters with either high predictive power or low predictive power for the loss given default.
    Keywords: Bimodality, EM Algorithm, Loss Given Default, Maximum Likelihood, Mixture Distribution, Portfolio Simulation
    JEL: C01 C13 C15 C16 C5
    Date: 2010–03
  6. By: Jan Annaert (Universiteit Antwerpen); Marc De Ceuster (Universiteit Antwerpen); Patrick Van Roy (National Bank of Belgium, Financial Stability Department; Université Libre de Bruxelles); Cristina Vespro (National Bank of Belgium, Financial Stability Department)
    Abstract: This paper decomposes the explained part of the CDS spread changes of 31 listed euro area banks according to various risk drivers. The choice of the credit risk drivers is inspired by the Merton (1974) model. Individual CDS liquidity and other market and business variables are identified to complement the Merton model and are shown to play an important role in explaining credit spread changes. Our decomposition reveals, however, highly changing dynamics in the credit, liquidity, and business cycle and market wide components. This result is important since supervisors and monetary policy makers extract different signals from liquidity based CDS spread changes than from business cycle or credit risk based changes. For the recent financial crisis, we confirm that the steeply rising CDS spreads are due to increased credit risk. However, individual CDS liquidity and market wide liquidity premia played a dominant role. In the period before the start of the crisis, our model and its decomposition suggest that credit risk was not correctly priced, a finding which was correctly observed by e.g. the International Monetary Fund
    Keywords: credit default spreads, credit risk, financial crisis, financial sector, liquidity premia, structural model
    JEL: G12 G21
    Date: 2010–05
  7. By: Tanskanen , Antti J (Varma Mutual Pension Insurance); Niininen , Petri (Varma Mutual Pension Insurance); Vatanen, Kari (Varma Mutual Pension Insurance)
    Abstract: Sufficient solvency of a pension insurance company responsible for defined-benefit pensions guarantees that the pensions are paid regardless of turbulence in the financial market. In the Finnish occupational pension system TyEL, the required level of solvency capital (solvency limit) and its computation are specified in the statutes. Before the solvency limit can be determined, financial instruments must be classified into the five statutory asset classes based on risk. The solvency limit is computed on the basis of this classification and the average return, volatility and correlation parameters defined in the statutes. The solvency limit framework is formulated in the spirit of Markowitz portfolio theory and implicitly assumes that returns follow Gaussian distributions. This, however, is not actually the case with many – if not most – financial instruments. Similarly, it is not obvious how to handle illiquid assets, those with short time series, and which collection of financial instruments can be combined into a single asset (portfoliocation) for the purpose of classification. In this study, we propose two methods of handling these issues: (1) a decision tree-based method; and (2) a Bayesian method. We show how fat tails of return distributions are taken into account in the classification process, and how qualitative assessment of risks is combined with quantitative classification of financial assets. Coupled with suitable data transformations, both proposed methods provide efficient and suitable bases for asset classification in the TyEL pension scheme.
    Keywords: Bayesian methods; classification; solvency; non-Gaussian return distributions; TyEL occupational pension scheme
    JEL: C11 G22 G23 G28 G32
    Date: 2010–04–28
  8. By: Dominique, C-Rene; Rivera-Solis, Luis Eduardo; Des Rosiers, Francois
    Abstract: ABSTRACT: In extant financial market models, including the Black-Scholes’ contruct, the dramatic events of October 1987 and August 2007 are totally unexpected, because these models are based on the assumptions of ‘independent price fluctuations’ and the existence of some ‘fixed-point equilibrium’. This paper argues that the convolution of a generalized fractional Brownian motion (into an array in frequency or time domain) and their corresponding amplitude spectra describes the surface of the attractor driving the evolution of prices. This more realistic approach shows that the SP-500 Index is characterized by a high long term Hurst exponent and hence by a ‘black noise’ with a power spectrum proportional to f-b (b > 2). In that set up, the above dramatic events are expected and their frequencies are determined. The paper also constructs an exhaustive frequency-variation relationship which can be used as practical guide to assess the ‘value at risk’.
    Keywords: Keywords: Market Collapse; Fractional Brownian Motion; Fractal Attractors; Maximum Hausdorff Dimension of Markets and Affine Profiles; Hurst Exponent; Power Spectrum Exponent; Value at Risk
    JEL: C90 G10
    Date: 2010–05–09
  9. By: Falko Juessen (TU Dortmund University); Ludger Linnemann (TU Dortmund University); Andreas Schabert (TU Dortmund University)
    Abstract: This paper examines the pricing of public debt in a quantitative macroeconomic model with government default risk. Default may occur due to a fiscal policy that does not preclude a Ponzi game. When a build-up of public debt makes this outcome inevitable, households stop lending such that the government has to default. Interest rates on government bonds reflect expectations of this event. There may exist multiple bond prices compatible with a rational expectations equilibrium. We analyze the conditions under which expected default risk premia can quantitatively rationalize sizeable spreads on public bonds. Sovereign default risk premia turn out to emerge at either very high debt to output ratios, or if the variance of productivity shocks is large.
    Keywords: Sovereign default; asset pricing; fiscal policy; government debt
    JEL: E62 G12 H6 E32
    Date: 2009–11–17
  10. By: Marco Bee
    Abstract: Copulas are an essential tool for the construction of non-standard multivariate probability distributions. In the actuarial and financial field they are particularly important because of their relationship with non-linear dependence and multivariate extreme value theory. In this paper we use a recently proposed generalization of Importance Sampling, called Adaptive Importance Sampling, for simulating copula-based distributions and computing tail probabilities. Unlike existing methods for copula simulation, this algorithm is general, in the sense that it can be used for any copula whose margins have an unbounded support. After working out the details for Archimedean copulas, we develop an extension, based on an appropriate transformation of the marginal distributions, for sampling extreme value copulas. Extensive Monte Carlo experiments show that the method works well and its implementation is simple. An example with equity data illustrates the potential of the algorithm for practical applications
    Keywords: Adaptive Importance Sampling, Copula, Multivariate Extreme Value Theory, Tail probability.
    JEL: C15 C63
    Date: 2010
  11. By: Satyajit Chatterjee; Burcu Eyigungor
    Abstract: In this paper, the authors present a new approach to incorporating long-term debt into equilibrium models of unsecured debt and default. They make three sets of contributions. First, the authors advance the theory of sovereign debt begun in Eaton and Gersovitz (1981) by proving the existence of an equilibrium price function with the property that the interest rate on debt is increasing in the amount borrowed. Second, using Argentina as a test case, they show that unlike a one-period debt model, their model of long-term debt is capable of accounting for the average external debt-to-output ratio, average spread on external debt, and the standard deviation of spreads for the 1993-2001 period, without any deterioration in the model's ability to account for Argentina's other cyclical facts. Third, the authors propose a new and very accurate method for solving the model.
    Keywords: Debt ; Default (Finance) ; Econometric models
    Date: 2010
  12. By: Mathieu Lefebvre (University of Liège, CREPP; Boulevard du Rectorat, 7 Bâtiment 31, boîte 39, 4000 Liège, Belgium); Ferdinand M. Vieider (GATE, CNRS UMR 5824 - Université de Lyon, 93 Chemin des Mouilles - B.P. 167, 69131 Ecully Cedex, France)
    Abstract: Compensation of executives by means of equity has long been seen as a means to tie executives? income to company performance, and thus as a solution to the principal-agent dilemma created by the separation of ownership and management in publicly owned companies. The overwhelming part of such equity compensation is currently provided in the form of stock-options. Recent events have however revived suspicions that the latter may induce excessive risk taking by executives. In an experiment, we find that subjects acting as executives do indeed take risks that are excessive from the perspective of shareholders if compensated through options. Comparing compensation mechanisms based on stock-options to long-term stock-ownership plans, we find that the latter significantly reduce the uptake of excessive risks by aligning the executives? interests with those of shareholders. Introducing an institutionalized accountability mechanism consisting in the requirement for executives to justify their choices in front of a shareholder reunion also reduces excessive risk taking, and appears to be even more effective than long-term stock-ownership plans. A combination of long-term stock-ownership plans and increased accountability thus seem a promising direction for reining in excessive risk taking by executives.
    Keywords: executive compensation; stock-options; incentives; accountability; risk taking
    JEL: G28 G32 J33 L22
    Date: 2010
  13. By: Ehsan Azmoodeh
    Abstract: We consider fractional Black-Scholes market with proportional transaction costs. When transaction costs are present, one trades periodically i.e. we have the discrete trading with equidistance $n^{-1}$ between trading times. We derive a non trivial hedging error for a class of European options with convex payoff in the case when the transaction costs coefficients decrease as $n^{-(1-H)}$. We study the expected hedging error and asymptotic behavior of the hedge as $H \to 1/2$
    Date: 2010–05

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