nep-rmg New Economics Papers
on Risk Management
Issue of 2010‒06‒04
thirteen papers chosen by
Stan Miles
Thompson Rivers University

  1. Is there a distress risk anomaly ? corporate bond spread as a proxy for default risk By Anginer, Deniz; Yildizhan, Celim
  2. Can banks circumvent minimum capital requirements? The case of mortgage portfolios under Basel II By Christopher Henderson; Julapa Jagtiani
  3. Threshold Accepting for Credit Risk Assessment and Validation By Marianna Lyra; Akwum Onwunta; Peter Winker
  4. Conditional Volatility and Correlations of Weekly Returns and the VaR Analysis of 2008 Stock Market By Pesaran, M.H.
  5. Policy Perspectives on OTC Derivatives Market Infrastructure By Duffie, Darrell; Li, Ada; Lubke, Theo
  6. Bootstrap prediction intervals for VaR and ES in the context of GARCH models By María Rosa Nieto; Esther Ruiz
  7. The Credit Crisis around the Globe: Why Did Some Banks Perform Better? By Beltratti, Andrea; Stulz, Rene M.
  8. Debt dilution and sovereign default risk By Juan Carlos Hatchondo; Leonardo Martinez
  9. Toward a global risk map By Stephen Cecchetti; Ingo Fender; Kostas Patrick McGuire
  10. Risk Management and Regulation Compliance with Tradable Permits under Dynamic Uncertainty By Pasquale Lucio Scandizzo; Odin K Knudsen
  11. RAISE YOUR GLASS: WINE INVESTMENT AND THE FINANCIAL CRISIS By Masset, Philippe; Weisskopf, Jean-Philippe
  12. Radical Islamic Terrorism in the Middle East and Its Direct Costs on Western Financial Markets By Martin Mullins; John Garvey
  13. The euro as a reserve currency for global investors By Luis M. Viceira; Ricardo Gimeno

  1. By: Anginer, Deniz; Yildizhan, Celim
    Abstract: Although financial theory suggests a positive relationship between default risk and equity returns, recent empirical papers find anomalously low returns for stocks with high probabilities of default. The authors show that returns to distressed stocks previously documented are really an amalgamation of anomalies associated with three stock characteristics -- leverage, volatility and profitability. In this paper they use a market based measure -- corporate credit spreads -- to proxy for default risk. Unlike previously used measures that proxy for a firm's real-world probability of default, credit spreads proxy for a risk-adjusted (or a risk-neutral) probability of default and thereby explicitly account for the systematic component of distress risk. The authors show that credit spreads predict corporate defaults better than previously used measures, such as, bond ratings, accounting variables and structural model parameters. They do not find default risk to be significantly priced in the cross-section of equity returns. There is also no evidence of firms with high default risk delivering anomalously low returns.
    Keywords: Debt Markets,Mutual Funds,Economic Theory&Research,Bankruptcy and Resolution of Financial Distress,Deposit Insurance
    Date: 2010–05–01
  2. By: Christopher Henderson; Julapa Jagtiani
    Abstract: The recent mortgage crisis has resulted in several bank failures as the number of mortgage defaults increased. The current Basel I capital framework does not require banks to hold sufficient amounts of capital to support their mortgage lending activities. The new Basel II capital rules are intended to correct this problem. However, Basel II models could become too complex and too costly to implement, often resulting in a trade-off between complexity and model accuracy. In addition, the variation of the model, particularly how mortgage portfolios are segmented, could have a significant impact on the default and loss estimated and, thus, could affect the amount of capital that banks are required to hold. This paper finds that the calculated Basel II capital varies considerably across the default prediction model and segmentation schemes, thus providing banks with an incentive to choose an approach that results in the least required capital for them. The authors also find that a more granular segmentation model produces smaller required capital, regardless of the economic environment. In addition, while borrowers' credit risk factors are consistently superior, economic factors have also played a role in mortgage default during the financial crisis.
    Keywords: Capital ; Banks and banking ; Basel capital accord
    Date: 2010
  3. By: Marianna Lyra; Akwum Onwunta; Peter Winker
    Abstract: According to the latest Basel framework of Banking Supervision, financial institutions should internally assign their borrowers into a number of homogeneous groups. Each group is assigned a probability of default which distinguishes it from other groups. This study aims at determining the optimal number and size of groups that allow for statistical ex post validation of the efficiency of the credit risk assignment system. Our credit risk assignment approach is based on Threshold Accepting, a local search optimization technique, which has recently performed reliably in credit risk clustering especially when considering several realistic constraints. Using a relatively large real-world retail credit portfolio, we propose a new technique to validate ex post the precision of the grading system.
    Keywords: credit risk assignment, Threshold Accepting, statistical validation
    Date: 2010–05–25
  4. By: Pesaran, M.H.
    Abstract: Modelling of conditional volatilities and correlations across asset returns is an integral part of portfolio decision making and risk management. Over the past three decades there has been a trend towards increased asset return correlations across markets, a trend which has been accentuated during the recent financial crisis. We shall examine the nature of asset return correlations using weekly returns on futures markets and investi- gate the extent to which multivariate volatility models proposed in the literature can be used to formally characterize and quantify market risk. In particular, we ask how adequate these models are for modelling market risk at times of financial crisis. In doing so we consider a multivariate t version of the Gaussian dynamic conditional correlation (DCC) model proposed by Engle (2002), and show that the t-DCC model passes the usual diagnostic tests based on probability integral transforms, but fails the value at risk (VaR) based diagnostics when applied to the post 2007 period that includes the recent financial crisis.
    Keywords: Volatilities and Correlations, Weekly Returns, Multivariate t, Financial Interdependence, VaR diagnostics, 2008 Stock Market Crash
    JEL: C51 C52 G11
    Date: 2010–05–29
  5. By: Duffie, Darrell (Stanford University); Li, Ada (Federal Reserve Bank of New York); Lubke, Theo (Federal Reserve Bank of New York)
    Abstract: In the wake of the recent financial crisis, over-the-counter (OTC) derivatives have been blamed for increasing systemic risk. Although OTC derivatives were not a central cause of the crisis, the complexity and limited transparency of the market reinforced the potential for excessive risk-taking, as regulators did not have a clear view into how OTC derivatives were being used. We discuss how the New York Fed and other regulators could improve weaknesses in the OTC derivatives market through stronger oversight and better regulatory incentives for infrastructure improvements to reduce counterparty credit risk and bolster market liquidity, efficiency, and transparency. Used responsibly with these reforms, over-the-counter derivatives can provide important risk management and liquidity benefits to the financial system.
    JEL: E61 G10 G18
    Date: 2010–01
  6. By: María Rosa Nieto; Esther Ruiz
    Abstract: In this paper, we propose a new bootstrap procedure to obtain prediction intervals of future Value at Risk (VaR) and Expected Shortfall (ES) in the context of univariate GARCH models. These intervals incorporate the parameter uncertainty associated with the estimation of the conditional variance of returns. Furthermore, they do not depend on any particular assumption on the error distribution. Alternative bootstrap intervals previously proposed in the literature incorporate the first but not the second source of uncertainty when computing the VaR and ES. We also consider an iterated smoothed bootstrap with better properties than traditional ones when computing prediction intervals for quantiles. However, this latter procedure depends on parameters that have to be arbitrarily chosen and is very complicated computationally. We analyze the finite sample performance of the proposed procedure and show that the coverage of our proposed procedure is closer to the nominal than that of the alternatives. All the results are illustrated by obtaining one-step-ahead prediction intervals of the VaR and ES of several real time series of financial returns.
    Keywords: Expected Shortfall, Feasible Historical Simulation, Hill estimator, Parameter uncertainty, Quantile intervals, Value at Risk
    Date: 2010–05
  7. By: Beltratti, Andrea (Bocconi University); Stulz, Rene M. (Ohio State University and ECGI)
    Abstract: Though overall bank performance from July 2007 to December 2008 was the worst since the Great Depression, there is significant variation in the cross-section of stock returns of large banks across the world during that period. We use this variation to evaluate the importance of factors that have been put forth as having contributed to the poor performance of banks during the credit crisis. Our evidence is inconsistent with the argument that poor governance of banks made the crisis worse, but it is supportive of theories that emphasize the fragility of banks financed with short-run capital market funding. Strikingly, differences in banking regulations across countries are generally uncorrelated with the performance of banks during the crisis, except that banks in countries with more restrictions on banking activities performed better, and are uncorrelated with observable risk measures of banks before the crisis. The better-performing banks had less leverage and lower returns in 2006 than the worst-performing banks.
    Date: 2010–03
  8. By: Juan Carlos Hatchondo; Leonardo Martinez
    Abstract: We propose a sovereign default framework that allows us to quantify the importance of the debt dilution problem in accounting for the level and volatility of sovereign default risk. We find that debt dilution accounts for almost 100% of the level and volatility of sovereign default risk in the simulations of a baseline model. Even without commitment to future repayment policies and without contingency of sovereign debt, if the sovereign could eliminate the dilution problem, the number of defaults per 100 years in our simulations decreases from 2.72 with debt dilution to 0.01 without debt dilution. This occurs in spite of dilution accounting for only 1% of the mean debt level. Our analysis is also relevant for the study of other credit markets where the debt dilution problem could appear.
    Date: 2010
  9. By: Stephen Cecchetti; Ingo Fender; Kostas Patrick McGuire
    Abstract: Global risk maps are unified databases that provide risk exposure data to supervisors and the broader financial market community worldwide. We think of them as giant matrices that track the bilateral (firm-level) exposures of banks, non-bank financial institutions and other relevant market participants. While useful in principle, these giant matrices are unlikely to materialise outside the narrow and targeted efforts currently being pursued in the supervisory domain. This reflects the well known trade-offs between the macro and micro dimensions of data collection and dissemination. It is possible, however, to adapt existing statistical reporting frameworks in ways that would facilitate an analysis of exposures and build-ups of risk over time at the aggregate (sectoral) level. To do so would move us significantly in the direction of constructing the ideal global risk map. It would also help us sidestep the complex legal challenges surrounding the sharing or dissemination of firm-level data, and it would support a two-step approach to systemic risk monitoring. That is, the alarms sounded by the aggregate data would yield the critical pieces of information to inform targeted analysis of more detailed data at the firm- or market-level.
    Keywords: risk map, international banking, financial crises, yen carry trade, funding risk
    Date: 2010–05
  10. By: Pasquale Lucio Scandizzo (Faculty of Economics, University of Rome "Tor Vergata"); Odin K Knudsen (JPMorgan Chase & Co)
    Abstract: In this paper, we explore the effects of dynamic uncertainty on the risk management of regulated industries and emission market. We consider as major sources of uncertainty the stochastic growth of demand for the industry output (e.g. electric energy) and the ensuing lack of information on the pollution levels of individual firms, their behavior and the behavior of the regulator. These sources of uncertainty are common in pollution permit trading as not only does the market respond to the volatility of fundamentals but also to the vagaries of the institutional structure, created by public policy and enforced through regulation. The paper shows that in the presence of strategic behavior on the part of the agents involved, even though both the level and the volatility of output increases over time, trading of permits is a highly effective instrument of risk management, since it allows the firms to pool the risks arising from the volatile environment, thereby simplifying enforcement, reducing emissions and improving resource allocation. Moreover, uncertainty plays a subtle influencing role, since on one hand it broadens the regulator’s deterrent power over potential polluters, while on the other it reduces the expected value of the sanction for the individual firm.
    Keywords: risk; permits; regulation; enforcement; dynamic uncertainty; option; pricing; equilibrium
    JEL: K34 H40 Q52
    Date: 2010–05–28
  11. By: Masset, Philippe; Weisskopf, Jean-Philippe
    Abstract: This paper uses auction hammer prices over the period 1996-2009, with a special emphasis on periods of economic downturns, to examine risk, return and diversification benefits of fine wine. Our research shows evidence that the wine market is heterogeneous with wine regions and price categories evolving differently in terms of volume and turnover. We construct wine indices for various wine regions and prices using repeat-sales regressions and find out that fine wine yields higher returns and has a lower volatility compared to stocks especially in times of economic crises. Forming portfolios for typical investors and taking risk aversion, different financial assets and various wine indices into consideration we confirm that the addition of wine to a portfolio as a separate asset-class is beneficial for private investors. Not only are returns favourably impacted and risk being minimised but skewness and kurtosis are also positively affected. Particularly, during the recent financial crisis these effects are most pronounced and improve portfolio diversification when it is most needed. Most importantly, balancing a portfolio with fine wine has resulted in added return while reducing volatility with the most prestigious and expensive vintages and estates outperforming the General Wine Index (GWI) during the entire research period. Results from the CAPM show that alpha is significantly positive over the period 1996- 2009 while showing a low beta coefficient. The use of a conditional CAPM model allows us to clarify the time-variance of alphas and betas depending on the economic environment that is not generally captured by the traditional CAPM. The time-varying dynamics of alphas and betas are in particular best explained by the spread between BAA- and AAA-rated bonds and the USD/EUR foreign exchange rate. Our findings confirm that wine returns are primarily related to economic conditions and not to the market risk.
    Keywords: wine, alternative assets, financial contagion, portfolio diversification, conditional CAPM, Financial Economics, Risk and Uncertainty,
    Date: 2010–03
  12. By: Martin Mullins; John Garvey
    Abstract: Close examination of the behaviour of participants in financial markets in the aftermath of terrorist attacks is a valuable line of enquiry. In this paper, we bring together insights from field of finance and politics. Specifically, we examine trading patterns on highly liquid insurance-type financial instruments around a specific terrorist event. This approach provides an insight into risk perception around political violence and allows us to answer a number of key questions on the impact of terrorist attacks on economies and societies. When examined and processed, intraday financial trade data yields valuable empirical evidence on immediate reactions to the threat posed by terrorist groups. The methodology applied in this paper also tells us much about the geographical resonance of terrorist events. We clearly show that fear of economic disruption can be activated in Western markets by events that are often geographically remote. Importantly, these datasets allow us to judge the vulnerability of financial markets to terrorist attack. This potentially allows public authorities to safeguard our interests more effectively. Financial markets are one important element of a "neglected home front" and the risks posed by disruption to those markets are such as to merit our urgent attention.
    Date: 2010
  13. By: Luis M. Viceira (Harvard Business School); Ricardo Gimeno (Banco de España)
    Abstract: In this article, we explore the demand for the euro for risk management purposes, and the evidence of stock market integration in the euro area. We define a reserve currency as one that investors demand either because it helps them hedge real interest risk and inflation risk, or because it helps them reduce the volatility of their portfolio of stocks and bonds because its return is negatively correlated with the returns on those assets. This article re-examines the role of the euro as a reserve currency in the sense of Campbell, Viceira and White (2003), updating their evidence, and reviews the evidence of Campbell, Serfaty-de Medeiros and Viceira (2010) in detail. Consistent with the intuition that an integrated capital market is one in which there is a common discount factor pricing securities, we also investigate whether stocks in the euro area have moved from a regime in which national stock markets were priced with discount rates that were predominantly country specific, to a regime in which national stock markets are predominantly priced by a euro area-wide common discount rate. We adopt the beta decomposition approach of Campbell and Vuolteenaho (2004) and Campbell, Polk and Vuolteenaho (2010) to test for capital market integration, and find robust evidence of increased capital market integration in the euro zone, and consequently improved risk sharing among euro zone economies.
    Keywords: Euro, Reserve Currency, Currency hedging, Market Integration, Beta decomposition
    JEL: G12 G15 F31 F15 E42
    Date: 2010–05

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