nep-rmg New Economics Papers
on Risk Management
Issue of 2010‒07‒10
eleven papers chosen by
Stan Miles
Thompson Rivers University

  1. The Merton Approach to Estimating Loss Given Default: Application to the Czech Republic By Jakub Seidler; Petr Jakubik
  2. Macroeconomic Conditions and the Puzzles of Credit Spreads and Capital Structure By Hui Chen
  3. Alan Greenspan, the quants and stochastic optimal control By Stein, Jerome L.
  4. Modelando a volatilidade dos retornos de petrobrás usando dados de alta frequência By Cappa, Leonardo; Pereira, Pedro L. Valls
  5. Alarm System for Insurance Companies: A Strategy for Capital Allocation By Shubhabrata Das; Marie Kratz
  6. A parsimonious default prediction model for Italian SMEs By Chiara Pederzoli; Costanza Torricelli
  7. How to Construct Fundamental Risk Factors? By Marie Lambert; George Hübner
  8. Structured Finance Influence on Financial Market Stability – Evaluation of Current Regulatory Developments By Schuetz, Sebastian Alexander
  9. Comoment Risk and Stock Returns By Marie Lambert; George Hübner
  10. A Dynamical Model for Forecasting Operational Losses By Marco Bardoscia; Roberto Bellotti
  11. "Detecting Ponzi Finance: An Evolutionary Approach to the Measure of Financial Fragility" By Eric Tymoigne

  1. By: Jakub Seidler; Petr Jakubik
    Abstract: This paper focuses on a key credit risk parameter – Loss Given Default (LGD). We illustrate how the LGD can be estimated with the help of an adjusted Mertonian structural approach. We present a derivation of the formula for expected LGD and show its sensitivity analysis with respect to other company structural parameters. Finally, we estimate the five-year expected LGDs for companies listed on Prague Stock Exchange and find that the average LGD for the analyzed sample is around 20–50%.
    Keywords: Credit risk, loss given default, structural models.
    JEL: C02 G13 G33
    Date: 2009–12
  2. By: Hui Chen
    Abstract: I build a dynamic capital structure model that demonstrates how business-cycle variations in expected growth rates, economic uncertainty, and risk premia influence firms' financing and default policies. Countercyclical fluctuations in risk prices, default probabilities, and default losses arise endogenously through firms' responses to the macroeconomic conditions. These comovements generate large credit risk premia for investment grade firms, which helps address the "credit spread puzzle" and "under-leverage puzzle" in a unified framework. The model generates interesting dynamics for financing and defaults, including "credit contagion" and market timing of debt issuance. It also provides a novel procedure to estimate state-dependent default losses.
    JEL: E44 G12 G13 G32 G33
    Date: 2010–07
  3. By: Stein, Jerome L.
    Abstract: Alan Greenspan's paper (March 2010) presents his retrospective view of the crisis. His theme has several parts. First, the housing price bubble, its subsequent collapse and the financial crisis were not predicted either by the market, the FED, the IMF or the regulators in the years leading to the current crisis. Second, financial intermediation tried to function on too thin layer of capital - high leverage - owing to a misreading of the degree of risk embodied in ever more complex financial products and markets. Third, the breakdown was unpredictable and inevitable, given the 'excessive' leverage - or low capital - of the financial intermediaries. The proposed legislation for the 'reform' of the financial system requires that the FED "identify, measure, manage and mitigate risks to the financial stability of the United States". The focus is upon capital requirements or debt ratios. The 'Quants' ignored systemic risk and just focused upon risk transfer in very liquid markets. The FED, IMF, Treasury and the 'Quants'/market lacked the appropriate tools of analysis to answer the following questions: what is an optimal leverage or capital requirement that balances the expected growth against risk? What are theoretically founded early warning signals of a crisis? The author explains why the application of stochastic optimal control (SOC)/dynamic risk management is an effective approach to determine the optimal degree of leverage, the optimum and excessive risk and the probability of a debt crisis. The theoretically derived early warning signal of a crisis is the excess debt ratio, equal to the difference between the actual and optimal ratio. The excess debt starting from 2004-05 indicated that a crisis was most likely. This SOC analysis should be used by those charged with surveillance of financial markets. --
    Keywords: Stochastic optimal control,warning signals of crisis,optimal leverage and debt ratios
    JEL: C61 G11 G12 G14
    Date: 2010
  4. By: Cappa, Leonardo; Pereira, Pedro L. Valls
    Abstract: The aim of this paper is to assess the empirical characteristics of a high-frequencyreturn series of one of the main assets traded at the São Paulo Stock Exchange. We areinterested in modeling the conditional volatility of these return series, particularly testing forlong-memory. Our findings reveal that besides long memory, there is strong intradayperiodicity, but we found no evidence of leverage effect. We use models that are able toaccount for the long memory in the conditional variance of the seasonally adjusted returns,yielding superior results when compared to traditional short-memory volatility models, withimportant implications to option pricing and risk management
    Date: 2010–06–29
  5. By: Shubhabrata Das; Marie Kratz
    Abstract: One possible way of risk management for an insurance company is to develop an early and appropriate alarm system before the possible ruin. The ruin is defined through the status of the aggregate risk process, which in turn is determined by premium accumulation as well as claim settlement outgo for the insurance company. The main purpose of this work is to design an effective alarm system, i.e. to define alarm times and to recommend augmentation of capital of suitable magnitude at those points to prevent or reduce the chance of ruin. To draw a fair measure of effectiveness of alarm system, comparison is drawn between an alarm system, with capital being added at the sound of every alarm, and the corresponding system without any alarm, but an equivalently higher initial capital. Analytical results are obtained in general setup and this is backed up by simulated performances with various types of loss severity distributions. This provides a strategy for suitably spreading out the capital and yet addressing survivability concerns at satisfactory level.
    Date: 2010–06
  6. By: Chiara Pederzoli; Costanza Torricelli
    Abstract: In the light of the fundamental role played by small and medium enterprises (SMEs) in the economy of many countries including Italy and of the specific treatment of this issue within the Basel II regulation, the aim of this work is to build a default prediction model for the Italian SMEs. Specifically, we develop a logit model based on financial ratios: using the AIDA database, we focus the attention on a specific region in Italy, Emilia Romagna, where SMEs represent the firms’ majority . We find that a parsimonious model based on only four explanatory variables fits well the default data.
    Keywords: credit default prediction; SMEs; Basel II
    JEL: G28 G31
    Date: 2010–06
  7. By: Marie Lambert (Luxembourg School of Finance, University of Luxembourg); George Hübner (HEC Management School, University of Liège, Belgium)
    Abstract: Our paper reexamines the methodology of Fama and French (1993) for creating US empirical risk factors, and proposes an extension on the way to compute the mimicking portfolios. Our objective is to develop a modified Fama and French (F&F) methodology that could be easily implemented on other markets, and that could also easily price other risk fundamentals. We raise three main problems in the F&F methodology. First, their annual rebalancing is consumptive in long timeseries which sometimes simply do not exist for small exchange markets. Moreover, this does not match with the investment horizon of the investors. Second, the independent sorting procedure underlying the formation of the 6 F&F twodimensional portfolios causes moderate level of correlation between premiums. Finally, sorting the stocks into portfolios according to NYSE stock returns tend to over-represent the proportion of small stocks in small and value portfolios. We estimate, along our technology, alternative premiums for the size, book-to-market and momentum risk fundamentals. We compare these three risk premiums to the Fama and French and Carhart benchmarks that Kenneth French make available on his website. In an analysis framework without data snooping bias, we show evidence that although they are correlated, the original F&F premiums and our versions of the F&F premiums bring complementary information. Furthermore, we find that our empirical model better complements the market model for explaining cross-sectional dispersion in returns than the F&F premiums.
    Keywords: Fama and French Factors, Momentum, Hedge/mimicking Portfolios, Market Risk Fundamentals
    JEL: G11 G12
    Date: 2010
  8. By: Schuetz, Sebastian Alexander
    Abstract: In 2007 the world faced one of the biggest financial crises ever. It was the third important financial crisis in the last 12 years. Spillovers to the real economy and moral hazard behaviour of carpetbaggers resulted in enormous pressure on worldwide political institutions to approve a more rigorous regulation on financial institutions and to predict financial crises via early warning systems. We analyzed the performance of structured finance ratings and structured finance issuance/outstanding to detect the main shortcomings of the subprime crisis. Afterwards, we explain the behaviour of market participants with theoretical models and a survey of institutions involved in securitization. With the conclusions of this analysis we evaluate the EU regulation on credit rating agencies and current Basel II enhancements. Finally we can determine that most regulatory enhancements are in accordance with our analyzed shortcomings. Some approaches like the introduction of a leverage ratio are counterproductive and a danger for worldwide economic growth.
    Keywords: Structured Finance; Ratings; Regulation; Subprime Crisis; Basel II; Leverage Ratio
    JEL: G18 G28
    Date: 2010–06–30
  9. By: Marie Lambert (Luxembourg School of Finance, University of Luxembourg); George Hübner (HEC Management School, University of Liège, Belgium)
    Abstract: This paper applies the methodology of Lambert and Hübner (2009) for creating fundamental risk factors and factor systematic variance, skewness, and kurtosis into returns from March 1989 to June 2008. The coskewness and cokurtosis premiums present significant monthly average returns of respectively 0.2% and 0.4% over the period. First, we show that our set of moment-related premiums consistently price 2 sets of 2x3 covariance/coskewness and of 2x3 covariance/cokurtosis portfolios. The model delivers for all portfolios low levels of specification errors, high levels of R2, and beta loadings consistent with the portfolio rankings. Second, we perform Fama and MacBeth (1973) cross-sectional regressions made of higher-moment market premiums and/or Fama and French (1993) factors on 25 and 100 two-dimensional portfolios sorted on size and bookto- market. Used separately, a four-moment factor model and a four-factor Fama and French (1993) and Carhart (1997) model have been shown to deliver similar model specification errors (alphas) for the size/BTM portfolios. The Four-Moment Asset Pricing Model captures however a higher proportion of the portfolio variability of size/BTM portfolios than an empirical Capital Asset Pricing Model. Finally, our study demonstrates that moment and empirical premiums present complementary significance over the period.
    Keywords: Comoment, Hedge portfolios, Fama and French methodology, Fama-MacBeth test
    JEL: G11 G12
    Date: 2010
  10. By: Marco Bardoscia; Roberto Bellotti
    Abstract: A novel dynamical model for the study of operational risk in banks is proposed. The equation of motion takes into account the interactions among different bank's processes, the spontaneous generation of losses via a noise term and the efforts made by the banks to avoid their occurrence. A scheme for the estimation of some parameters of the model is illustrated, so that it can be tailored on the internal organizational structure of a specific bank. We focus on the case in which there are no causal loops in the matrix of couplings and exploit the exact solution to estimate also the parameters of the noise. The scheme for the estimation of the parameters is proved to be consistent and the model is shown to exhibit a remarkable capability in forecasting future cumulative losses.
    Date: 2010–06
  11. By: Eric Tymoigne
    Abstract: Different frameworks of analysis lead to different conceptions of financial instability and financial fragility. On one side, the static approach conceptualizes financial instability as an unfortunate byproduct of capitalism that results from unpredictable random forces that no one can do anything about except prepare for through adequate loss reserves, capital, and liquidation buffers. On the other side, the evolutionary approach conceptualizes financial instability as something that the current economic system invariably brings upon itself through internal market and nonmarket forces, and that requires change in financial practices rather than merely good financial buffers. This paper compares the two approaches in order to lay the foundation for the empirical analysis developed within the evolutionary approach. The paper shows that, with the use of macroeconomic data, it is possible to detect financial fragility, especially Ponzi finance. The methodology is applied to residential housing in the U.S. household sector and is able to capture some of the trends that are known to be sources of economic difficulties. Notably, the paper finds that Ponzi finance was going on in the housing sector from at least 2004 to 2007, which concurs with other works based on more detailed data.
    Keywords: Financial Fragility; Financial Crisis; Financial Policy; Minsky
    JEL: E12 E32
    Date: 2010–06

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