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on Risk Management |
| By: | Michael B. Gordy; James Marrone |
| Abstract: | The impact of undiversified idiosyncratic risk on value-at-risk and expected shortfall can be approximated analytically via a methodology known as granularity adjustment (GA). In principle, the GA methodology can be applied to any risk-factor model of portfolio risk. Thus far, however, analytical results have been derived only for simple models of actuarial loss, i.e., credit loss due to default. We demonstrate that the GA is entirely tractable for single-factor versions of a large class of models that includes all the commonly used mark-to-market approaches. Our approach covers both finite ratings-based models and models with a continuum of obligor states. We apply our methodology to CreditMetrics and KMV Portfolio Manager, as these are benchmark models for the finite and continuous classes, respectively. Comparative statics of the GA with respect to model parameters in CreditMetrics reveal striking and counterintuitive patterns. We explain these relationships with a stylized model of portfolio risk. |
| Date: | 2010 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedgfe:2010-37&r=rmg |
| By: | Jean Tirole (Toulouse School of Economics) |
| Abstract: | The recent crisis was characterized by massive illiquidity. This paper reviews what we know and don't know about illiquidity and all its friends: market freezes, fire sales, contagion, and ultimately insolvencies and bailouts. It first explains why liquidity cannot easily be apprehended through a single statistics, and asks whether liquidity should be regulated given that a capital adequacy requirement is already in place. The paper then analyzes market breakdowns due to either adverse selection or shortages of financial muscle, and explains why such breakdowns are endogenous to balance sheet choices and to information acquisition. It then looks at what economics can contribute to the debate on systemic risk and its containment. Finally, the paper takes a macroeconomic perspective, discusses shortages of aggregate liquidity and analyses how market value accounting and capital adequacy should react to asset prices. It concludes with a topical form of liquidity provision, monetary bailouts and recapitalizations, and analyses optimal combinations thereof; it stresses the need for macro-prudential policies. |
| Keywords: | Liquidity, Contagion, Bailouts, Regulation |
| JEL: | E44 E52 G28 |
| Date: | 2010–06 |
| URL: | http://d.repec.org/n?u=RePEc:fem:femwpa:2010.78&r=rmg |
| By: | Romain Biard (SAF - Laboratoire de Sciences Actuarielle et Financière - Université Claude Bernard - Lyon I : EA2429); Claude Lefèvre (Département de Mathématique - Université Libre de Bruxelles); Stéphane Loisel (SAF - Laboratoire de Sciences Actuarielle et Financière - Université Claude Bernard - Lyon I : EA2429); Haikady Nagaraja (Department of Statistics - Ohio State University) |
| Abstract: | In the compound Poisson risk model, several strong hypotheses may be found too restrictive to describe accurately the evolution of the reserves of an insurance company. This is especially true for a company that faces natural disaster risks like earthquake or flooding. For such risks, claim amounts are often inter-dependent and they may also depend on the history of the natural phenomenon. The present paper is concerned with a situation of this kind where each claim amount depends on the previous interclaim arrival time, or on past interclaim arrival times in a more complex way. Our main purpose is to evaluate, for large initial reserves, the asymptotic finite-time ruin probabilities of the company when the claim sizes have a heavy-tailed distribution. The approach is based more particularly on the analysis of spacings in a conditioned Poisson process. |
| Keywords: | Risk process; finite-time ruin probabilities; asymptotic approximation for large initial reserves; path-dependent claims, heavy-tailed claim amounts; Poisson spacing; |
| Date: | 2010 |
| URL: | http://d.repec.org/n?u=RePEc:hal:journl:hal-00409418_v1&r=rmg |
| By: | Pauline Barrieu (Department of Statistics - London School of Economics); Harry Bensusan (CMAP UMR 7641 - Centre de Mathématiques Appliquées - Ecole Polytechnique - Polytechnique - X - CNRS : UMR7641); Nicole El Karoui (CMAP UMR 7641 - Centre de Mathématiques Appliquées - Ecole Polytechnique - Polytechnique - X - CNRS : UMR7641); Caroline Hillairet (CMAP UMR 7641 - Centre de Mathématiques Appliquées - Ecole Polytechnique - Polytechnique - X - CNRS : UMR7641); Stéphane Loisel (SAF - Laboratoire de Sciences Actuarielle et Financière - Université Claude Bernard - Lyon I : EA2429); Claudia Ravanelli (Swiss Financial Institute - École Polytechnique Fédérale de Lausanne); Yahia Salhi (SAF - Laboratoire de Sciences Actuarielle et Financière - Université Claude Bernard - Lyon I : EA2429, CERDALM - SCOR Global Life) |
| Abstract: | This article investigates the latest developments in longevity risk modelling, and explores the key risk management challenges for both the financial and insurance industries. The article discusses key definitions that are crucial for the enhancement of the way longevity risk is understood; providing a global view of the practical issues for longevity-linked insurance and pension products that have evolved concurrently with the steady increase in life expectancy since 1960s. In addition, the article frames the recent and forthcoming developments that are expected to action industry-wide changes as more effective regulation, designed to better assess and efficiently manage inherited risks, is adopted. Simultaneously, the evolution of longevity is intensifying the need for capital markets to be used to manage and transfer the risk through what are known as Insurance-Linked Securities (ILS). Thus, the article will examine the emerging scenarios, and will finally highlight some important potential developments for longevity risk management from a financial perspective with reference to the most relevant modelling and pricing practices in the banking industry. |
| Keywords: | Longevity Risk ; securitization ; risk transfer ; incomplete market ; life insurance ; stochastic mortality ; pensions ; long term interest rate ; regulation ; population dynamics |
| Date: | 2010 |
| URL: | http://d.repec.org/n?u=RePEc:hal:journl:hal-00417800_v2&r=rmg |
| By: | Leonard I. Nakamura |
| Abstract: | This paper sets forth a discussion framework for the information requirements of systemic financial regulation. It specifically proposes a large macro-micro database for the U.S. based on an extended version of the Flow of Funds. The author argues that such a database would have been of material value to U.S. regulators in ameliorating the recent financial crisis and will be of aid in understanding the potential vulnerabilities of an innovative financial system in the future. The author also argues that the data should -- under strict confidentiality conditions -- be made available to academic researchers investigating the detection and measurement of systemic risk. |
| Keywords: | Flow of funds ; Financial crises ; Financial institutions - Law and legislation |
| Date: | 2010 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedpwp:10-22&r=rmg |
| By: | Christine Cumming; Robert A. Eisenbeis |
| Abstract: | This paper explores the advantages of a new financial charter for large, complex, internationally active financial institutions that would address the corporate governance challenges of such organizations, including incentive problems in risk decisions and the complicated corporate and regulatory structures that impede cross-border resolutions. The charter envisions a single entity with broad powers in which the extent and timing of compensation are tied to financial results, senior managers and risk takers form a new risk-bearing stakeholder class, and a home-country-based resolution regime operates for the benefit of all creditors. The proposal is offered 1) to highlight the point that even in the face of a more efficient and effective resolution process, incentives for excessive risk taking will continue unless the costs of risk decisions are internalized by institutions, 2) to suggest another avenue for moving toward a streamlined organizational structure and single global resolution process, and 3) to complement other proposals aimed at preserving a large role for market discipline and firm incentives in a post-reform financial system. |
| Keywords: | International business enterprises ; Corporate governance ; Executives - Salaries ; Financial risk management ; Reward (Psychology) ; Bank charters |
| Date: | 2010 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fednsr:457&r=rmg |
| By: | Adam Gersl (Czech National Bank; Institute of Economic Studies, Faculty of Social Sciences, Charles University, Prague, Czech Republic); Petr Jakubík (European Central Bank; Institute of Economic Studies, Faculty of Social Sciences, Charles University, Prague, Czech Republic) |
| Abstract: | This paper examines procyclicality of the financial system. The introduction describes the natural and regulatory sources of procyclicality, focusing on the potential procyclical effect of the current Basel II regulatory framework for banks. It also mentions the regulatory tools for mitigating procyclical behaviour by financial institutions currently being discussed in international forums. Under certain conditions, procyclical behaviour of the banking sector can lead to an adverse feedback loop whereby banks, in response to an economic downswing, engage in deleveraging and reduce their lending to the economy in order to maintain the required capital adequacy ratio. This then further negatively affects economic output and impacts back on banks in the form of, for example, increased loan losses. In the main empirical section of the paper, this effect was simulated on the example of the Czech banking sector. The simulation results suggest that under certain assumptions the feedback loop may play an important role. |
| Keywords: | procyclicality; feedback loop; bank regulation; deleveragin |
| JEL: | G21 E44 E47 |
| Date: | 2010–07 |
| URL: | http://d.repec.org/n?u=RePEc:fau:wpaper:wp2010_14&r=rmg |
| By: | Suhadolnik, Nicolas; Galimberti, Jaqueson; Da Silva, Sergio |
| Abstract: | If stock markets are complex, monetary policy and even financial regulation may be useless to prevent bubbles and crashes. Here, we suggest the use of robot traders as an anti-bubble decoy. To make our case, we put forward a new stochastic cellular automata model that generates an emergent stock price dynamics as a result of the interaction between traders. After introducing socially integrated robot traders, the stock price dynamics can be controlled, so as to make the market more Gaussian. |
| Keywords: | Stock markets; Robot traders; Financial regulation; Econophysics |
| JEL: | G18 |
| Date: | 2010 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:23923&r=rmg |
| By: | Paresh Kumar Narayan; Xinwei Zheng |
| Abstract: | In this paper, using data for the period January 1995 to May 2009 for the Shanghai stock exchange (SHSE), we show that aggregate illiquidity is a priced risk factor. We develop the relationship between the illiquidity factor, asymmetric information, and market collapse. Our empirical results show that while the illiquidity factor is a source of asymmetric information on the SHSE, asymmetric information does not trigger a market collapse. |
| Keywords: | Illiquidity Factor; Asymmetric Information; Market Collapse. |
| Date: | 2010–07–16 |
| URL: | http://d.repec.org/n?u=RePEc:dkn:econwp:eco_2010_07&r=rmg |
| By: | Neil Bhutta; Jane Dokko; Hui Shan |
| Abstract: | A central question in the literature on mortgage default is at what point underwater homeowners walk away from their homes even if they can afford to pay. We study borrowers from Arizona, California, Florida, and Nevada who purchased homes in 2006 using non-prime mortgages with 100 percent financing. Almost 80 percent of these borrowers default by the end of the observation period in September 2009. After distinguishing between defaults induced by job losses and other income shocks from those induced purely by negative equity, we find that the median borrower does not strategically default until equity falls to -62 percent of their home's value. This result suggests that borrowers face high default and transaction costs. Our estimates show that about 80 percent of defaults in our sample are the result of income shocks combined with negative equity. However, when equity falls below -50 percent, half of the defaults are driven purely by negative equity. Therefore, our findings lend support to both the "double-trigger" theory of default and the view that mortgage borrowers exercise the implicit put option when it is in their interest. |
| Date: | 2010 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedgfe:2010-35&r=rmg |
| By: | Rémi Rhodes (CEREMADE - CEntre de REcherches en MAthématiques de la DEcision - CNRS : UMR7534 - Université Paris Dauphine - Paris IX); Vincent Vargas (CEREMADE - CEntre de REcherches en MAthématiques de la DEcision - CNRS : UMR7534 - Université Paris Dauphine - Paris IX); Jean-Christophe Domenge (Laboratoire de Physique Théorique de la Matière Condensée - Aucune) |
| Abstract: | We define a simple and tractable method for adding the Leverage effect in general volatility predictions. As an application, we compare volatility predictions with and without Leverage on the SP500 Index during the period 2002-2010. |
| Date: | 2010–07–13 |
| URL: | http://d.repec.org/n?u=RePEc:hal:wpaper:hal-00502273_v1&r=rmg |
| By: | Allen C. Goodman; Brent C. Smith |
| Abstract: | Using a national loan level data set we examine loan default as explained by local demographic characteristics and state level legislation that regulates foreclosure procedures and predatory lending through a hierarchical linear model. We observe significant variation in the default rate across states, with lower default levels in states with higher temporal and financial costs to lenders when controlling for loan and location conditions. The results are notable given that many of the observed loans were sold to investors in national and international markets. State level legislative influences provide a foundation for discussion of national level policy that further regulates predatory lending and financial institution foreclosure activities. |
| Date: | 2010 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedrwp:10-10&r=rmg |