New Economics Papers
on Risk Management
Issue of 2010‒09‒11
thirteen papers chosen by

  1. Dynamic VaR models and the Peaks over Threshold method for market risk measurement: an empirical investigation during a financial crisis By Marco Bee; Fabrizio Miorelli
  2. Value at Risk Computation in a Non-Stationary Setting By Dominique Guegan
  3. Insurance Solvency Regulation: Regulatory Approaches Compared By Benjamin Lorent
  4. Model-free bounds on bilateral counterparty valuation By Haase, Joerdis; Ilg, Melanie; Werner, Ralf
  5. The feasibility of through-the-cycle ratings By Kauko, Karlo
  6. Credit Growth, Bank Soundness and Financial Fragility: Evidence from Indian Banking Sector By Ghosh, Saibal
  7. MBS Ratings and the Mortgage Credit Boom By Ashcraft, A.; Goldsmith-Pinkham, P.; Vickery, J.
  8. Measures aimed at mitigating pro cyclical effects of the Capital Requirements Framework: counter cyclical capital buffer proposals By Ojo, Marianne
  9. The Role of the State in Managing and Forestalling Systemic Financial Crises: Some Issues and Perspectives By Charles Adams
  10. Interemporal Risk Aversion - or - Wouldn't it be Nice to Tell Whether Robinson Crusoe is Risk By Traeger, Christian P.
  11. The Risk-Return Tradeoff and Leverage Effect in a Stochastic Volatility-in-Mean Model By Bent Jesper Christensen; Petra Posedel
  12. Normalization for Implied Volatility By Masaaki Fukasawa
  13. Resolving the financial crisis: are we heeding the lessons from the Nordics? By Claudio Borio; Bent Vale; Goetz von Peter

  1. By: Marco Bee; Fabrizio Miorelli
    Abstract: This paper presents a backtesting exercise involving several VaR models for measuring market risk in a dynamic context. The focus is on the comparison of standard dynamic VaR models, ad hoc fat-tailed models and the dynamic Peaks over Threshold (POT) procedure for VaR estimation with different volatility specifications. We introduce three different stochastic processes for the losses: two of them are of the GARCH-type and one is of the EWMA-type. In order to assess the performance of the models, we implement a backtesting procedure using the log-losses of a diversified sample of 15 financial assets. The backtesting analysis covers the period March 2004 - May 2009, thus including the turmoil period corresponding to the subprime crisis. The results show that the POT approach and a Dynamic Historical Simulation method, both combined with the EWMA volatility specification, are particularly effective at high VaR coverage probabilities and outperform the other models under consideration. Moreover, VaR measures estimated with these models react quickly to the turmoil of the last part of the backtesting period, so that they seem to be efficient in high-risk periods as well.
    Keywords: Market risk, Extreme Value Theory, Peaks over Threshold, Value at Risk, Fat tails
    Date: 2010
  2. By: Dominique Guegan (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Panthéon-Sorbonne - Paris I, EEP-PSE - Ecole d'Économie de Paris - Paris School of Economics - Ecole d'Économie de Paris)
    Abstract: This chapter recalls the main tools useful to compute Value at Risk associated with a m-dimensional portfolio. Then, the limitations of the use of these tools is explained, as soon as non-stationarities are observed in time series. Indeed, specific behaviours observed by financial assets, like volatility, jumps, explosions, and pseudo-seasonalities, provoke non-stationarities which affect the distribution function of the portfolio. Thus, a new way for computing VaR is proposed which allows the potential non-invariance of the m-dimensional portfolio distribution function to be avoided.
    Keywords: Non-stationarity – Value-at-Risk – Dynamic copula –Meta-distribution – POT method.
    Date: 2010
  3. By: Benjamin Lorent
    Abstract: In this paper we compare the main regulatory frameworks: American (US RBC, Risk-Based-Capital), Swiss (SST, Swiss Solvency Test) and European (Solvency II). We improve on the existing literature by focusing on technical aspects of regulation schemes, particularly the capital requirements’ calculation and by including latest quantitative and qualitative improvements of the Solvency II project. The comparison concludes that Swiss and European systems are advanced regulatory processes in comparison with American regulation although the latter system was perceived as a revolution some years ago. Even if the Swiss regime and the future European directive are quite similar, there are also some key differences to highlight. European approach to determine regulatory capital is mainly risk-sensitive, based on risk measures, whereas US RBC is mainly based on static factors and accounting data reported in the audited statutory annual statement. The three systems also differ with regards to the use of different risk measures, the consideration of operational and catastrophe risks, the use of internal models, the treatment of diversification effect, the limits imposed to investments, and the consideration of qualitative aspects.
    Keywords: Solvency II; Swiss Solvency Test; US RBC; Insurance Regulation
    JEL: G22 G28 G32 K23
    Date: 2010–08
  4. By: Haase, Joerdis; Ilg, Melanie; Werner, Ralf
    Abstract: In the last years, counterparty default risk has experienced an increased interest both by academics as well as practitioners. This was especially motivated by the market turbulences and the financial crises over the past years which have highlighted the importance of counterparty default risk for uncollateralized derivatives. The following paper focuses on the pricing of derivatives subject to such counterparty risk. After a succinct introduction to the topic, a brief review of state-of-the-art methods for the calculation of bilateral counterparty value adjustments is presented. Due to some weaknesses of these models, a novel method for the determination of model-free tight lower and upper bounds on these adjustments is presented. It will be shown in detail how these bounds can be easily and eciently calculated by the solution of a corresponding linear optimization problem. It will be illustrated how usual discretization methods like Monte Carlo methods allow to reduce the calculation of bounds to an ordinary finite dimensional transportation problem, whereas a continuous time approach will lead to a general mass transportation problem. The paper is closed with several applications of these model-free bounds, like stress-testing and estimation of model reserves.
    Keywords: Counterparty risk; CVA; model risk
    JEL: C60
    Date: 2010–09–02
  5. By: Kauko, Karlo (Bank of Finland Research)
    Abstract: It has been proposed that the potential procyclicality of Basel II could be alleviated by using through-the-cycle (TTC) ratings in IRBA models. A TTC rating would be based on the structural component of the debtor’s credit risk ignoring cyclical fluctuations. This paper tests for the existence of such fluctuations in corporate sector credit risk and finds vietually no evidence for their existence at the company level. It is not possible to assign satisfactory TTC ratings to debtors if there are no cyclical variations to be filtered out.
    Keywords: through-the-cycle rating; credit risk; procyclicality
    JEL: G21 G33
    Date: 2010–08–16
  6. By: Ghosh, Saibal
    Abstract: Using data on Indian banks for 1996-2008, the paper examines the interconnect among credit growth, bank soundness and financial fragility. The analysis appears to indicate that higher credit growth amplifies bank fragility. Besides, the results point to the fact that sounder banks increase loan supply. Coming to bank ownership, the evidence testifies that credit growth has been rapid in state-owned and de novo private banks. In terms of policy implications, the analysis appears to suggest the need for giving priority to risk-based supervision as a way to contain the potential risks associated with rapid credit growth
    Keywords: Banking; Credit growth; Z-score; Non-performing loans; India
    JEL: G21
    Date: 2010–03
  7. By: Ashcraft, A.; Goldsmith-Pinkham, P.; Vickery, J. (Tilburg University, Center for Economic Research)
    Abstract: We study credit ratings on subprime and Alt-A mortgage-backed securities (MBS) deals issued between 2001 and 2007, the period leading up to the subprime crisis. The fraction of highly-rated securities in each deal is decreasing in mortgage credit risk (measured either ex-ante or ex-post), suggesting ratings contain useful information for investors. However, we also find evidence of significant time-variation in risk-adjusted credit ratings, including a progressive decline in standards around the MBS market peak between the start of 2005 and mid-2007. Conditional on initial ratings, we observe underperformance (high mortgage defaults and losses, and large rating downgrades) amongst deals with observably higher-risk mortgages based on a simple ex-ante model, and deals with a high fraction of opaque low-documentation loans. These findings hold over the entire sample period, not just for deal cohorts most affected by the crisis.
    Keywords: Credit Rating Agencies;Subprime Crisis;Mortgage-Backed Securities
    JEL: G21 G24
    Date: 2010
  8. By: Ojo, Marianne
    Abstract: As well as highlighting the importance of introducing counter cyclical capital buffers, this paper draws attention to the need for greater focus on “more forward looking provisions”, as well as provisions which are aimed at addressing losses and unforeseen problems attributed to “maturity transformation of short-term deposits into long term loans.” Whilst the need for forward looking provisioning has been echoed by some authorities on the literature, the paper also adds weight to the argument through its attempt to link such an argument to the ever increasing prominence assumed by liquidity risks – since liquidity also contributes to pro cyclicality. “The complex response of financial institutions to deteriorating market conditions - which to a large extent, is attributed to liquidity shortfalls which reflected on and off balance sheet maturity mismatches and excessive levels of leverage, has resulted in an increasingly important role for liquidity provided by central banks in the funding of bank balance sheets.” Owing to such increased importance of liquidity risks, this paper also attempts to highlight why the Basel Committee’s Counter Cyclical Buffer Proposal – a response to the recent financial crisis (which to a significant extent, focuses on banking sector capital requirements), should also take greater account of more forward looking provisions. In so doing, it draws attention to the importance of coupling forward looking provisions (as well as other measures) with counter cyclical charges and why this provides a better alternative to the mere introduction of counter cyclical capital charges.
    Keywords: counter cyclical buffers; liquidity risks; pro cyclicality; capital; loan loss provisions; financial crises; bank; regulation
    JEL: D53 K2 E32
    Date: 2010–08–27
  9. By: Charles Adams (Asian Development Bank Institute)
    Abstract: This paper reviews recent state interventions in financial crises and draws lessons for crisis management. A number of areas are identified where crisis management could be strengthened, including with regard to the tools and instruments used to involve the private sector in crisis resolution (with a view to reducing the recent enhanced role of official bailouts and the associated moral hazard), to allow for the orderly resolution of systemically important financial firms (to make these firms “safe to fail”), and with regard to achieving better integration with ex ante macroprudential surveillance. The paper proposes the establishment of high level systemic risk councils (SRCs) in each country with responsibility for overseeing systemic risk in both tranquil times and crisis periods and coordinating the activities of key government ministries, agencies, and the central bank.
    Keywords: financial crisis, crisis management, private sector, moral hazard, systemic risk councils
    JEL: E58 E01
    Date: 2010
  10. By: Traeger, Christian P.
    Abstract: The paper introduces a new notion of risk aversion that is independent of the good under observation and its measure scale. The representational framework builds on a time consistent combination of additive separability on certain consumption paths and the von Neumann & Morgenstern (1944) assumptions. In the one-commodity special case, the new notion of risk aversion closely relates to a disentanglement of standard risk aversion and intertemporal substitutability.
    Keywords: uncertainty, expected utility, recursive utility, risk aversion, intertemporal substitutability, certainty additivity, temporal lotteries, gauge-freedom, intertemporal risk aversion
    Date: 2010–05–01
  11. By: Bent Jesper Christensen (Aarhus University, School of Economics and Management, Bartholins Allé 10, Aarhus, Denmark & CREATES); Petra Posedel (University of Zagreb)
    Abstract: We study the risk premium and leverage effect in the S&P500 market using the stochastic volatility-in-mean model of Barndor¤-Nielsen & Shephard (2001). The Merton (1973, 1980) equilibrium asset pricing condition linking the conditional mean and conditional variance of discrete time returns is reinterpreted in terms of the continuous time model. Tests are per- formed on the risk-return relation, the leverage effect, and the overidentifying zero intercept restriction in the Merton condition. Results are compared across alternative volatility proxies, in particular, realized volatility from high-frequency (5-minute) returns, implied Black-Scholes volatility backed out from observed option prices, model-free implied volatility (VIX), and staggered bipower variation. Our results are consistent with a positive risk-return relation and a significant leverage effect, whereas an additional overidentifying zero intercept condition is rejected. We also show that these inferences are sensitive to the exact timing of the chosen volatility proxy. Robustness of the conclusions is verified in bootstrap experiments.
    Keywords: Financial leverage effect, implied volatility, realized volatility, risk-return relation, stochastic volatility, VIX
    JEL: G13 L12
    Date: 2010–09–01
  12. By: Masaaki Fukasawa
    Abstract: We study specific nonlinear transformations of the Black-Scholes implied volatility to show remarkable properties of the volatility surface. Model-free bounds on the implied volatility skew are given. Pricing formulas for the European options which are written in terms of the implied volatility are given. In particular, we prove elegant formulas for the fair strikes of the variance swap and the gamma swap.
    Date: 2010–08
  13. By: Claudio Borio (Bank for International Settlements); Bent Vale (Norges Bank (Central Bank of Norway)); Goetz von Peter (Bank for International Settlements)
    Abstract: How does the management and resolution of the current crisis compare with the response of the Nordic countries in the early 1990s, widely regarded as exemplary? We argue that, while intervention has been prompter, the measures taken so far remain less comprehensive and in-depth. In particular, the cleansing of balance sheets has proceeded more slowly, and less attention has been paid to reducing excess capacity and avoiding competitive distortions. In general, policymakers have given higher priority to sustaining aggregate demand in the short term than to encouraging adjustment in the financial sector and containing moral hazard. We argue that three factors largely explain this outcome: the more international nature of the crisis; the complexity of the instruments involved; and, hardly appreciated so far, the effect of accounting practices on the dynamics of the events, reflecting in particular the prominent role of fair value accounting (and mark to market losses) in relation to amortised cost accounting for loan books. There is a risk that the policies followed so far may delay the establishment of the basis for a sustainably profitable and less risk-prone financial sector.
    Keywords: Crisis management and resolution, principles for successful resolution, Nordic countries, fair value and amortised cost accounting, mark to market losses
    JEL: G21 G28
    Date: 2010–08–31

General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.