New Economics Papers
on Risk Management
Issue of 2010‒09‒18
fifteen papers chosen by

  1. Understanding the Effect of Concentration Risk in the Banks’ Credit Portfolio: Indian Cases By Bandyopadhyay, Arindam
  2. It Pays to Violate: How Effective are the Basel Accord Penalties? By Bernardo da Veiga; Felix Chan; Michael McAleer
  3. The CFO’s Information Challenge in Managing Macroeconomic Risk By Oxelheim, Lars; Wihlborg, Clas; Thorsheim, Marcus
  4. Collateral Posting and Choice of Collateral Currency -Implications for Derivative Pricing and Risk Management- By Masaaki Fujii; Yasufumi Shimada; Akihiko Takahashi
  5. The Credit Default Swap Market and the Settlement of Large Defaults By Virginie Coudert; Mathieu Gex
  6. Using Dynamic Copulae for Modeling Dependency in Currency Denominations of a Diversifed World Stock Index By Katja Ignatieva; Eckhard Platen; Renata Rendek
  7. Optimal Dividend and reinsurance strategy of a Property Insurance Company under Catastrophe Risk By Zongxia Liang; Lin He; Jiaoling Wu
  8. Measures aimed at enhancing the loss absorbency of regulatory capital at the point of non viability By Ojo, Marianne
  9. Realized Volatility Risk ( Revised in January 2010 ) By David E. Allen; Michael McAleer; Marcel Scharth
  10. Conditional Correlations and Volatility Spillovers Between Crude Oil and Stock Index Returns By Roengchai Tansuchat; Chia-Lin Chang; Michael McAleer
  11. Gold and Financial Assets: Are There Any Safe Havens in Bear Markets? By Virginie Coudert; Helene Raymond
  12. Hidden Regular Variation: Detection and Estimation By Abhimanyu Mitra; Sidney I. Resnick
  13. The joint distribution of stock returns is not elliptical By R\'emy Chicheportiche; Jean-Philippe Bouchaud
  14. Isobars and the Efficient Market Hypothesis By Kristýna Ivanková
  15. A Cholesky-MIDAS model for predicting stock portfolio volatility By Ralf Becker; Adam Clements; Robert O'Neill

  1. By: Bandyopadhyay, Arindam
    Abstract: Credit Concentration Risk has been the specific cause of many occurrences of financial distress of banks world wide. This paper analyzes the credit portfolio composition of a large and medium sized leading public sector Bank in India to understand the nature and dimensions of credit concentration risk and measure its impact on bank capital from different angles. In evaluating the bank wide measures in managing concentration risk, we demonstrate how economic capital approach may enable the bank to assess the impact of regional, industry and individual concentration. We also show how portfolio selection can be done through correlation, stress tests, marginal risk contribution vis-à-vis risk adjusted return that will enable the top management to manage portfolio concentration risk and accordingly plan its capital.
    Keywords: Credit Concentration; Portfolio Risk; Bank’s Economic Capital
    JEL: G18 G32 G21
    Date: 2010–07
  2. By: Bernardo da Veiga (School of Economics and Finance,); Felix Chan (School of Economics and Finance,); Michael McAleer (Econometric Institute, Erasmus School)
    Abstract: The internal models amendment to the Basel Accord allows banks to use internal models to forecast Value-at-Risk (VaR) thresholds, which are used to calculate the required capital that banks must hold in reserve as a protection against negative changes in the value of their trading portfolios. As capital reserves lead to an opportunity cost to banks, it is likely that banks could be tempted to use models that underpredict risk, and hence lead to low capital charges. In order to avoid this problem the Basel Accord introduced a backtesting procedure, whereby banks using models that led to excessive violations are penalised through higher capital charges. This paper investigates the performance of five popular volatility models that can be used to forecast VaR thresholds under a variety of distributional assumptions. The results suggest that, within the current constraints and the penalty structure of the Basel Accord, the lowest capital charges arise when using models that lead to excessive violations, thereby suggesting the current penalty structure is not severe enough to control risk management. In addition, an alternative penalty structure is suggested to be more effective in aligning the interests of banks and regulators.
    Date: 2009–10
  3. By: Oxelheim, Lars (Research Institute of Industrial Economics (IFN)); Wihlborg, Clas (Argyros School of Business); Thorsheim, Marcus (Lund Institute of Economic Research)
    Abstract: In this chapter we examine the role of the CFO in setting risk management strategy with respect to macroeconomic risk, in particular, and we consider the information requirements for setting a strategy that is consistent with corporate objectives. We argue that macroeconomic risk management requires a broad approach encompassing financial, operational and strategic considerations. Furthermore, several interdependent sources of risk in the macroeconomic environment must be taken into account. Once this interdependence among, for example, exchange rates, interest rates and inflation are taken into account macroeconomic risk management can be considered a relatively self-contained aspect of Integrated Risk Management (IRM) provided relevant information is available to management. Financial risk management cannot be considered a self-contained part of macroeconomic risk management, however, since value increasing investments in flexibility of business operations affect corporate exposure and make it uncertain.
    Keywords: Risk Management Strategy; Macroeconomic Risk; Integrated Risk Management; Chief Financial Officer; Information Needs; Corporate Strategy; Financial Risk; Real Options
    JEL: F23 G32 G34 M21
    Date: 2010–08–20
  4. By: Masaaki Fujii (Graduate School of Economics, University of Tokyo); Yasufumi Shimada (Capital Markets Division, Shinsei Bank, Limited); Akihiko Takahashi (Faculty of Economics, University of Tokyo)
    Abstract: In recent years, we have observed the dramatic increase of the use of collateral as an important credit risk mitigation tool. It has become even rare to make a contract without collateral agreement among the major financial institutions. In addition to the significant reduction of the counterparty exposure, collateralization has important implications for the pricing of derivatives through the change of effective funding cost. This paper has demonstrated the impact of collateralization on the derivative pricing by constructing the term structure of swap rates based on the actual market data. It has also shown the importance of the ?choice? of collateral currency. Especially, when the contract allows multiple currencies as eligible collateral and free replacement among them, the paper has found that the embedded ?cheapest-to-deliver? option can be quite valuable and significantly change the fair value of a trade. The implications of these findings for market risk management have been also discussed.
    Date: 2010–05
  5. By: Virginie Coudert; Mathieu Gex
    Abstract: The huge positions on the credit default swaps (CDS) have raised concerns about the ability of the market to settle major entities’ defaults. The near-failure of AIG and the bankruptcy of Lehman Brothers in 2008 have revealed the exposure of CDS’s buyers to counterparty risk and hence highlighted the necessity of organizing the market, which triggered a large reform process. First we analyse the vulnerabilities of the market at the bursting of this crisis. Second, to understand its resilience to major credit events, we unravel the auction process implemented to settle defaults, the strategies of buyers and sellers and the links with the bond market. We then study the way it worked for key defaults, such as Lehman Brothers, Washington Mutual, CIT and Thomson, as well as, for the Government Sponsored Enterprises. Third, we discuss the ongoing reforms aimed at strengthening the market resilience.
    Keywords: Credit derivatives; bankruptcy; credit default swap; auction
    JEL: D44 G15 G33
    Date: 2010–08
  6. By: Katja Ignatieva (School of Finance and Economics, University of Technology, Sydney); Eckhard Platen (School of Finance and Economics, University of Technology, Sydney); Renata Rendek (School of Finance and Economics, University of Technology, Sydney)
    Abstract: The aim of this paper is to model the dependencya mong log-returns when security account prices are expressed in units of a well diversified world stock index. The paper uses the equi-weighted index EWI104s, calculated as the average of 104 world industry sector indices. The log-returns of its denominations in different currencies appear to be Student-t distributed with about four degrees of freedom. Motivated by these findings, the dependency in log-returns of currency denominations of the EWI104s is modeled using time-varying copulae, aiming to identify the best fitting copula family. The Student-t copula turns generally out to be superior to e.g. the Gaussian copula, where the dependence structure relates to the multivariate normal distribution. It is shown that merely changing the distributional assumption for the log-returns of the marginals from normal to Student-t leads to a significantly better fit. Furthermore, the Student-t copula with Student-t marginals is able to better capture dependent extreme values than the other models considered. Finally, the paper applies copulae to the estimation of the Value-at-Risk and the expected shortfall of a portfolio, constructed of savings accounts of different currencies. The proposed copula-based approach allows to split market risk into general and specific market risk, as defied in regulatory documents. The paper demonstrates that the approach performs clearly better than the Risk Metrics approach.
    Keywords: diversified world stock index; Student-t distribution; time-varying copula; Value-at-Risk; expected shortfall
    Date: 2010–09–01
  7. By: Zongxia Liang; Lin He; Jiaoling Wu
    Abstract: We consider an optimal control problem of a property insurance company with proportional reinsurance strategy. The insurance business brings in catastrophe risk, such as earthquake and flood. The catastrophe risk could be partly reduced by reinsurance. The management of the company controls the reinsurance rate and dividend payments process to maximize the expected present value of the dividends before bankruptcy. This is the first time to consider the catastrophe risk in property insurance model, which is more realistic. We establish the solution of the problem by the mixed singular-regular control of jump diffusions. We first derive the optimal retention ratio, the optimal dividend payments level, the optimal return function and the optimal control strategy of the property insurance company, then the impacts of the catastrophe risk and key model parameters on the optimal return function and the optimal control strategy of the company are discussed.
    Date: 2010–09
  8. By: Ojo, Marianne
    Abstract: The Basel Committee’s recent consultative document on the “Proposal to Ensure the Loss Absorbency of Regulatory Capital at the Point of Non Viability” sets out a proposal aimed at “enhancing the entry criteria of regulatory capital to ensure that all regulatory capital instruments issued by banks are capable of absorbing losses in the event that a bank is unable to support itself in the private market.” As well as demonstrating its support of the Basel Committee’s statement that a public sector injection of capital should not protect investors from absorbing the loss that they would have incurred (had the public sector not chosen to rescue the bank), this paper also highlights identified measures which have been put forward as means of rescuing failing banks – without taxpayer financing. Furthermore, it highlights why the controlled winding down procedure also constitutes a means whereby losses could still be absorbed in the event that a bank is unable to support itself in the private market.
    Keywords: capital; insolvency; financial crises; moral hazard; Basel III; Investor Compensation Schemes Directive; bail outs; equity; liquidity
    JEL: D53 K2 E58
    Date: 2010–09
  9. By: David E. Allen (School of Accounting, Finance and Economics,); Michael McAleer (Econometric Institute,); Marcel Scharth (VU University Amsterdam)
    Abstract: In this paper we document that realized variation measures constructed from high-frequency returns reveal a large degree of volatility risk in stock and index returns, where we characterize volatility risk by the extent to which forecasting errors in realized volatility are substantive. Even though returns standardized by ex post quadratic variation measures are nearly gaussian, this unpredictability brings considerably more uncertainty to the empirically relevant ex ante distribution of returns. Carefully modeling this volatility risk is fundamental. We propose a dually asymmetric realized volatility (DARV) model, which incorporates the important fact that realized volatility series are systematically more volatile in high volatility periods. Returns in this framework display time varying volatility, skewness and kurtosis. We provide a detailed account of the empirical advantages of the model using data on the S&P 500 index and eight other indexes and stocks.
    Date: 2009–12
  10. By: Roengchai Tansuchat (Faculty of Economics, Maejo University); Chia-Lin Chang (Department of Applied Economics, National Chung Hsing University); Michael McAleer (Erasmus School of Economics, Erasmus University Rotterdam)
    Abstract: This paper investigates the conditional correlations and volatility spillovers between crude oil returns and stock index returns. Daily returns from 2 January 1998 to 4 November 2009 of the crude oil spot, forward and futures prices from the WTI and Brent markets, and the FTSE100, NYSE, Dow Jones and S&P500 index returns, are analysed using the CCC model of Bollerslev (1990), VARMA-GARCH model of Ling and McAleer (2003), VARMAAGARCH model of McAleer, Hoti and Chan (2008), and DCC model of Engle (2002). Based on the CCC model, the estimates of conditional correlations for returns across markets are very low, and some are not statistically significant, which means the conditional shocks are correlated only in the same market and not across markets. However, the DCC estimates of the conditional correlations are always significant. This result makes it clear that the assumption of constant conditional correlations is not supported empirically. Surprisingly, the empirical results from the VARMA-GARCH and VARMA-AGARCH models provide little evidence of volatility spillovers between the crude oil and financial markets. The evidence of asymmetric effects of negative and positive shocks of equal magnitude on the conditional variances suggests that VARMA-AGARCH is superior to VARMA-GARCH and CCC.
    Date: 2010–01
  11. By: Virginie Coudert; Helene Raymond
    Abstract: This paper looks into the role of gold as a safe haven against stocks during recessions and bear markets. Following Baur and McDermott (2010) and Baur and Lucey (2010), we characterize safe havens by their negative correlations with stocks during crises. We extend their results in three ways. First, we identify crisis periods by exogeneous means using, successively, recession periods provided by the NBER and periods of bear US stock markets. Second, we estimate a model allowing for time varying conditional covariances between gold and stocks returns. Third, we test if long run relationships exist between gold and stocks and explore whether they can be used to construct portfolios immune to crises. The regressions are run on monthly data for gold and several stock market indices (France, Germany, UK, US, G7) over the period 1978:2-2009:1. In the short run, we find that the correlation between gold and stocks is close to zero during recessions, which qualifies gold for being a “weak safe haven”. This is also the case during bear markets against the stock indices of most considered countries, although gold appears as a strong hedge versus the US stock index. A closer look at the data shows that these results only hold on average and not for every crisis episode or every country. In the longer run a negative relationships exists between gold and some stock markets (France, UK, US). However, it does not allow the construction of a hedged portfolio immune to all crises. Overall, despite its interest for the diversification of portfolios, gold stays a risky investment, even during crises.
    Keywords: Gold; stock; safe haven; hedge; nonlinearity
    JEL: G15 F30 F36
    Date: 2010–07
  12. By: Abhimanyu Mitra; Sidney I. Resnick
    Abstract: Hidden regular variation defines a subfamily of distributions satisfying multivariate regular variation on $\mathbb{E} = [0, \infty]^d \backslash \{(0,0, ..., 0) \} $ and models another regular variation on the sub-cone $\mathbb{E}^{(2)} = \mathbb{E} \backslash \cup_{i=1}^d \mathbb{L}_i$, where $\mathbb{L}_i$ is the $i$-th axis. We extend the concept of hidden regular variation to sub-cones of $\mathbb{E}^{(2)}$ as well. We suggest a procedure for detecting the presence of hidden regular variation, and if it exists, propose a method of estimating the limit measure exploiting its semi-parametric structure. We exhibit examples where hidden regular variation yields better estimates of probabilities of risk sets.
    Date: 2010–01
  13. By: R\'emy Chicheportiche; Jean-Philippe Bouchaud
    Abstract: Using a large set of daily US and Japanese stock returns, we test in detail the relevance of Student models, and of more general elliptical models, for describing the joint distribution of returns. We find that while Student copulas provide a good approximation for strongly correlated pairs of stocks, systematic discrepancies appear as the linear correlation between stocks decreases, that rule out all elliptical models. Intuitively, the failure of elliptical models can be traced to the inadequacy of the assumption of a single volatility mode for all stocks. We suggest several ideas of methodological interest to efficiently visualise and compare different copulas. We identify the rescaled difference with the Gaussian copula and the central value of the copula as strongly discriminating observables. We insist on the need to shun away from formal choices of copulas with no financial interpretation.
    Date: 2010–09
  14. By: Kristýna Ivanková (Institute of Economic Studies, Faculty of Social Sciences, Charles University, Prague, Czech Republic)
    Abstract: Isobar surfaces, a method for describing the overall shape of multidimensional data, are estimated by nonparametric regression and used to evaluate the efficiency of selected markets based on returns of their stock market indices.
    Keywords: Isobars, Efficient market hypothesis, Nonparametric regression, Extreme value theory
    JEL: C14 G14
    Date: 2010–09
  15. By: Ralf Becker; Adam Clements; Robert O'Neill
    Abstract: This paper presents a simple forecasting technique for variance covariance matrices. It relies significantly on the contribution of Chiriac and Voev (2010) who propose to forecast elements of the Cholesky decomposition which recombine to form a positive definite forecast for the variance covariance matrix. The method proposed here combines this methodology with advances made in the MIDAS literature to produce a forecasting methodology that is flexible, scales easily with the size of the portfolio and produces superior forecasts in simulation experiments and an empirical application.
    Date: 2010

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