New Economics Papers
on Risk Management
Issue of 2010‒10‒16
nine papers chosen by

  1. Risk-return Efficiency, Financial Distress Risk, and Bank Financial Strength Ratings By Changchun Hua; Li-Gang Liu
  2. An Ordinal Approach to Risk Measurement By Marta Cardin; Miguel Couceiro
  3. Asymmetry and Long Memory in Volatility Modelling By Manabu Asai; Michael McAleer; Marcelo C. Medeiros
  4. The Effects of the Global Crisis on Islamic and Conventional Banks: A Comparative Study By Maher Hasan; Jemma Dridi
  5. Bank Capital and Uncertainty By Fabian Valencia
  6. The emergence and future of central counterparties By Thorsten V. Koeppl; Cyril Monnet
  7. A Cross-Sectional Performance Measure for Portfolio Management By Monica Billio; Ludovic Calès; Dominique Guegan
  8. Insuring student loans against the risk of college failure By Satyajit Chatterjee; Felicia Ionescu
  9. Modeling Financial Crises: A Schematic Approach By John Harvey

  1. By: Changchun Hua; Li-Gang Liu
    Abstract: This paper investigates whether there is any consistency between banks’ financial strength ratings (bank rating) and their risk-return profiles. It is expected that banks with high ratings tend to earn high expected returns for the risks they assume and thereby have a low probability of experiencing financial distress. Bank ratings, a measure of a bank’s intrinsic safety and soundness, should therefore be able to capture the bank’s ability to manage financial distress while achieving risk-return efficiency. We first estimate the expected returns, risks, and financial distress risk proxy (the inverse z-score), then apply the stochastic frontier analysis (SFA) to obtain the risk-return efficiency score for each bank, and finally conduct ordered logit regressions of bank ratings on estimated risks, risk-return efficiency, and the inverse z-score by controlling for other variables related to each bank’s operating environment. We find that banks with a higher efficiency score on average tend to obtain favorable ratings. It appears that rating agencies generally encourage banks to trade expected returns for reduced risks, suggesting that these ratings are generally consistent with banks’ risk-return profiles. [ADBI Working Paper 240]
    Keywords: bank, financial, high ratings, safety, efficiency,
    Date: 2010
  2. By: Marta Cardin (Dept. of Applied Mathematics, University Ca'Foscari of Venice); Miguel Couceiro (Mathematics Research Unit, University of Luxembourg)
    Abstract: In this short note, we aim at a qualitative framework for modeling multivariate risk. To this extent, we consider completely distributive lattices as underlying universes, and make use of lattice functions to formalize the notion of risk measure. Several properties of risk measures are translated into this general setting, and used to provide axiomatic characterizations. Moreover, a notion of quantile of a lattice-valued random variable is proposed, which shown to retain several desirable properties of its real-valued counterpart.
    Keywords: lattice; risk measure; Sugeno integral; quantile.
    JEL: C02 C40
    Date: 2010–09
  3. By: Manabu Asai (Faculty of Economics, Soka University); Michael McAleer (Erasmus University Rotterdam, Tinbergen Institute, The Netherlands, and Institute of Economic Research, Kyoto University); Marcelo C. Medeiros (Department of Economics, Pontifical Catholic University of Rio de Janeiro)
    Abstract: A wide variety of conditional and stochastic variance models has been used to estimate latent volatility (or risk). In this paper, we propose a new long memory asymmetric volatility model which captures more flexible asymmetric patterns as compared with existing models. We extend the new specification to realized volatility by taking account of measurement errors, and use the Efficient Importance Sampling technique to estimate the model. As an empirical example, we apply the new model to the realized volatility of Standard and Poor’s 500 Composite Index to show that the new specification of asymmetry significantly improves the goodness of fit, and that the out-of-sample forecasts and Value-at-Risk (VaR) thresholds are satisfactory. Overall, the results of the out-of-sample forecasts show the adequacy of the new asymmetric and long memory volatility model for the period including the global financial crisis.
    Keywords: Asymmetric volatility, long memory, realized volatility, measurement errors, efficient importance sampling
    Date: 2010–10
  4. By: Maher Hasan; Jemma Dridi
    Abstract: This paper examines the performance of Islamic banks (IBs) and conventional banks (CBs) during the recent global crisis by looking at the impact of the crisis on profitability, credit and asset growth, and external ratings in a group of countries where the two types of banks have significant market share. Our analysis suggests that IBs have been affected differently than CBs. Factors related to IBs‘ business model helped limit the adverse impact on profitability in 2008, while weaknesses in risk management practices in some IBs led to a larger decline in profitability in 2009 compared to CBs. IBs‘ credit and asset growth performed better than did that of CBs in 2008-09, contributing to financial and economic stability. External rating agencies‘ re-assessment of IBs‘ risk was generally more favorable.
    Keywords: Banking systems , Banks , Competition , Credit expansion , Financial assets , Financial crisis , Global Financial Crisis 2008-2009 , Islamic banking , Markets , Profit margins , Risk management ,
    Date: 2010–09–03
  5. By: Fabian Valencia
    Abstract: An important role for bank capital is that of a buffer against unexpected losses. As uncertainty about these losses increases, the theory predicts an increase in the optimal level of bank capital. This paper investigates this implication empirically with U.S. Commercial Banks data and finds statistically significant and robust evidence supporting it. A counterfactual experiment suggests that a decline in uncertainty to the lowest level measured in the sample generates an average reduction in bank capital ratios of slightly over 1 percentage point. However, I also find suggestive evidence that the intensity of this precautionary motive is stronger during recessions. From a policy perspective, these results suggest that the effectiveness of countercyclical capital requirements during bad times will be undermined by banks desire to hold more capital in response to increased uncertainty.
    Keywords: Banking , Banks , Business cycles , Capital , Debt , Economic models , Financial crisis , Financial risk , Global Financial Crisis 2008-2009 , Risk management , United States ,
    Date: 2010–09–09
  6. By: Thorsten V. Koeppl; Cyril Monnet
    Abstract: The authors explain why central counterparties (CCPs) emerged historically. With standardized contracts, it is optimal to insure counterparty risk by clearing those contracts through a CCP that uses novation and mutualization. As netting is not essential for these services, it does not explain why CCPs exist. In over-the-counter markets, as contracts are customized and not fungible, a CCP cannot fully guarantee contract performance. Still, a CCP can help: As bargaining leads to an inefficient allocation of default risk relative to the gains from customization, a transfer scheme is needed. A CCP can implement it by offering partial insurance for customized contracts.
    Keywords: Risk management ; Over-the-counter markets ; Contracts
    Date: 2010
  7. By: Monica Billio (Università Ca' Foscari of Venice - Department of Economics); Ludovic Calès (Università Ca' Foscari of Venice - Department of Economics, CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Panthéon-Sorbonne - Paris I); 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: Sharpe-like ratios have been traditionally used to measure the performances of portfolio managers. However, they are known to suffer major drawbacks. Among them, two are intricate : (1) they are relative to a peer's performance and (2) the best score is generally assumed to correspond to a "good" portfolio allocation, with no guarantee on the goodness of this allocation. Last but no least (3) these measures suffer significant estimation errors leading to the inability to distinguish two managers' performances. In this paper, we propose a cross-sectional measure of portfolio performance dealing with these three issues. First, we define the score of a portfolio over a single period as the percentage of investable portfolios outperformed by this portfolio. This score quantifies the goodness of the allocation remedying drawbacks (1) and (2). The new information brought by the cross-sectionality of this score is then discussed through applications. Secondly, we build a performance index, as the average cross-section score over successive periods, whose estimation partially answers drawback (3). In order to assess its informativeness and using empirical data, we compare its forecasts with those of the Sharpe and Sortino ratios. The results show that our measure is the most robust and informative. It validates the utility of such cross-sectional performance measure.
    Keywords: Performance measure, portfolio management, relative-value strategy, large portfolios, absolute return strategy, multivariate statistics, Generalized hyperbolic Distribution.
    Date: 2010–08
  8. By: Satyajit Chatterjee; Felicia Ionescu
    Abstract: Participants in student loan programs must repay loans in full regardless of whether they complete college. But many students who take out a loan do not earn a degree (the dropout rate among college students is between 33 to 50 percent). The authors examine whether insurance against college-failure risk can be offered, taking into account moral hazard and adverse selection. To do so, they develop a model that accounts for college enrollment, dropout, and completion rates among new high school graduates in the US and use that model to study the feasibility and optimality of offering insurance against college failure risk. The authors find that optimal insurance raises the enrollment rate by 3.5 percent, the fraction acquiring a degree by 3.8 percent and welfare by 2.7 percent. These effects are more pronounced for students with low scholastic ability (the ones with high failure probability).
    Keywords: Student loans ; Risk management ; Education, Higher - Economic aspects ; Insurance
    Date: 2010
  9. By: John Harvey (Department of Economics, Texas Christian University)
    Abstract: John Maynard Keynes’ argued that crises were systemic and that, unless serious reforms were implemented, they would tend to grow in frequency and severity. The paper sets out to build a Keynes-style model of crises that captures both the unique characteristics of each type and their common roots. A schematic method is employed that traces the processes in time and shows how events become interrelated and mutually causal. This permits us, as much as possible, to see everything at once, a necessity when the build up to a crisis may manifest itself in so many places
    Keywords: financial crisis, Keynes, Minsky
    JEL: E12 E32
    Date: 2010–01

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