nep-rmg New Economics Papers
on Risk Management
Issue of 2011‒03‒26
ten papers chosen by
Stan Miles
Thompson Rivers University

  1. Risk Management of Risk under the Basel Accord: Forecasting Value-at-Risk of VIX Futures By Chia-Lin Chang; Juan-Ángel Jiménez-Martín; Michael McAleer; Teodosio Pérez-Amaral
  2. Dynamic hedging of portfolio credit derivatives By Rama Cont; Yu Hang Kan
  3. Capital Regulation and Tail Risk By Enrico Perotti; Lev Ratnovski; Razvan Vlahu
  4. Modelling credit risk for innovative firms: the role of innovation measures By Chiara Pederzoli; Grid Thoma; Costanza Torricelli
  5. BASEL III: long-term impact on economic performance and fluctuations By Paolo Angelini; Laurent Clerc; Vasco Cúrdia; Leonardo Gambacorta; Andrea Gerali; Alberto Locarno; Roberto Motto; Werner Roeger; Skander Van den Heuvel; Jan Vlcek
  6. Observation Driven Mixed-Measurement Dynamic Factor Models with an Application to Credit Risk By Drew Creal; Bernd Schwaab; Siem Jan Koopman; Andre Lucas
  7. Unobservable savings, risk sharing and default in the financial system By Panetti, Ettore
  8. Disentangling the Enteprise Book-to-Price and Leverage Effects in Stock Returns By Skogsvik, Kenth; Skogsvik, Stina; Thorsell, Håkan
  9. Theory of financial risk By Estrada, Fernando
  10. Mapping systemic risk in the international banking network By Garratt, Rodney; Mahadeva, Lavan; Svirydzenka, Katsiaryna

  1. By: Chia-Lin Chang (Department of Applied Economics, Department of Finance, National Chung Hsing University); Juan-Ángel Jiménez-Martín (Department of Quantitative Economics, Complutense University of Madrid); Michael McAleer (Erasmus University Rotterdam, Tinbergen Institute, The Netherlands, and Institute of Economic Research, Kyoto University); Teodosio Pérez-Amaral (Department of Quantitative Economics, Complutense University of Madrid)
    Abstract: The Basel II Accord requires that banks and other Authorized Deposit-taking Institutions (ADIs) communicate their daily risk forecasts to the appropriate monetary authorities at the beginning of each trading day, using one or more risk models to measure Value-at-Risk (VaR). The risk estimates of these models are used to determine capital requirements and associated capital costs of ADIs, depending in part on the number of previous violations, whereby realised losses exceed the estimated VaR. McAleer, Jimenez-Martin and Perez- Amaral (2009) proposed a new approach to model selection for predicting VaR, consisting of combining alternative risk models, and comparing conservative and aggressive strategies for choosing between VaR models. This paper addresses the question of risk management of risk, namely VaR of VIX futures prices. We examine how different risk management strategies performed during the 2008-09 global financial crisis (GFC). We find that an aggressive strategy of choosing the Supremum of the single model forecasts is preferred to the other alternatives, and is robust during the GFC. However, this strategy implies relatively high numbers of violations and accumulated losses, though these are admissible under the Basel II Accord.
    Keywords: Median strategy, Value-at-Risk (VaR), daily capital charges, violation penalties, optimizing strategy, aggressive risk management, conservative risk management, Basel II Accord, VIX futures, global financial crisis (GFC).
    JEL: G32 G11 C53 C22
    Date: 2011–03
  2. By: Rama Cont (PMA - Laboratoire de Probabilités et Modèles Aléatoires - CNRS : UMR7599 - Université Pierre et Marie Curie - Paris VI - Université Paris-Diderot - Paris VII); Yu Hang Kan (Center for Financial Engineering, Columbia University - Columbia University)
    Abstract: We compare the performance of various hedging strategies for index collateralized debt obligation (CDO) tranches across a variety of models and hedging methods during the recent credit crisis. Our empirical analysis shows evidence for market incompleteness: a large proportion of risk in the CDO tranches appears to be unhedgeable. We also show that, unlike what is commonly assumed, dynamic models do not necessarily perform better than static models, nor do high-dimensional bottom-up models perform better than simpler top-down models. When it comes to hedging, top-down and regression-based hedging with the index provide significantly better results during the credit crisis than bottom-up hedging with single-name credit default swap (CDS) contracts. Our empirical study also reveals that while significantly large moves—“jumps”—do occur in CDS, index, and tranche spreads, these jumps do not necessarily occur on the default dates of index constituents, an observation which shows the insufficiency of some recently proposed portfolio credit risk models.
    Keywords: hedging, credit default swaps, portfolio credit derivatives, index default swaps, collateralized debt obligations, portfolio credit risk models, default contagion, spread risk, sensitivity-based hedging, variance minimization
    Date: 2011–02–01
  3. By: Enrico Perotti (University of Amsterdam, Duisenberg school of finance, and CEPR); Lev Ratnovski (International Monetary Fund); Razvan Vlahu (Dutch Central Bank)
    Abstract: The paper studies risk mitigation associated with capital regulation, in a context when banks may choose tail risk assets. We show that this undermines the traditional result that higher capital reduces excess risk-taking driven by limited liability. When capital raising is costly, poorly capitalized banks may limit risk to avoid breaching the minimal capital ratio. A bank with higher capital has less
    Keywords: Bank Regulation; Risk Shifting; Capital Requirements; Tail Risk; Systemic Risk
    JEL: E6 F3 F4 G2 G3 O16
    Date: 2011–02–17
  4. By: Chiara Pederzoli; Grid Thoma; Costanza Torricelli
    Abstract: Financial constraints are particularly severe for R&D projects of SMEs, which cannot generally rely on equity markets and, in the EU, on a sufficiently developed VC industry. If innovative SMEs have to depend on banks to finance their R&D projects, it is particularly important to develop models able to estimate their probability of default (PD) in consideration of their peculiar features. Based on the signaling value of some innovative assets, the purpose of this paper is to show the importance to include them into models which have proved to be successful for SMEs. To this end, we take a logit model and test it on a unique dataset of innovative SMEs (based on PATSTAT database, EPO BULLETIN and AMADEUS) to estimate a two-year PD with default years 2006-2008. In the regression analysis the innovation-related variables are two in order to account for R&D productivity at the level of the firm and to consider the value of the inventive output. Our analyses first address measurement issues concerning innovation-related variable and then show that, while the accounting variables and the patent value are always significant with the expected sign, the patent number per se reduces the PD only in the presence of an appropriate equity level.
    Keywords: innovative SMEs; default probability; patent value
    JEL: G21 G32 C25 O31 O34
    Date: 2011–03
  5. By: Paolo Angelini; Laurent Clerc; Vasco Cúrdia; Leonardo Gambacorta; Andrea Gerali; Alberto Locarno; Roberto Motto; Werner Roeger; Skander Van den Heuvel; Jan Vlcek
    Abstract: We assess the long-term economic impact of the new regulatory standards (the Basel III reform), answering the following questions: 1) What is the impact of the reform on long-term economic performance? 2) What is the impact of the reform on economic fluctuations? 3) What is the impact of the adoption of countercyclical capital buffers on economic fluctuations? The main results are the following: 1) Each percentage point increase in the capital ratio causes a median 0.09 percent decline in the level of steady-state output, relative to the baseline. The impact of the new liquidity regulation is of a similar order of magnitude, at 0.08 percent. This paper does not estimate the benefits of the new regulation in terms of reduced frequency and severity of financial crisis, analyzed in Basel Committee on Banking Supervision (2010b). 2) The reform should dampen output volatility; the magnitude of the effect is heterogeneous across models; the median effect is modest. 3) The adoption of countercyclical capital buffers could have a more sizable dampening effect on output volatility.
    Keywords: Basel capital accord ; Business cycles ; Economic conditions ; Bank supervision ; Bank capital
    Date: 2011
  6. By: Drew Creal (University of Chicago, Booth School of Business); Bernd Schwaab (European Central Bank); Siem Jan Koopman (VU University Amsterdam); Andre Lucas (VU University Amsterdam)
    Abstract: We propose a dynamic factor model for mixed-measurement and mixed-frequency panel data. In this framework time series observations may come from a range of families of parametric distributions, may be observed at different time frequencies, may have missing observations, and may exhibit common dynamics and cross-sectional dependence due to shared exposure to dynamic latent factors. The distinguishing feature of our model is that the likelihood function is known in closed form and need not be obtained by means of simulation, thus enabling straightforward parameter estimation by standard maximum likelihood. We use the new mixed-measurement framework for the signal extraction and forecasting of macro, credit, and loss given default risk conditions for U.S. Moody's-rated firms from January 1982 until March 2010.
    Keywords: panel data; loss given default; default risk; dynamic beta density; dynamic ordered probit; dynamic factor model
    JEL: C32 G32
    Date: 2011–02–21
  7. By: Panetti, Ettore
    Abstract: In the present paper, I analyze how unobservable savings affect risk sharing and bankruptcy decisions in the financial system. I extend the Diamond and Dybvig (1983) model of financial intermediation to an environment with heterogeneous intermediaries, aggregate uncertainty and agents' hidden borrowing and lending. I demonstrate three results. First, unobservability imposes a burden on financial intermediaries, that in equilibrium are not able to offer a banking contract that balances insurance and incentive motivations. Second, unobservable markets do induce default, but only as long as insurance markets are incomplete. Therefore, their presence is not a rationale for government intervention on bankruptcy via "resolution regimes". Third, even in case of complete markets the competitive equilibrium is inefficient, and a simple tier-1 capital ratio similar to the one proposed in the Basel III Accord implements the efficient allocation.
    Keywords: financial intermediation; hidden savings; bankruptcy; insurance; optimal regulation
    JEL: E44 G28 G21
    Date: 2011–02–10
  8. By: Skogsvik, Kenth (Dept. of Business Administration, Stockholm School of Economics); Skogsvik, Stina (Dept. of Business Administration, Stockholm School of Economics); Thorsell, Håkan (Dept. of Business Administration, Stockholm School of Economics)
    Abstract: Despite the propositions in Miller and Modigliani (1958) and (1963), claims of a puzzling negative empirical relationship between stock returns and financial leverage have been made in Penman et al. (2007). Based on the leverage formula of Miller and Modigliani, we take account of a twofold effect of leverage on stock returns – a compounding operating risk effect and a negative interest cost effect. The first effect is captured by multiplying the firm’s operating risk by its leverage. Using a large U.S. sample, stock returns have been regressed on variables representing the operating covariance risk premium, leverage and the compounding operating covariance risk. The results show that there is a positive coefficient associated with the operating covariance risk premium and the corresponding compounding operating risk variable. There is also a negative coefficient associated with leverage, presumably mirroring the negative interest cost of debt. The results also hold for the accounting-based indicator of operating risk – the enterprise book-to-price ratio – suggested in Penman et al. (2007). The observed negative coefficient of leverage hence appears to be due to the omission of the compounding operating risk effect of leverage. Additional analyses show that the enterprise book-to-price ratio potentially represents two characteristics of operating risk – the operating covariance risk and a novel risk factor representing the assessment of the firm’s competitive advantage.
    Keywords: financial risk; leverage; operating risk; book-to-market; enterprise book-to-price
    Date: 2011–03–04
  9. By: Estrada, Fernando
    Abstract: This paper examines relationships between theory of financial risk and size. Based on the work of Makridakis / Taleb [2009] and Taleb / Tapiero [2009], presents the problems of excessive risk and imbalances caused by the size of firms. Markets mixed on firm growth traps externalities can influence risk, high-cost for the commons. A policy of regulation and control in markets, while necessary, are still insufficient in economies with little institutional support. Externalities of risk and firm size categories are fundamental to understanding the present financial crisis since the economies of scale.
    Keywords: Finance; financial engineering; risk assesment.
    JEL: G1 B0 Z1 B4 G3 G15 G38 G28 G32 G10 G0 B41
    Date: 2011–03–17
  10. By: Garratt, Rodney (University of California); Mahadeva, Lavan (Bank of England); Svirydzenka, Katsiaryna (Graduate Institute, Geneva)
    Abstract: Systemic risk among the network of international banking groups arises when financial stress threatens to criss-cross many national boundaries and expose imperfect international co-ordination. To assess this risk, we apply an information theoretic map equation due to Martin Rosvall and Carl Bergstrom to partition banking groups from 21 countries into modules. The resulting modular structure reflects the flow of financial stress through the network, combining nodes that are most closely related in terms of the transmission of stress. The modular structure of the international banking network has changed dramatically over the past three decades. In the late 1980s four important financial centres formed one large supercluster that was highly contagious in terms of transmission of stress within its ranks, but less contagious on a global scale. Since then the most influential modules have become significantly smaller and more broadly contagious. The analysis contributes to our understanding as to why defaults in US sub-prime mortgages had such large global implications.
    Keywords: Networks; international banking groups; systemic risk; information theory.
    JEL: F20 F30
    Date: 2011–03–02

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