nep-rmg New Economics Papers
on Risk Management
Issue of 2011‒04‒02
eleven papers chosen by
Stan Miles
Thompson Rivers University

  1. Risk Management of Precious Metals By Shawkat Hammoudeh; Farooq Malik; Michael McAleer
  2. An Empirical Analysis of Dynamic Multiscale Hedging using Wavelet Decomposition By Thomas Conlon; John Cotter
  3. Regulation, Credit Risk Transfer, and Bank Lending By Thilo Pausch; Peter Welzel
  5. About the Impact of Model Risk on Capital Reserves: A Quantitative Analysis. By Bertram, Philip; Sibbertsen, Philipp; Stahl, Gerhard
  6. BASEL III: Long-term impact on economic performance and fluctuations By Angelini, P.; Clerc, L.; Cúrdia, V.; Gambacorta, L.; Gerali, A.; Locarno, A.; Motto, R.; Roeger, W.; Van den Heuvel, S.; Vlcek, J.
  7. Size Value and Asset Quality Premium in European Banking Stocks By Nawazish Mirza; Herve Alexandre
  8. Loan-to-Value Ratio as a Macro-Prudential Tool - Hong Kong's Experience and Cross-Country Evidence By Eric Wong; Ka-fai Li; Henry Choi
  9. What Happens After Default? Stylized Facts on Access to Credit By Diana Bonfim; Daniel Dias; Christine Richmond
  10. Stochastic evolution equations in portfolio credit modelling By Nick Bush; Ben M. Hambly; Helen Haworth; Lei Jin; Christoph Reisinger
  11. Model Based Monte Carlo Pricing of Energy and Temperature Quanto Options By Massimiliano Caporin; Juliusz Pres'; Hipolit Torro

  1. By: Shawkat Hammoudeh (Department of Economics & International Business, LeBow College of Business, Drexel University); Farooq Malik (College of Business University of Southern Mississippi); Michael McAleer (Econometrisch Instituut (Econometric Institute), Faculteit der Economische Wetenschappen (Erasmus School of Economics) Erasmus Universiteit, Tinbergen Instituut (Tinbergen Institute).)
    Abstract: This paper examines volatility and correlation dynamics in price returns of gold, silver, platinum and palladium, and explores the corresponding risk management implications for market risk and hedging. Value-at-Risk (VaR) is used to analyze the downside market risk associated with investments in precious metals, and to design optimal risk management strategies. We compute the VaR for major precious metals using the calibrated RiskMetrics, different GARCH models, and the semi-parametric Filtered Historical Simulation approach. The best approach for estimating VaR based on conditional and unconditional statistical tests is documented. The economic importance of the results is highlighted by assessing the daily capital charges from the estimated VaRs.
    Keywords: Precious metals, conditional volatility, risk management, value-at-risk.
    JEL: G1
    Date: 2011
  2. By: Thomas Conlon; John Cotter
    Abstract: This paper investigates the hedging effectiveness of a dynamic moving window OLS hedging model, formed using wavelet decomposed time-series. The wavelet transform is applied to calculate the appropriate dynamic minimum-variance hedge ratio for various hedging horizons for a number of assets. The effectiveness of the dynamic multiscale hedging strategy is then tested, both in- and out-of-sample, using standard variance reduction and expanded to include a downside risk metric, the time horizon dependent Value-at-Risk. Measured using variance reduction, the effectiveness converges to one at longer scales, while a measure of VaR reduction indicates a portion of residual risk remains at all scales. Analysis of the hedge portfolio distributions indicate that this unhedged tail risk is related to excess portfolio kurtosis found at all scales.
    Date: 2011–03
  3. By: Thilo Pausch (Deutsche Bundesbank Frankfurt); Peter Welzel (University of Augsburg, Department of Economics)
    Abstract: We integrate Basel II (and III) regulations into the industrial organization approach to banking and analyze lending behavior and risk sensitivity of a risk-neutral bank. The bank is exposed to credit risk and may use credit default swaps (CDS) for hedging purposes. Regulation is found to induce the risk-neutral bank to behave in a more risk-sensitive way: Compared to a situation without regulation the optimal volume of loans decreases more as the riskiness of loans increases. CDS trading is found to interact with the former effect when regulation accepts CDS as an instrument to mitigate credit risk. Under the Substitution Approach in Basel II (and III) a risk-neutral bank will over-, fully or under-hedge its total exposure to credit risk conditional on the CDS price being downward biased, unbiased or upward biased. This interaction promotes the intention of the Basel II (and III) regulations to “strengthen the soundness and stability of banks”, since capital adequacy regulation without accounting for the risk-mitigating effect of CDS trading would stimulate a risk-neutral bank to take more extreme positions in the CDS market.
    Keywords: banking, regulation, credit risk
    JEL: G21 G28
    Date: 2011–02
  4. By: Rafael Repullo (CEMFI, Centro de Estudios Monetarios y Financieros); Jesús Saurina (Banco de España)
    Abstract: We provide a critical assessment of the countercyclical capital buffer in the new regulatory framework known as Basel III, which is based on the deviation of the credit-to-GDP ratio with respect to its trend. We argue that a mechanical application of the buffer would tend to reduce capital requirements when GDP growth is high and increase them when GDP growth is low, so it may end up exacerbating the inherent pro-cyclicality of risk-sensitive bank capital regulation. We also note that Basel III does not address pro-cyclicality in any other way. We propose a fully rule-based smoothing of minimum capital requirements based on GDP growth.
    Keywords: Bank capital regulation, Basel III, Pro-cyclicality, Business cycles, Credit crunch.
    JEL: E32 G28
    Date: 2011–03
  5. By: Bertram, Philip; Sibbertsen, Philipp; Stahl, Gerhard
    Abstract: This paper analyzes and quantifies the idea of model risk in the environment of internal model building. We define various types of model risk including estimation risk, model risk in distribution and model risk in functional form. By the quantification of these concepts we analyze the impact of the modeling process of an econometric model on the resulting company model. Utilizing real insurance data we specify, estimate and simulate various linear and nonlinear time series models for the inflation rate and examine its impact on pension liabilities under the aspect of model risk. Under consideration of different risk measures it is shown that model risk can differ profoundly due to the specification process of the econometric model resulting in remarkable monetary differences concerning capital reserves. We furthermore propose a specification strategy for univariate time series models and demonstrate that thereby market risk and capital reserves can be reduced distinctively.
    Keywords: Model risk, Estimation risk, Misspecification risk, Basel multiplication factor, Empirical model specification, Capital reserves
    JEL: G12 G18
    Date: 2011–03
  6. By: Angelini, P.; Clerc, L.; Cúrdia, V.; Gambacorta, L.; Gerali, A.; Locarno, A.; Motto, R.; Roeger, W.; Van den Heuvel, S.; Vlcek, J.
    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, analysed in Basel Committee on Banking Supervision (BCBS, 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 sizeable dampening effect on output volatility. These conclusions are fully consistent with those of the reports by the Long-term Economic Impact group (BCBS, 2010b) and Macro Assessment Group (MAG, 2010b).
    Keywords: Basel III, countercyclical capital buffers, financial (in)stability, procyclicality, macroprudential policy.
    JEL: E44 E61 G21
    Date: 2011
  7. By: Nawazish Mirza (CREB - Centre for Research in Economics and Business - Lahore School of Economics - Lahore School of Economics); Herve Alexandre (DRM - Dauphine Recherches en Management - CNRS : UMR7088 - Université Paris Dauphine - Paris IX)
    Abstract: Banking firms exhibit unique business and financial dynamics that are priced in their stock returns. This paper compares traditional empirical asset pricing models on portfolio of banking firms from fourteen European countries and proposes a banking specific risk factor. We compared a single factor CAPM with three factors Fama and French model on exchange rate adjusted returns and found substantial support for firm specific factors of size and value. We propose that asset quality premium (proportion of non-performing loans to total advances and measured as BMG - bad minus good) constitutes an important asset pricing factor for banking stocks. The portfolios sorted on size, value and asset quality explained the maximum variation in returns depicting asset quality as a critical investment factor for banking stocks. These results have considerable implications for investment appraisals, cost of capital and risk management in financial stocks.
    Keywords: Banking Stocks, Asset Quality, Size Premiuim, Value Premium, factor model
    Date: 2010–07–07
  8. By: Eric Wong (Research Department, Hong Kong Monetary Authority); Ka-fai Li (Research Department, Hong Kong Monetary Authority); Henry Choi (Research Department, Hong Kong Monetary Authority)
    Abstract: This study assesses the effectiveness and drawbacks of maximum loan-to-value (LTV) ratios as a macroprudential tool based on Hong Kong¡¦s experience and econometric analyses of panel data from 13 economies. The tool is found to be effective in reducing systemic risk stemming from the boom-and-bust cycle of property markets. Although the tool could impose higher liquidity constraints on homebuyers, empirical evidence shows that mortgage insurance programmes (MIPs) that protect lenders from credit losses on the portion of loans over maximum LTV thresholds can mitigate this drawback without undermining the effectiveness of the tool. This finding indicates the important role of MIPs in enhancing the net benefits of LTV policy. Our estimations also show that the dampening effect of LTV policy on household leverage is more apparent than its effect on property market activities, suggesting that the policy effect may mainly manifest in impacts on household sector leverage.
    Keywords: systemic risk, macroprudential policy, loan-to-value ratio, Hong Kong
    JEL: G21 G28
    Date: 2011–02
  9. By: Diana Bonfim; Daniel Dias; Christine Richmond
    Abstract: In this paper we investigate what happens to firms after they default on their bank loans. We approach this question by establishing a set of stylized facts concerning the evolution of default and its resolution, focusing on access to credit after default. Using a unique dataset from Portugal, we observe that half of the default episodes last 5 quarters or less and that larger firms have shorter default periods. Most firms continue to have access to credit immediately after default, though only a minority has access to new loans. Firms have more difficulties in regaining access to credit if they are small, if their default was long and severe, if they borrow from only one bank or if they default with their main lender. Further, half of the defaulting firms record another default in the future. We observe that firms with repeated defaults are, on average, smaller and have experienced longer and more severe defaults.
    JEL: C41 G21 G32 G33
    Date: 2011
  10. By: Nick Bush; Ben M. Hambly; Helen Haworth; Lei Jin; Christoph Reisinger
    Abstract: We consider a structural credit model for a large portfolio of credit risky assets where the correlation is due to a market factor. By considering the large portfolio limit of this system we show the existence of a density process for the asset values. This density evolves according to a stochastic partial differential equation and we establish existence and uniqueness for the solution taking values in a suitable function space. The loss function of the portfolio is then a function of the evolution of this density at the default boundary. We develop numerical methods for pricing and calibration of the model to credit indices and consider its performance pre and post credit crunch.
    Date: 2011–03
  11. By: Massimiliano Caporin (Università di Padova); Juliusz Pres' (West Pomeranian University of Technology); Hipolit Torro (Universitat de València)
    Abstract: Weather derivatives have become very popular tools in weather risk management in recent years. One of the elements supporting their diffusion has been the increase in volatility observed on many energy markets. Among the several available contracts, Quanto options are now becoming very popular for a simple reason: they take into account the strong correlation between energy consumption and certain weather conditions, so enabling price and weather risk to be controlled at the same time. These products are more efficient and, in many cases, significantly cheaper than simpler plain vanilla options. Unfortunately, the specific features of energy and weather time series do not enable the use of analytical formulae based on the Black-Scholes pricing approach, nor other more advanced continuous time methods that extend the Black-Scholes approach, unless under strong and unrealistic assumptions. In this study, we propose a Monte Carlo pricing framework based on a bivariate time series model. Our approach takes into account the average and variance interdependence between temperature and energy price series. Furthermore, our approach includes other relevant empirical features, such as periodic patterns in average, variance, and correlations. The model structure enables a more appropriate pricing of Quanto options compared to traditional methods.
    Keywords: weather derivatives, Quanto options pricing, derivative pricing, model simulation and forecast.
    JEL: C32 C51 C53
    Date: 2010–12

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