nep-rmg New Economics Papers
on Risk Management
Issue of 2011‒05‒14
fifteen papers chosen by
Stan Miles
Thompson Rivers University

  1. Measurement, Monitoring, and Forecasting of Consumer Credit Default Risk - An Indicator Approach Based on Individual Payment Histories By Alexandra Schwarz
  2. Next Generation Balance Sheet Stress Testing By Maher Hasan; Christian Schmieder; Claus Puhr
  3. Fat Tails and their (Un)happy Endings: Correlation Bias and its Implications for Systemic Risk and Prudential Regulation By Jorge A. Chan-Lau
  4. Construction of uncertainty sets for portfolio selection problems By Wiechers, Christof
  5. Multi-period credit default prediction with time-varying covariates By Orth, Walter
  6. Incentives through the cycle: microfounded macroprudential regulation By di Iasio, Giovanni; Quagliariello, Mario
  7. Probabilities of Default and the Market Price of Risk in a Distressed Economy By Miguel A. Segoviano Basurto; Raphael A. Espinoza
  8. Longevity Risk and Natural Hedge Potential in Portfolios Of Life Insurance Products: The Effect of Investment Risk By Stevens, R.S.P.; De Waegenaere, A.M.B.; Melenberg, B.
  9. Durable Financial Regulation: Monitoring Financial Instruments as a Counterpart to Regulating Financial Institutions By Leonard Nakamura
  10. الخيارات وإدارة المخاطر فى أسواق السلع: دعوة لرؤية جديدة By Onour, Ibrahim
  11. Credit Risk and Disaster Risk By Francois Gourio
  12. From deterministic to stochastic surrender risk models: impact of correlation crises on economic capital By Stéphane Loisel; Xavier Milhaud
  13. The Quantification of Systemic Risk and Stability: New Methods and Measures By Romney B. Duffey
  14. On the diversification of portfolios of risky assets By Frahm, Gabriel; Wiechers, Christof
  15. Large Deviations of Realized Volatility By Shin Kanaya; Taisuke Otsu

  1. By: Alexandra Schwarz (German Institute for International Educational Research, Frankfurt am Main, Germany)
    Abstract: The statistical techniques which cover the process of modeling and evaluating consumer credit risk have become widely accepted instruments in risk management. In contrast, we find only few and vague statements on how to define the default event, i. e. on the concrete circumstances that lead to the decision of identifying a certain credit as defaulted. Based on a unique data set of individual payment histories this paper proposes a definition of default which is based on the time due amounts are outstanding and the resulting profitability of the receivables portfolio. Furthermore, to assess the individual payment performance during the credit period, indicators for monitoring and forecasting default events are derived. The empirical results show that these indicators generate valuable information which can be used by the creditor to improve his credit and collection policy and hence, to improve cash flows and reduce bad debt loss.
    Keywords: Credit Risk Analysis, Credit Default, Risk Management, Accounts Receivable Management, Performance Measurement
    JEL: C44 G32 M21
    Date: 2011–04
  2. By: Maher Hasan; Christian Schmieder; Claus Puhr
    Abstract: This paper presents a "second-generation" solvency stress testing framework extending applied stress testing work centered on Cihák (2007). The framework seeks enriching stress tests in terms of risk-sensitivity, while keeping them flexible, transparent, and user-friendly. The main contributions include (a) increasing the risk-sensitivity of stress testing by capturing changes in risk-weighted assets (RWAs) under stress, including for non-internal ratings based (IRB) banks (through a quasi-IRB approach); (b) providing stress testers with a comprehensive platform to use satellite models, and to define various assumptions and scenarios; (c) allowing stress testers to run multi-year scenarios (up to five years) for hundreds of banks, depending on the availability of data. The framework uses balance sheet data and is Excel-based with detailed guidance and documentation.
    Keywords: Bank supervision , Banks , Basel Core Principles , Credit risk , Financial risk , Risk management ,
    Date: 2011–04–18
  3. By: Jorge A. Chan-Lau
    Abstract: The correlation bias refers to the fact that claim subordination in the capital structure of the firm influences claim holders’ preferred degree of asset correlation in portfolios held by the firm. Using the copula capital structure model, it is shown that the correlation bias shifts shareholder preferences towards highly correlated assets, making financial institutions more prone to fail and increasing systemic risk given interconnectedness in the financial system. The implications for systemic risk and prudential regulation are assessed under the prism of Basel III, and potential solutions involving changes to the prudential framework and corporate governance are suggested.
    Keywords: Asset management , Bank supervision , Banks , Corporate governance , Economic models , Financial institutions , Financial risk , Risk management ,
    Date: 2011–04–15
  4. By: Wiechers, Christof
    Abstract: While modern portfolio theory grounds on the trade-off between portfolio return and portfolio variance to determine the optimal investment decision, postmodern portfolio theory uses downside risk measures instead of the variance. Prominent examples are given by the risk measures Value-at-Risk and its coherent extension, Conditional Value-at-Risk. When avoiding distributional assumptions on the process that generates the risky assets' returns, historical return data or expert knowledge remain the only data available to the investor. His problem is then to maximize the return of his portfolio given the risk constraint that his portfolio does not fall short of some threshold return. For the Conditional Value-at-Risk, the solution is known to be achievable by a linear program. This paper extends the solution to the investor's problem whenever his risk preferences are given by any coherent distortion risk measure. More precisely, it is shown that whenever the risk constraint is given by a coherent distortion risk measure, a linear program leads to the solution. A geometric interpretation of this solution is immediate, which is related to the non-parametric description of data by socalled weighted-mean trimmed regions. The connections of the solution to robust optimization and decision theory are illustrated. --
    Keywords: Portfolio Optimization,Risk Constraints,Coherent Distortion Risk Measures,Uncertainty Sets
    JEL: C13 C61 G11 G32
    Date: 2011
  5. By: Orth, Walter
    Abstract: In credit default prediction models, the need to deal with time-varying covariates often arises. For instance, in the context of corporate default prediction a typical approach is to estimate a hazard model by regressing the hazard rate on time-varying covariates like balance sheet or stock market variables. If the prediction horizon covers multiple periods, this leads to the problem that the future evolution of these covariates is unknown. Consequently, some authors have proposed a framework that augments the prediction problem by covariate forecasting models. In this paper, we present simple alternatives for multi-period prediction that avoid the burden to specify and estimate a model for the covariate processes. In an application to North American public firms, we show that the proposed models deliver high out-of-sample predictive accuracy. --
    Keywords: credit default,multi-period predictions,hazard models,panel data,out-of-sample tests
    JEL: C41 C53 G32 G33
    Date: 2011
  6. By: di Iasio, Giovanni; Quagliariello, Mario
    Abstract: Following a decline in the fundamental risk of assets, the ability of banks to expand the balance sheet under a Value-at-Risk constraint in- creases (as in Adrian and Shin (2010)), boosting the bank’s incentives to provide costly monitoring effort that prevents asset deterioration. On the other hand, high asset demand and prices, eventually, raise the bank’s pay- off in the event of liquidation associated to asset deterioration, jeopardiz- ing incentives. This paper shows that a microprudential regulatory regime that disregards the equilibrium effect of macro variables (asset prices) on micro behavior (effort), performs poorly as low fundamental (exogenous) risk reduces bank’s effort and induces high (endogenous) deterioration risk. This analysis calls for a macroprudential regulatory regime in which the equilibrium feedback effect is fully taken into account by the author- ity in designing incentive compatible capital requirements, providing a theoretical foundation to the countercyclical buffer of Basel III.
    Keywords: Macroprudential regulation; financial stability; capital requirement.
    JEL: D86 G18 E44
    Date: 2011–01–17
  7. By: Miguel A. Segoviano Basurto; Raphael A. Espinoza
    Abstract: We propose an original method to estimate the market price of risk under stress, which is needed to correct for risk aversion the CDS-implied probabilities of distress. The method is based, for simplicity, on a one-factor asset pricing model. The market price of risk under stress (the expectation of the market price of risk, conditional on it exceeding a certain threshold) is computed from the price of risk (which is the variance of the market price of risk) and the discount factor (which is the inverse of the expected market price of risk). The threshold is endogenously determined so that the probability of the price of risk exceeding it is also the probability of distress of the asset. The price of risk can be estimated via different methods, for instance derived from the VIX or from the factors in a Fama-MacBeth regression.
    Keywords: Asset prices , Bankruptcy , Banks , Credit risk , Economic models , Financial crisis , Risk premium ,
    Date: 2011–04–04
  8. By: Stevens, R.S.P.; De Waegenaere, A.M.B.; Melenberg, B. (Tilburg University, Center for Economic Research)
    Abstract: Payments of life insurance products depend on the uncertain future evolution of survival probabilities. This uncertainty is referred to as longevity risk. Existing literature shows that the effect of longevity risk on single life annuities can be substantial, and that there exists a (natural) hedge potential from combining single life annuities with death benefits or from investing in survivor swaps. The effect of financial risk on these hedge effects is typically ignored. The aim of this paper is to quantify longevity risk in portfolios of mortality-linked assets and liabilities, taking into account the effect of financial risk. We find that investment risk significantly affects the impact of longevity risk in life insurance products. It also significantly affects the hedge potential that arises from combining life insurance products, or from investing in longevity-linked assets. For example, our results suggest that ignoring the effect of financial risk can lead to severe overestimation of the natural hedge potential from death benefits, and underestimation of the hedge effects of survivor swaps.
    Keywords: Life insurance;life annuities;death benefits;survivor swaps;risk management;financial risk;longevity risk;insolvency risk;capital adequacy.
    JEL: G22 G23
    Date: 2011
  9. By: Leonard Nakamura
    Abstract: This paper sets forth a discussion framework for the information requirements of systemic financial regulation. It specifically describes a potentially large macro-micro database for the U.S. based on an extended version of the Flow of Funds. I argue that such a database would have been of material value to U.S. regulators in ameliorating the recent financial crisis and could be of aid in understanding the potential vulnerabilities of an innovative financial system in the future. I also suggest that making these data available to the academic research community, under strict confidentiality restrictions, would enhance the detection and measurement of systemic risk.
    JEL: G28
    Date: 2011–05
  10. By: Onour, Ibrahim
    Abstract: After highlighting different views of Islamic scholars on option derivatives, the paper explores a potential role for option derivatives as useful risk management tool in commodity markets, while attuned to Islamic Shariah principles. The author illustrated a model of commodity stock market to show how options can play a role similar to that of insurance of risks in commodity markets.
    Keywords: options;risk;islamic derivative
    JEL: E00 G10
    Date: 2011–04–28
  11. By: Francois Gourio
    Abstract: Corporate credit spreads are large, volatile, countercyclical, and significantly larger than expected losses, but existing macroeconomic models with financial frictions fail to reproduce these patterns, because they imply small and constant aggregate risk premia. Building on the idea that corporate debt, while safe in normal times, is exposed to the risk of economic depression, this paper embeds a trade-off theory of capital structure into a real business cycle model with a small, time-varying risk of large economic disaster. This simple feature generates large, volatile and countercyclical credit spreads as well as novel business cycle implications. In particular, financial frictions substantially amplify the effect of shocks to the disaster probability.
    JEL: E22 E32 E44 G12
    Date: 2011–05
  12. By: Stéphane Loisel (SAF - Laboratoire de Sciences Actuarielle et Financière - Université Claude Bernard - Lyon I : EA2429); Xavier Milhaud (SAF - Laboratoire de Sciences Actuarielle et Financière - Université Claude Bernard - Lyon I : EA2429, Axa Cessions - AXA)
    Abstract: In this paper we raise the matter of considering a stochastic modeling of the surrender rate instead of the classical S-shaped deterministic curve (in function of the spread), still used in almost all insurance companies. A stochastic model in which surrenders are conditionally independent with respect to a S-curve disturbance would be tempting in some extreme scenarii, especially to address the question of the lack of data. However, we explain why this conditional independence between policyholders, which has the advantage to be the simplest assumption, looks particularly maladaptive when the spread increases. Indeed the correlation between policyholders' decisions is most likely to increase in this situation. We suggest and develop a simple model which integrates those phenomena. With stochastic orders it is possible to compare it to the conditional independence approach qualitatively. In an partially internal Solvency II model, we quantify the impact of the correlation phenomenon on a real life portfolio for a global risk management strategy.
    Date: 2011
  13. By: Romney B. Duffey
    Abstract: We address the question of the prediction of large failures, busts, or system collapse, and the necessary concepts related to risk quantification, minimization and management. Answering this question requires a new approach since predictions using standard financial techniques and statistical distributions fail to predict or anticipate crises. The key points are that financial markets, systems, trading and manoeuvres are not just about money, debt, stocks, instruments and assets but reflect the actions and motivations of humans, which includes the presence or absence of learning effects. Therefore we have the possibility of failures or rare or low frequency events due to human involvement. The rare or unknown event is directly due to human influence, and reflects both learning and risk taking, with the presence of the finite and persistent human error contribution while taking or exposed to risk. This presence of humans in the marketplace explains the failure of present purely statistical methods to correctly estimate, predict or determine the onset of financial crises, busts and collapses. In this essay, we unify the concepts for predicting financial systemic risk with the general theory for outcomes, trends and measures already derived for other technical and social systems with human involvement. We replace words and qualitative reasoning with measures and quantitative predictions. The paper is therefore written with an introductory section devoted to the measures relevant to risk prediction in other modern technological systems; and is then extended and applied specifically to risk prediction for financial and business systems. The resulting measures also provide useful guidance for risk governance.
    JEL: C99 Z19
    Date: 2011–05
  14. By: Frahm, Gabriel; Wiechers, Christof
    Abstract: We introduce a measure of diversification for portfolios comprising d risky assets. This measure relates the smallest possible return variance among these d assets to the overall portfolio return variance, yielding the portion of non-diversifiable risk. In the context of normally distributed asset returns, its estimator and finite-sample properties are explored when being applied to the trivial asset allocation strategy. An overview of different previous approaches towards the measurement of diversification is provided, and the shortcomings of some of these approaches are illustrated. A categorization of tests regarding the portfolio return variance is given, especially for comparing naively allocated with minimum-variance portfolios. The empirical part of this work is carried out on monthly return data for the S&P500 constituents, with a return history spanning the last five decades. When measuring the diversification of naively allocated 40-asset portfolios, the average degree of diversification barely exceeds 60%. This result indicates that - for the mutual fund manager as well as for the private investor - well-founded selection of assets indeed leads to better portfolio diversification than naive allocation does. --
    Keywords: Diversification,Portfolio Management,Naive Portfolio,Variance Estimation,Finite-Sample Distribution,S&P500
    JEL: C13 C16 G11
    Date: 2011
  15. By: Shin Kanaya (Dept. of Economics, Nuffield College and Oxford-Man Institute); Taisuke Otsu (Cowles Foundation, Yale University)
    Abstract: This paper studies large and moderate deviation properties of a realized volatility statistic of high frequency financial data. We establish a large deviation principle for the realized volatility when the number of high frequency observations in a fixed time interval increases to infinity. Our large deviation result can be used to evaluate tail probabilities of the realized volatility. We also derive a moderate deviation rate function for a standardized realized volatility statistic. The moderate deviation result is useful for assessing the validity of normal approximations based on the central limit theorem. In particular, it clarifies that there exists a trade-off between the accuracy of the normal approximations and the path regularity of an underlying volatility process. Our large and moderate deviation results complement the existing asymptotic theory on high frequency data. In addition, the paper contributes to the literature of large deviation theory in that the theory is extended to a high frequency data environment.
    Keywords: Realized volatility, Large deviation, Moderate deviation
    JEL: C10 C20
    Date: 2011–05

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