
on Risk Management 
By:  Skoglund, Jimmy; Chen, Wei 
Abstract:  The recent incremental risk charge addition to the Basel (1996) market risk amend ment requires banks to estimate, separately, the default and migration risk of their trading portfolios that are exposed to credit risk. The new regulation requires the total regulatory charges for trading books to be computed as the sum of the market risk capi tal and the incremental risk charge for credit risk. In contrast to Basel II models for the banking book no model is prescribed and banks can use internal models for calculating the incremental risk charge. In the calculation of incremental risk charges a key compo nent is the choice of the liquidity horizon for traded credits. In this paper we explore the e¤ect of the liquidity horizon on the incremental risk charge. Speci cally we consider a sample of 28 bonds with di¤erent rating and liquidity horizons to evaluate the impact of the choice of the liquidity horizon for a certain rating class of credits. We find that choosing the liquidity horizon for a particular credit there are two important effects that needs to be considered. Firstly, for bonds with short liquidity horizons there is a miti gation effect of preventing the bond from further downgrades by trading it frequently. Secondly, there is the possibility of multiple defaults. Of these two effects the multiple default effect will generally be more pronounced for non investment grade credits as the probability of default is severe even for short liquidity periods. For medium investment grade credits these two effects will in general o¤set and the incremental risk charge will be approximately the same across liquidity horizons. For high quality investment grade credits the effect of the multiple defaults is low for short liquidity horizons as the frequent trading effectively prevents severe downgrades. 
Keywords:  credit risk; incremental risk charge; liquidity horizon; Basel III 
JEL:  C00 
Date:  2010–06–30 
URL:  http://d.repec.org/n?u=RePEc:pra:mprapa:31535&r=rmg 
By:  Cathy W. S. Chen (College of Business, Feng Chia University); Richard Gerlach (Econometrisch Instituut (Econometric Institute), Faculteit der Economische Wetenschappen (Erasmus School of Economics), Erasmus Universiteit); Bruce B. K. Hwang (Graduate Institute of Statistics and Actuarial Science, Feng Chia University); Michael McAleer (Econometrisch Instituut (Econometric Institute), Faculteit der Economische Wetenschappen (Erasmus School of Economics) Erasmus Universiteit, Tinbergen Instituut (Tinbergen Institute).) 
Abstract:  ValueatRisk (VaR) is commonly used for financial risk measurement. It has recently become even more important, especially during the 200809 global financial crisis. We pro pose some novel nonlinear threshold conditional autoregressive VaR (CAViaR) models that incorporate intraday price ranges. Model estimation and inference are performed using the Bayesian approach via the link with the SkewedLaplace distribution. We examine how a range of risk models perform during the 200809 financial crisis, and evaluate how the crisis aects the performance of risk models via forecasting VaR. Empirical analysis is conducted on five AsiaPacific Economic Cooperation stock market indices as well as two exchange rate series. We examine violation rates, backtesting criteria, market risk charges and quantile loss function values to measure and assess the forecasting performance of a variety of risk models. The proposed threshold CAViaR model, incorporating range information, is shown to forecast VaR more eficiently than other models, across the series considered, which should be useful for financial practitioners. 
Keywords:  Individual forecasts, mean forecasts, efficient estimation, generated regressors, replicable forecasts, nonreplicable forecasts, expert intuition. 
JEL:  C53 C22 E27 E37 
Date:  2011 
URL:  http://d.repec.org/n?u=RePEc:ucm:doicae:1116&r=rmg 
By:  Belén Nieto (Departamento de Economía financiera y Contabilidad, Universidad de Alicante); Alfonso Novales Cinca (Departamento de Economía Cuantitativa (Department of Quantitative Economics), Facultad de Ciencias Económicas y Empresariales (Faculty of Economics and Business), Universidad Complutense de Madrid); Gonzalo Rubio (Universidad CEU Cardenal Herrera) 
Abstract:  This paper studies the determinants of the variance risk premium and concludes on the hedging possibilities offered by variance swaps. We start by showing that the variance risk premium responds to changes in higher order moments of the distribution of market returns. But the uncertainty that determines the variance risk premium –the fear by investors to deviations from Normality in returns is also strongly related to a variety of risks: risk of default, employment growth risk, consumption growth risk, stock market risk and market illiquidity risk. Therefore, the variance risk premium could be interpreted as reflecting the market willingness to pay for hedging against financial and macroeconomic sources of risk. We provide additional evidence in support of that view. 
Keywords:  Variance risk premium, Nonnormality, Economic risks, Hedging 
JEL:  C13 C14 G10 G12 
Date:  2011 
URL:  http://d.repec.org/n?u=RePEc:ucm:doicae:1106&r=rmg 
By:  Brahim Brahimi; Djamel Meraghni; Abdelhakim Necir 
Abstract:  We discuss two distinct approaches, for distorting risk measures of sums of dependent random variables, which preserve the property of coherence. The first, based on distorted expectations, operates on the survival function of the sum. The second, simultaneously applies the distortion on the survival function of the sum and the dependence structure of risks, represented by copulas. Our goal is to propose risk measures that take into account the fluctuations of losses and possible correlations between risk components. 
Date:  2011–06 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1106.2791&r=rmg 
By:  Damiano Brigo; Cristin Buescu; Massimo Morini 
Abstract:  We compare two different bilateral counterparty valuation adjustment (BVA) formulas. The first formula is an approximation and is based on subtracting the two unilateral Credit Valuation Adjustment (CVA)'s formulas as seen from the two different parties in the transaction. This formula is only a simplified representation of bilateral risk and ignores that upon the first default closeout proceedings are ignited. As such, it involves double counting. We compare this formula with the fully specified bilateral risk formula, where the first to default time is taken into account. The latter correct formula depends on default dependence between the two parties, whereas the simplified one does not. We also analyze a candidate simplified formula in case the replacement closeout is used upon default, following ISDA's recommendations, and we find the simplified formula to be the same as in the risk free closeout case. We analyze the error that is encountered when using the simplified formula in a couple of simple products: a zero coupon bond, where the exposure is unidirectional, and an equity forward contract where exposure can go both ways. For the latter case we adopt a bivariate exponential distribution due to Gumbel to model the joint default risk of the two parties in the deal. We present a number of realistic cases where the simplified formula differs considerably from the correct one. 
Date:  2011–06 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1106.3496&r=rmg 
By:  Stephens, Eric (University of Alberta, Department of Economics); Thompson, James (University of Waterloo, School of Accounting and Business) 
Abstract:  In this paper we update the traditional insurance economics framework to incorporate key features of the credit default swap (CDS) market. First, we allow for insurer insolvency, with asymmetric information as to its probability. We find that stable insurers become less stable because they are forced to compete on price. When insurer type is known, increased competition among insurers can create instability for the same reason. Second, we allow the insured party to have heterogeneous motivations for purchasing CDS. For example, some may own the underlying asset and purchase CDS for risk management, while others buy these contracts purely for speculation. We show that speculators will choose to contract with less stable insurers, resulting in higher counterparty risk in this market relative to that of traditional insurance; however, a regulatory policy that disallows speculative trading can, perversely, cause market counterparty risk to increase. Third, we relax the standard assumption of contract exclusivity, which does not apply to the CDS market, by allowing the insured to purchase contracts from many insurers. In contrast to the traditional insurance model, we show that separation of risk type among insured parties can be achieved through insurer choice. We use our model to shed light on the debate over Central Counterparties (CCP). We show that requiring CDS contracts to be negotiated through CCPs can push stable insurers out of the market, mitigating the benefi t of risk pooling. 
Keywords:  credit default swaps; insurance; counterparty risk; banking; regulation 
JEL:  D82 G18 G21 G22 
Date:  2011–06–16 
URL:  http://d.repec.org/n?u=RePEc:ris:albaec:2011_009&r=rmg 
By:  Shawkat Hammoudeh (Lebow College of Business, Drexel University, USA); Tengdong Liu (Lebow College of Business, Drexel University, USA); ChiaLin Chang (Department of Applied Economics, Department of Finance, National Chung Hsing University, Taichung, Taiwan); Michael McAleer (Econometrisch Instituut (Econometric Institute), Faculteit der Economische Wetenschappen (Erasmus School of Economics) Erasmus Universiteit, Tinbergen Instituut (Tinbergen Institute).) 
Abstract:  This paper examines risk transmission and migration among six US measures of credit and market risk during the full period 20042011 period and the 20092011 recovery subperiod, with a focus on four sectors related to the highly volatile oil price. There are more longrun equilibrium risk relationships and shortrun causal relationships among the four oilrelated Credit Default Swaps (CDS) indexes, the (expected equity volatility) VIX index and the (swaption expected volatility) SMOVE index for the full period than for the recovery subperiod. The auto sector CDS spread is the most errorcorrecting in the long run and also leads in the risk discovery process in the short run. On the other hand, the CDS spread of the highly regulated, natural monopoly utility sector does not error correct. The four oilrelated CDS spread indexes are responsive to VIX in the short and longrun, while no index is sensitive to SMOVE which, in turn, unilaterally assembles risk migration from VIX. The 20072008 Great Recession seems to have led to “localization” and less migration of credit and market risk in the oilrelated sectors. 
Keywords:  Risk, Sectoral CDS, VIX, SMOVE, MOVE, Adjustments. 
JEL:  C13 C22 G1 G12 Q40 
Date:  2011 
URL:  http://d.repec.org/n?u=RePEc:ucm:doicae:1112&r=rmg 
By:  Bryan T. Kelly; Hanno Lustig; Stijn Van Nieuwerburgh 
Abstract:  Investors in option markets price in a substantial collective government bailout guarantee in the financial sector, which puts a floor on the equity value of the financial sector as a whole, but not on the value of the individual firms. The guarantee makes put options on the financial sector index cheap relative to put options on its member banks. The basketindex put spread rises fourfold from 0.8 cents per dollar insured before the financial crisis to 3.8 cents during the crisis for deep outofthemoney options. The spread peaks at 12.5 cents per dollar, or 70% of the value of the index put. The rise in the put spread cannot be attributed to an increase in idiosyncratic risk because the correlation of stock returns increased during the crisis. Sectorwide tail risk, partially absorbed by the government's collective guarantee for the financial sector, lowers the index put prices but not the individual put prices, and hence can explain the basketindex spread. A structural model with financial disasters quantitatively matches these facts and attributes as much as half of the value of the financial sector to the bailout guarantee during the crisis. The model solves the problem of how to measure systemic risk in a world where the government distorts market prices. 
JEL:  G12 G2 G38 
Date:  2011–06 
URL:  http://d.repec.org/n?u=RePEc:nbr:nberwo:17149&r=rmg 
By:  Belén Nieto (Departamento de Economía Financiera y Contabilizad, Universidad de Alicante); Alfonso Novales Cinca (Departamento de Economía Cuantitativa (Department of Quantitative Economics), Facultad de Ciencias Económicas y Empresariales (Faculty of Economics and Business), Universidad Complutense de Madrid); Gonzalo Rubio (Universidad CEU Cardenal Herrera) 
Abstract:  This paper proposes an ICAPM in which the risk premium embedded in variance swaps is the factor mimicking portfolio for hedging exposure to changes in future investment conditions. Recent empirical evidence shows that the fears by investors to deviations from Normality in the distribution of returns are able to explain timevarying financial and macroeconomic risks in addition to being a determinant of the variance risk premium. Moreover, variance swaps hedges unfavorable changes in the stochastic investment opportunity set, and is not a redundant asset because significantly expands the efficient meanvariance frontier. Thence, we should expect the variance swap risk incremental pricing information associated with the variance risk premium, particularly at shorter horizons. 
Keywords:  variance risk premium, intertemporal asset pricing 
JEL:  C13 C14 G10 G12 
Date:  2011 
URL:  http://d.repec.org/n?u=RePEc:ucm:doicae:1108&r=rmg 
By:  Runhuan Feng; Shuaiqi Zhang; Chao Zhu 
Abstract:  This paper deals with optimal dividend payment problem in the general setup of a piecewisedeterministic compound Poisson risk model. The objective of an insurance business under consideration is to maximize the expected discounted dividend payout up to the time of ruin. Both restricted and unrestricted payment schemes are considered. In the case of restricted payment scheme, the value function is shown to be a classical solution of the corresponding HamiltonJacobiBellman equation, which, in turn, leads to an optimal restricted dividend payment policy. When the claims are exponentially distributed, the value function and an optimal dividend payment policy of the threshold type are determined in closed forms under certain conditions. The case of unrestricted payment scheme gives rise to a singular stochastic control problem. By solving the associated integrodifferential quasivariational inequality, the value function and an optimal barrier strategy are determined explicitly in exponential claim size distributions. Two examples are demonstrated and compared to illustrate the main results. 
Date:  2011–06 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1106.2781&r=rmg 
By:  Jeon, DohShin; Lovo, Stefano 
Abstract:  We present an infinite horizon model that studies the competition between a relatively ineffective incumbent Credit Rating Agency (CRA) and a sequence of entrant CRAs that are potentially more e¤ective but whose ability in appraising default risk is unproven at the time they enter the market. We show that free entry competition in the credit rating business fails in selecting the most competent CRA as long as two conditions are met. First, investors and issuers trust the incumbent CRA to provide a sincere, although imperfect, assessment of issuersdefault risk. Second, CRAs cannot charge higher fees for low rating than for high rating. Under these conditions a rather incompetent CRA can dominate the market without being worried about potentially more competent entrants. We derive policy implications. 
JEL:  D82 G29 L11 L13 L15 
Date:  2011–05–10 
URL:  http://d.repec.org/n?u=RePEc:ide:wpaper:24498&r=rmg 
By:  Isao Ishida (Center for the Study of Finance and Insurance Osaka University, Japan); Michael McAleer (Econometrisch Instituut (Econometric Institute), Faculteit der Economische Wetenschappen (Erasmus School of Economics), Erasmus Universiteit, Tinbergen Instituut (Tinbergen Institute).); Kosuke Oya (Graduate School of Economics and Center for the Study of Finance and Insurance Osaka University, Japan) 
Abstract:  This paper proposes a new method for estimating continuoustime stochastic volatility (SV) models for the S&P 500 stock index process using intraday highfrequency observations of both the S&P 500 index and the Chicago Board of Exchange (CBOE) implied (or expected) volatility index (VIX). Intraday highfrequency observations data have become readily available for an increasing number of financial assets and their derivatives in recent years, but it is well known that attempts to directly apply popular continuoustime models to short intraday time intervals, and estimate the parameters using such data, can lead to nonsensical estimates due to severe intraday seasonality. A primary purpose of the paper is to provide a framework for using intraday high frequency data of both the index estimate, in particular, for improving the estimation accuracy of the leverage parameter, , that is, the correlation between the two Brownian motions driving the diffusive components of the price process and its spot variance process, respectively. As a special case, we focus on Heston’s (1993) squareroot SV model, and propose the realized leverage estimator for , noting that, under this model without measurement errors, the “realized leverage,” or the realized covariation of the price and VIX processes divided by the product of the realized volatilities of the two processes, is infill consistent for . Finite sample simulation results show that the proposed estimator delivers more accurate estimates of the leverage parameter than do existing methods. 
Keywords:  Continuous time, high frequency data, stochastic volatility, S&P 500, implied volatility, VIX. 
JEL:  G13 G32 
Date:  2011 
URL:  http://d.repec.org/n?u=RePEc:ucm:doicae:1117&r=rmg 