nep-rmg New Economics Papers
on Risk Management
Issue of 2013‒06‒09
nine papers chosen by
Stan Miles
Thompson Rivers University

  1. An Economic Evaluation of Model Risk in Long-term Asset Allocations By Christophe Boucher; Gregory Jannin; Bertrand Maillet; Patrick Kouontchou
  2. Is the Jump-Diffusion Model a Good Solution for Credit Risk Modeling? The Case of Convertible Bonds By Xiao, Tim
  3. Government Debt Management and Operational Risk: A Risk Management Framework and its Application in Turkey By Hakan Tokaç; Mike Williams
  4. Credit ratings and bank monitoring ability By Leonard I. Nakamura; Kasper Roszbach.
  5. Market Valuation and Risk Assessment of Indian Banks using Black -Scholes -Merton Model By Sinha, Pankaj; Sharma, Sakshi; Sondhi, Kriti
  6. Impact of the Subprime Crisis on Bank Ratings: The Effect of the Hardening of Rating Policies and Worsening of Solvency By Pastor Monsálvez José Manuel; Fernández de Guevara Radoselovics Juan; Salvador Muñoz Carlos
  7. "The Wrong Risks: What a Hedge Gone Awry at JPMorgan Chase Tells Us about What's Wrong with Dodd-Frank" By Rainer Kattel; Ringa Raudla
  8. B-spline techniques for volatility modeling By Sylvain Corlay
  9. An Economic Examination of Collateralization in Different Financial Markets By Xiao, Tim

  1. By: Christophe Boucher (A.A.Advisors-QCG - ABN AMRO, CEREFIGE - Variances et Université de Lorraine - Université de Lorraine); Gregory Jannin (PRISM Sorbonne - Variances et Université de Paris-1 - Université de Paris1 - Université de Paris1 - Panthéon-Sorbonne - Université Paris-1 - Université de Paris-1 - Université Paris1); Bertrand Maillet (A.A.Advisors-QCG - ABN AMRO, EIF - Europlace Institute of Finance, LEO - Laboratoire d'économie d'Orleans - CNRS : UMR7322 - Université d'Orléans); Patrick Kouontchou (CEREFIGE - Variances et Université de Lorraine - Université de Lorraine)
    Abstract: Following the recent crisis and the revealed weakness of risk management practices, regulators of developed markets have recommended that financial institutions assess model risk. Standard risk measures, such as the Value-at-Risk (VaR), emerged over recent decades as the industry standard for risk management and have today become a key tool for asset allocation. We illustrate and estimate model risk, and focus on the evaluation of its impact on optimal portfolios at various time horizons. Based on a long sample of U.S. data, we find a non-linear relation between VaR model errors and the horizon that impacts optimal asset allocations.
    Keywords: Model Risk, VaR, Long-term Asset Allocation, Safety First Criterion.
    Date: 2013–03–05
  2. By: Xiao, Tim
    Abstract: Tim Xiao: This paper argues that the reduced-form jump diffusion model may not be appropriate for credit risk modeling. To correctly value hybrid defaultable financial instruments, e.g., convertible bonds, we present a new framework that relies on the probability distribution of a default jump rather than the default jump itself, as the default jump is usually inaccessible. The model is quite accurate. A prevailing belief in the market is that convertible arbitrage is mainly due to convertible underpricing. Empirically, however, we do not find evidence supporting the underpricing hypothesis. Instead, we find that convertibles have relatively large position gammas. As a typical convertible arbitrage strategy employs delta-neutral hedging, a large positive gamma can make the portfolio high profitable, especially for a large movement in the underlying stock price.
    Keywords: jump diffusion model, hybrid financial instrument, convertible bond, convertible underpricing, convertible arbitrage, default time approach, default probability (intensity) approach, asset pricing, credit risk modeling.
    JEL: G12 G13 G32
    Date: 2013–05–21
  3. By: Hakan Tokaç; Mike Williams
    Abstract: The management of operational risk is at the heart of efficient government, but countries often fail to apply good or even routine operational risk management practices and have difficulty in understanding how to put the processes in place. Through an analysis of Turkey’s Undersecretariat of Treasury, SIGMA Paper 50 presents an overview of key operational risks and recommendations on how to develop a framework for managing them, and provides lessons learnt that can be applied in debt management units and related treasury functions across a wide range of countries.
    Date: 2013–04–17
  4. By: Leonard I. Nakamura; Kasper Roszbach.
    Abstract: In this paper we use credit rating data from two large Swedish banks to elicit evidence on banks’ loan monitoring ability. For these banks, our tests reveal that banks’ credit ratings indeed include valuable private information from monitoring, as theory suggests. However, our tests also reveal that publicly available information from a credit bureau is not efficiently impounded in the bank ratings: The credit bureau ratings not only predict future movements in the bank ratings but also improve forecasts of bankruptcy and loan default. We investigate possible explanations for these findings. Our results are consistent with bank loan officers placing too much weight on their private information, a form of overconfidence. To the extent that overconfidence results in placing too much weight on private information, risk analyses of the bank loan portfolios in our data could be improved by combining the bank credit ratings and public credit bureau ratings. The methods we use represent a new basket of straightforward techniques that enable both financial institutions and regulators to assess the performance of credit rating systems. ; Supersedes Working Paper 10-21.
    Keywords: Credit ratings ; Risk assessment
    Date: 2013
  5. By: Sinha, Pankaj; Sharma, Sakshi; Sondhi, Kriti
    Abstract: The most pernicious effect of the global financial crisis is that it triggers a sequence of unpleasant consequences for the banking sector and for the entire economy as a whole. The recent financial crisis has compelled regulators to focus on the necessity of resilience of banks towards risks and sudden financial shocks. The riskiness of banks assets and its equity are two important factors for valuation of banks. These risks can be incorporated in market valuation only through Black-Scholes-Merton Model. This paper uses Black-Scholes-Merton option valuation approach for calculation of the market value and volatility of bank’s assets for a random sample of 13 Public and 8 Private sector banks in India over the period from March 2003 to March 2012. Further, it calculates yearly Z-score for each bank, allowing for capital adequacy as per the Basel II and III norms, for the periods before and after 2008 financial crisis. The obtained Z-scores suggest that the Indian banks are far from default and the impact of global recession of 2008 on the banks solvency was insignificant. All the Indian banks have market value to enterprise value ratio typically in the range of 93 to 99 per cent, suggesting that market value of bank’s assets obtained from Black-Scholes-Merton is characteristically below its enterprise value since market value considers the riskiness of the equity and assets both. It is found that the volatility of banks assets is significantly different for public and private sector banks over the period of study. Investigation of NPA to Total Assets reveals that presently NPA levels of the public sector banks are increasing whereas it is declining for the private sector banks.
    Keywords: Black-Scholes -Merton, Market value, Volatility, Z-score, Non-Performing Assets
    JEL: G01 G21 G28 G33 G38
    Date: 2013–06–06
  6. By: Pastor Monsálvez José Manuel (UNIVERSITY OF VALENCIA INSTITUTO VALENCIANO DE INVESTIGACIONES ECONÓMICAS (Ivie)); Fernández de Guevara Radoselovics Juan (University of Valencia; Ivie); Salvador Muñoz Carlos (Universidad de Valencia)
    Abstract: This working paper studies the impact of the subprime crisis on the ratings issued by the rating agencies in evaluating the solvency of banks. After ascertaining a significant worsening of ratings after the crisis, the paper hypothesizes the possibility that this worsening is not due exclusively to deterioration in the banks' credit quality, but also to a change in the behavior of the rating agencies. The study designs a methodology to separate the observed change in ratings into two multiplicative components: one associated with the deterioration of the banks' solvency itself and another associated with the change in the agencies' valuation criteria. The methodology is applied to the Spanish Banking System during the period 2000-2009. The results obtained show that the observed ratings cuts (13%) are explained (65%) by the deterioration in the solvency of the banks, but also (35%) by the hardening of the valuation criteria adopted by the agencies. This shows the procyclical character of ratings.
    Keywords: Bank ratings, subprime crisis effect, financial and environmental risk factors, ordered probit models.
    JEL: G21 G24 G32
    Date: 2012–09
  7. By: Rainer Kattel; Ringa Raudla
    Abstract: What can we learn from JPMorgan Chase's recent self-proclaimed "stupidity" in attempting to hedge the bank's global risk position? Clearly, the description of the bank's trading as "sloppy" and reflecting "bad judgment" was designed to prevent the press reports of large losses from being used to justify the introduction of more stringent regulation of large, multifunction financial institutions. But the lessons to be drawn are not to be found in the specifics of the hedges that were put on to protect the bank from an anticipated decline in the value of its corporate bond holdings, or in any of its other global portfolio hedging activities. The first lesson is this: despite their acumen in avoiding the worst excesses of the subprime crisis, the bank's top managers did not have a good idea of its exposure, which serves as evidence that the bank was "too big to manage." And if it was too big to manage, it was clearly too big to regulate effectively.
    Date: 2012–06
  8. By: Sylvain Corlay
    Abstract: This paper is devoted to the application of B-splines to volatility modeling, specifically the calibration of the leverage function in stochastic local volatility models and the parameterization of an arbitrage-free implied volatility surface calibrated to sparse option data. We use an extension to the classical B-splines obtained by including basis functions of infinite support. \par We first come back to the application of shape-constrained B-splines to the estimation of conditional expectations, not merely from a scatter plot but also with the given of the marginal distributions. An application is the Monte Carlo calibration of stochastic local volatility models by Markov projection. Then we present a new technique for the calibration of an implied volatility surface to sparse option data. We use a B-spline parameterization of the Radon-Nikodym derivative of the underlying's risk-neutral probability density with respect to a roughly calibrated base model. We show that the method provides smooth arbitrage-free implied volatility surfaces. Eventually, we propose a Galerkin method with B-spline finite elements to the solution of the P.D.E. satisfied by the Radon Nikodym derivative.
    Date: 2013–06
  9. By: Xiao, Tim
    Abstract: Tim Xiao: This paper attempts to assess the economic significance and implications of collateralization in different financial markets, which is essentially a matter of theoretical justification and empirical verification. We present a comprehensive theoretical framework that allows for collateralization adhering to bankruptcy laws. As such, the model can back out differences in asset prices due to collateralized counterparty risk. This framework is very useful for pricing outstanding defaultable financial contracts. By using a unique data set, we are able to achieve a clean decomposition of prices into their credit risk factors. We find empirical evidence that counterparty risk is not overly important in credit-related spreads. Only the joint effects of collateralization and credit risk can sufficiently explain unsecured credit costs. This finding suggests that failure to properly account for collateralization may result in significant mispricing of financial contracts. We also analyze the difference between cleared and OTC markets.
    Keywords: unilateral/bilateral collateralization, partial/full/over collateralization, asset pricing, plumbing of the financial system, swap premium spread, OTC/cleared/listed financial markets.
    JEL: E44 G12 G18 G24 G28 G32 G33
    Date: 2012–05–01

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