nep-rmg New Economics Papers
on Risk Management
Issue of 2013‒08‒10
thirteen papers chosen by
Stan Miles
Thompson Rivers University

  1. Risk Modelling and Management: An Overview By Chang, C.L.; Allen, D.E.; McAleer, M.J.; Pérez-Amaral, T.
  2. Network versus portfolio structure in financial systems By Teruyoshi Kobayashi
  3. Leverage ratios and Basel III: proposed Basel III leverage and supplementary leverage ratios By Ojo, Marianne
  4. Replacing Ratings By Bo Becker; Marcus Opp
  5. The effect of the enterprise risk management implementation on the firm value of European companies By Giorgio Stefano Bertinetti; Elisa Cavezzali; Gloria Gardenal
  6. Asset Allocation under the Basel Accord Risk Measures By Zaiwen Wen; Xianhua Peng; Xin Liu; Xiaoling Sun; Xiaodi Bai
  7. Efficient immunization strategies to prevent financial contagion By Teruyoshi Kobayashi; Kohei Hasui
  8. A general Multidimensional Monte Carlo Approach for Dynamic Hedging under stochastic volatility By Dorival Le\~ao; Alberto Ohashi; Vinicius Siqueira
  9. The Basel capital adequacy and regulatory framework: balancing risk sensitivity, simplicity and comparability By Ojo, Marianne
  10. The Financing of Innovative SMEs: a multicriteria credit rating model By Silvia Angilella; Sebastiano Mazz\`u
  11. The Skin In The Game Heuristic for Protection Against Tail Events By Nassim N. Taleb; Constantine Sandis
  12. Optimal Prevention for Correlated Risks By Christophe Courbage; Henry Loubergé; Richard Peter
  13. Analogy Making, Option Prices, and Implied Volatility By Siddiqi, Hammad

  1. By: Chang, C.L.; Allen, D.E.; McAleer, M.J.; Pérez-Amaral, T.
    Abstract: The papers in this special issue of Mathematics and Computers in Simulation are substantially revised versions of the papers that were presented at the 2011 Madrid International Conference on “Risk Modelling and Management†(RMM2011). The papers cover the following topics: currency hedging strategies using dynamic multivariate GARCH, risk management of risk under the Basel Accord: A Bayesian approach to forecasting value-at-risk of VIX futures, fast clustering of GARCH processes via Gaussian mixture models, GFC-robust risk management under the Basel Accord using extreme value methodologies, volatility spillovers from the Chinese stock market to economic neighbours, a detailed comparison of Value-at-Risk estimates, the dynamics of BRICS's country risk ratings and domestic stock markets, U.S. stock market and oil price, forecasting value-at-risk with a duration-based POT method, and extreme market risk and extreme value theory.
    Keywords: risk management;forecasting;value-at-risk;volatility spillovers;mixture models;VIX futures;Basel Accord;BRICS;currency hedging strategies;country risk ratings;extreme value methodologies;fast clustering;extreme market risks
    Date: 2013–06–01
  2. By: Teruyoshi Kobayashi
    Abstract: The question of how to stabilize financial systems has attracted considerable attention since the global financial crisis of 2007-2009. Recently, Beale et al. ("Individual versus systemic risk and the regulator's dilemma", Proc Natl Acad Sci USA 108: 12647-12652, 2011) demonstrated that higher portfolio diversity among banks would reduce systemic risk by decreasing the risk of simultaneous defaults at the expense of a higher likelihood of individual defaults. In practice, however, a bank default has an externality in that it undermines other banks' balance sheets. This paper explores how each of these different sources of risk, simultaneity risk and externality, contributes to systemic risk. The results show that the allocation of external assets that minimizes systemic risk varies with the topology of the financial network as long as asset returns have negative correlations. In the model, a well-known centrality measure, PageRank, reflects an appropriately defined "infectiveness" of a bank. An important result is that the most infective bank need not always be the safest bank. Under certain circumstances, the most infective node should act as a firewall to prevent large-scale collective defaults. The introduction of a counteractive portfolio structure will significantly reduce systemic risk.
    Date: 2013–08
  3. By: Ojo, Marianne
    Abstract: The Basel III Leverage Ratio, as originally agreed upon in December 2010, has recently undergone revisions and updates – both in relation to those proposed by the Basel Committee on Banking Supervision – as well as proposals introduced in the United States. Whilst recent proposals have been introduced by the Basel Committee to improve, particularly, the denominator component of the Leverage Ratio, new requirements have been introduced in the U.S to upgrade and increase these ratios, and it is those updates which relate to the Basel III Supplementary Leverage Ratio that have primarily generated a lot of interests. This is attributed not only to concerns that many subsidiaries of US Bank Holding Companies (BHCs) will find it cumbersome to meet such requirements, but also to potential or possible increases in regulatory capital arbitrage: a phenomenon which plagued the era of the original 1988 Basel Capital Accord and which also partially provided impetus for the introduction of Basel II. This paper is aimed at providing an analysis of the recent updates which have taken place in respect of the Basel III Leverage Ratio and the Basel III Supplementary Leverage Ratio – both in respect of recent amendments introduced by the Basel Committee and proposals introduced in the United States. It will also consider the consequences – as well as the impact - which the U.S Leverage ratios could have on Basel III. There are ongoing debates in relation to revision by the Basel Committee, as well as the most recent U.S proposals to update Basel III Leverage ratios and whilst these revisions have been welcomed to a large extent, in view of the need to address Tier One capital requirements and exposure criteria, there is every likelihood, indication, as well as tendency that many global systemically important banks (GSIBS), and particularly their subsidiaries, will resort to capital arbitrage. What is likely to be the impact of the recent proposals in the U.S.? The recent U.S proposals are certainly very encouraging and should also serve as impetus for other jurisdictions to adopt a pro-active approach – particularly where existing ratios or standards appear to be inadequate. This paper also adopts the approach of evaluating the causes and consequences of the most recent updates by the Basel Committee, as well as those revisions which have taken place in the U.S, by attempting to balance the merits of the respective legislative updates and proposals. The value of adopting leverage ratios as a supplementary regulatory tool will also be illustrated by way of reference to the impact of the recent legislative changes on risk taking activities, as well as the need to also supplement capital adequacy requirements with the Basel Leverage ratios and the Basel liquidity standards.
    Keywords: global systemically important banks (G-SIBs); risk weighted assets; leverage ratios; harmonisation; accounting rules; capital arbitrage; disclosure; stress testing techniques; U.S Basel III Final Rule
    JEL: E3 E5 G2 G3 K2
    Date: 2013–07–31
  4. By: Bo Becker; Marcus Opp
    Abstract: Since the financial crisis, replacing ratings has been a key item on the regulatory agenda. We examine a unique change in how capital requirements are assigned to insurance holdings of mortgage-backed securities. The change replaced credit ratings with regulator-paid risk assessments by Pimco and BlackRock. We find no evidence for exploitation of the new system for trading purposes by the providers of the credit risk measure. However, replacing ratings has led to significant reductions in aggregate capital requirements: By 2012, equity capital requirements for structured securities were at $3.73bn compared to of $19.36bn if the old system had been maintained. These savings reflect the new measures of risk, and new rules allowing companies to economize on capital charges if assets are held below par. These book-value adjustments dilute the predictive power of the underlying risk measures, Our results are consistent with a regulatory change being largely driven by industry interests rather than maintaining financial stability.
    JEL: G22 G24 G28
    Date: 2013–07
  5. By: Giorgio Stefano Bertinetti (Università Ca' Foscari Venice); Elisa Cavezzali (Università Ca' Foscari Venice); Gloria Gardenal (Università Ca' Foscari Venice)
    Abstract: We aim to investigate the impact of the adoption of an Enterprise Risk Management (ERM) system on the enterprise value and to discover which are the determinants of this choice. Several economic actors have decided to face the current economic and financial complexity shifting from a Traditional silo-based Risk Management approach (TRM) to a more comprehensive one, the so called Enterprise Risk Management (ERM). Some academics have tried to investigate the effects of the ERM implementation on firm value, mainly focusing on the financial industry. The results are still controversial. Moreover, there is no empirical evidence about the adoption of ERM programs among non-financial companies. The aim of our study is double: first, we try to understand if the ERM implementation affects firm value on a sample of 200 European companies, belonging to both financial and non-financial industries; second, we test which are the determinants of the adoption of an ERM system. We do this performing a fixed effects panel regression analysis (goal 1) and a fixed effects logistic analysis (goal 2). We find a positive statistically significant relation between the ERM adoption and firm value. As for the probability that a firm engages in an ERM protocol, we find that size, the company beta and profitability (ROA) are the statistically significant determinants.
    Keywords: traditional risk management, enterprise risk management, industry, firm val
    JEL: G32 L22 L25
    Date: 2013–08
  6. By: Zaiwen Wen; Xianhua Peng; Xin Liu; Xiaoling Sun; Xiaodi Bai
    Abstract: Financial institutions are currently required to meet more stringent capital requirements than they were before the recent financial crisis; in particular, the capital requirement for a large bank's trading book under the Basel 2.5 Accord more than doubles that under the Basel II Accord. The significant increase in capital requirements renders it necessary for banks to take into account the constraint of capital requirement when they make asset allocation decisions. In this paper, we propose a new asset allocation model that incorporates the regulatory capital requirements under both the Basel 2.5 Accord, which is currently in effect, and the Basel III Accord, which was recently proposed and is currently under discussion. We propose an unified algorithm based on the alternating direction augmented Lagrangian method to solve the model; we also establish the first-order optimality of the limit points of the sequence generated by the algorithm under some mild conditions. The algorithm is simple and easy to implement; each step of the algorithm consists of solving convex quadratic programming or one-dimensional subproblems. Numerical experiments on simulated and real market data show that the algorithm compares favorably with other existing methods, especially in cases in which the model is non-convex.
    Date: 2013–08
  7. By: Teruyoshi Kobayashi; Kohei Hasui
    Abstract: Many immunization strategies have been proposed to prevent infectious viruses from spreading through a network. In this study, we propose efficient immunization strategies to prevent a default contagion that might occur in a financial network. An essential difference from the previous studies on immunization strategy is that we take into account the possibility of serious side effects. Uniform immunization refers to a situation in which banks are "vaccinated" with a common low-risk asset. The riskiness of immunized banks will decrease significantly, but the level of systemic risk may increase due to the de-diversification effect. To overcome this side effect, we propose another immunization strategy, counteractive immunization, which prevents pairs of banks from failing simultaneously. We find that counteractive immunization can efficiently reduce systemic risk without altering the riskiness of individual banks.
    Date: 2013–08
  8. By: Dorival Le\~ao; Alberto Ohashi; Vinicius Siqueira
    Abstract: In this work, we introduce a Monte Carlo method for the dynamic hedging of general European-type contingent claims in a multidimensional Brownian arbitrage-free market. Based on bounded variation martingale approximations for Galtchouk-Kunita-Watanabe decompositions, we propose a feasible and constructive methodology which allows us to compute pure hedging strategies w.r.t arbitrary square-integrable claims in incomplete markets. In particular, the methodology can be applied to quadratic hedging-type strategies for fully path-dependent options with stochastic volatility and discontinuous payoffs. We illustrate the method with numerical examples based on generalized Follmer-Schweizer decompositions, locally-risk minimizing and mean-variance hedging strategies for vanilla and path-dependent options written on local volatility and stochastic volatility models.
    Date: 2013–08
  9. By: Ojo, Marianne
    Abstract: As well as highlighting the importance of cost benefit analyses in decision- making processes where (expected) outcomes are very difficult to predict – given the degree of prevailing and potential risks and uncertainties, as well as the unquantifiable nature of such risks and uncertainties, this paper also illustrates the importance of complementary measures in the current Basel risk based capital adequacy framework. As technological advances and societal changes contribute towards the generation of certain levels of risks – some of which were previously not in existence, it is increasingly becoming evident that risks certainly have a dual nature. Institutional risks comprise of risks which are not only attributable to the firm or organisation where models (such as internal controls) or techniques are operated, namely internal control risks, but also the risks involved in managing those risks. In view of such uncertainties, and the continual evolution of risks, it becomes immediately apparent that certain outcomes cannot be predicted with high accuracy and certainty – hence the need to weigh the investment of high expenditure in such unpredictable outcomes. Is the desire to achieve comparability, as well as simplicity, greater than the need to attain accurate, reliable and more relevant results through investment in more complex techniques? Such techniques involving not only initially high outlays but also costs (as well as risks) involved in managing such techniques? These constitute some of the questions which this paper attempts to address.
    Keywords: comparability; simplicity; risk based capital adequacy framework; bank stress testing; risks; risk theories; Basel leverage ratios; liquidity standards
    JEL: E6 G2 G28 G3 K2
    Date: 2013–08–01
  10. By: Silvia Angilella; Sebastiano Mazz\`u
    Abstract: Small Medium-sized Enterprises (SMEs) face many obstacles when they try to access credit market. These obstacles are increased if the SMEs are innovative. In this case, financial data are insufficient or even not reliable. Thus, when building a judgemental rating model, mainly based on qualitative criteria (soft information), it is very important to finance SMEs' activities. Until now, there isn't a multicriteria credit risk model based on soft information for innovative SMEs. In this paper, we try to fill this gap by presenting a multicriteria credit risk model, specifically, ELECTRE-TRI. To obtain robust SMEs' assignments to the risk classes, a SMAA-TRI analysis is also implemented. In fact, SMAA-TRI incorporates ELECTRE-TRI by considering different sets of preference parameters with Monte Carlo simulations. Finally, we carry out some real case studies, with the aim of illustrating the multicriteria credit risk model proposed.
    Date: 2013–08
  11. By: Nassim N. Taleb; Constantine Sandis
    Abstract: Standard economic theory makes an allowance for the agency problem, but not the compounding of moral hazard in the presence of informational opacity, particularly in what concerns high-impact events in fat tailed domains. But the ancients did; so did many aspects of moral philosophy. We propose a global and morally mandatory heuristic that anyone involved in an action which can possibly generate harm for others, even probabilistically, should be required to be exposed to some damage, regardless of context. While perhaps not sufficient, the heuristic is certainly necessary hence mandatory. It is supposed to counter risk hiding in the tails. We link the rule to various philosophical approaches to ethics and moral luck.
    Date: 2013–08
  12. By: Christophe Courbage; Henry Loubergé; Richard Peter
    Abstract: This paper analyzes optimal prevention expenditures in a situation of multiple correlated risks. We focus on probability reduction (self-protection). This renders correlation endogenous so that we measure dependence as the relative deviation of the probability of joint losses from the uncorrelated case. If prevention concerns only one risk, introducing a negatively correlated exogenous risk increases the level of prevention expenditures. If prevention expenditures may be invested for both risks, a substitution effect arises due to the competition for resources. Under decreasing returns on self-protection we find that increased dependence increases overall prevention expenditures, but not necessarily prevention expenditures for each risk due to differences in prevention efficiency. Similar results are found when considering the impact of more severe losses. We derive policy implications from our results.
    Keywords: Prevention, correlation, multiple risks
    Date: 2013–07
  13. By: Siddiqi, Hammad
    Abstract: We put forward a new option pricing formula based on the notion that people tend to think by analogies and comparisons. The new formula differs from the Black Scholes formula due to the appearance of a parameter in the formula that captures the risk premium on the underlying. The new formula, called the analogy option pricing formula, provides an explanation for the implied volatility skew puzzle in equity options. We also discuss the key empirical predictions of the analogy formula.
    Keywords: Analogy Making, Implied Volatility, Implied Volatility Skew, Option Prices, Risk Premium
    JEL: G12 G13 G15
    Date: 2013–07–01

This nep-rmg issue is ©2013 by Stan Miles. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.