nep-rmg New Economics Papers
on Risk Management
Issue of 2013‒08‒31
nineteen papers chosen by
Stan Miles
Thompson Rivers University

  1. Basis Risk, Procylicality, and Systemic Risk in the Solvency II Equity Risk Module By Eling, Martin; Pankoke, David
  2. Tail probabilities and partial moments for quadratic forms in multivariate generalized hyperbolic random vectors By Simon A. Broda
  3. Risk Preferences and Estimation Risk in Portfolio Choice By Hao Liu; Winfried Pohlmeier
  4. Network Centrality Measures and Systemic Risk: An Application to the Turkish Financial Crisis By Tolga Umut Kuzubas; Inci Omercikoglu; Burak Saltoglu
  5. Common Risk Factors of Infrastructure Firms By Ben Ammar, Semir; Eling, Martin
  6. Semiparametric Conditional Quantile Models for Financial Returns and Realized Volatility By Filip Zikes; Jozef Barunik
  7. The effect of capital controls and prudential FX measures on options-implied exchange rate stability By Marius del Giudice Rodriguez; Thomas Wu
  8. Following a Trend with an Exponential Moving Average: Analytical Results for a Gaussian Model By D. S. Grebenkov; J. Serror
  9. Stock index hedge using trend and volatility regime switch model considering hedging cost By Su, EnDer
  10. Measuring and Testing Tail Dependence and Contagion Risk between Major Stock Markets By Su, EnDer
  11. Energy, entropy, and arbitrage By Soumik Pal; Ting-Kam Leonard Wong
  12. Computation of ruin probabilities for general discrete-time Markov models By Ilya Tkachev; Alessandro Abate
  13. Efficient hedging in general Black-Scholes model By Kyong-Hui Kim; Myong-Guk Sin
  14. Common correlated effects and international risk sharing By Peter Fuleky; Luigi Ventura; Qianxue Zhao
  15. Macroeconomic factors strike back: A Bayesian change-point model of time-varying risk exposures and premia in the U.S. cross-section By Daniele Bianchi; Massimo Guidolin; Francesco Ravazzolo
  16. Variance Risk Premiums in Foreign Exchange Markets By Ammann, Manuel; Buesser, Ralf
  17. Bank leverage, financial fragility and prudential regulation By Olivier Bruno; André Cartapanis; Eric Nasica
  18. An Asian Perspective on Global Financial Reforms By Morgan, Peter J.; Pontines, Victor
  19. Aggregation of not necessarily independent opinions By Marcello Basili; Luca Pratelli

  1. By: Eling, Martin; Pankoke, David
    Abstract: This paper analyzes the equity risk module of Solvency II, the new regulatory framework in the European Union. The equity risk module contains a symmetric adjustment mechanism called equity dampener which shall reduce procyclicality of capital requirements and thus systemic risk in the insurance sector. We critically review the equity risk module in three steps: we first analyze the sensitivities of the equity risk module with respect to the underlying technical basis, then work out potential basis risk (i.e., deviations of the insurers actual equity risk from the Solvency II equity risk), and — based on these results — measure the impact of the symmetric adjustment mechanism on the goals of Solvency II. The equity risk module is backward looking in nature and a substantial basis risk exists if realistic equity portfolios of insurers are considered. Both results underline the importance of the own risk and solvency assessment (ORSA) under Solvency II. Moreover, we show that the equity dampener leads to substantial deviations from the proposed 99.5% confidence level and thereby reduces procyclicality of capital requirements. Our results are helpful for academics interested in regulation and risk management as well as for practitioners and regulators working on the implementation of such models.
    Keywords: Solvency II, procyclicality, systemic risk, CoVaR, MES.
    JEL: G22 G28 G32
    Date: 2013–02
  2. By: Simon A. Broda
    Abstract: Countless test statistics can be written as quadratic forms in certain random vectors, or ratios thereof. Consequently, their distribution has received considerable attention in the literature. Except for a few special cases, no closed-form expression for the cdf exists, and one resorts to numerical methods. Traditionally the problem is analyzed under the assumption of joint Gaussianity; the algorithm that is usually employed is that of Imhof (1961). The present manuscript generalizes this result to the case of multivariate generalized hyperbolic (MGHyp) random vectors. The MGHyp is a very flexible distribution which nests, among others, the multivariate t, Laplace, and variance gamma distributions. An expression for the first partial moment is also obtained, which plays a vital role in financial risk management. The proof involves a generalization of the classic inversion formula due to Gil-Pelaez (1951). Two applications are considered: first, the finite-sample distribution of the 2SLS estimator of a structural parameter. Second, the Value at Risk and Expected Shortfall of a quadratic portfolio with heavy-tailed risk factors.
    Date: 2013–05–01
  3. By: Hao Liu (CoFE, University of Konstanz, Germany); Winfried Pohlmeier (CoFE, University of Konstanz, Germany; ZEW, Germany; RCEA, Italy)
    Abstract: This paper analyzes the estimation risk of efficient portfolio selection. We use the concept of certainty equivalent as the basis for a well-defined statistical loss function and a monetary measure to assess estimation risk. For given risk preferences we provide analytical results for different sources of estimation risk such as sample size, dimension of the portfolio choice problem and correlation structure of the return process. Our results show that theoretically sub-optimal portfolio choice strategies turn out to be superior once estimation risk is taken into account. Since estimation risk crucially depends on risk preferences, the choice of the estimator for a given portfolio strategy becomes endogenous. We show that a shrinkage approach accounting for estimation risk in both, mean and covariance of the return vector, is generally superior to simple theoretically suboptimal strategies. Moreover, focusing on just one source of estimation risk, e.g. risk reduction in covariance estimation, can lead to suboptimal portfolios.
    Keywords: efficient portfolio, estimation risk, certainty equivalent, shrinkage
    JEL: G11 G12 G17
    Date: 2013–08
  4. By: Tolga Umut Kuzubas; Inci Omercikoglu; Burak Saltoglu
    Date: 2013–12
  5. By: Ben Ammar, Semir; Eling, Martin
    Abstract: The risk of infrastructure firms is driven by unique factors that cannot be well described by standard asset class factor models. We thus create a seven-factor model based on infrastructure-specific risk exposure, i.e., market risk, cash flow volatility, leverage, investment growth, term risk, default risk, and regulatory risk. We empirically test our model on a large dataset of U.S. infrastructure stocks in different subsectors (utility, telecommunication, and transportation) and over a long period of time (1980 to 2011). The new factor model is able to capture the variation of infrastructure returns better than the Fama/French three-factor or the Carhart four-factor models. Thus, our model helps to better determine the cost of capital of infrastructure firms, something that is increasingly relevant in light of the growing need for privately financed infrastructure projects.
    Keywords: Infrastructure, Asset class, Factor model, Fama/French factors, Leverage, Cash ow volatility, Investment factor.
    JEL: G11 G12 G19 O18
    Date: 2013–05
  6. By: Filip Zikes; Jozef Barunik
    Abstract: This paper investigates how the conditional quantiles of future returns and volatility of financial assets vary with various measures of ex-post variation in asset prices as well as option-implied volatility. We work in the flexible quantile regression framework and rely on recently developed model-free measures of integrated variance, upside and downside semivariance, and jump variation. Our results for the S&P 500 and WTI Crude Oil futures contracts show that simple linear quantile regressions for returns and heterogenous quantile autoregressions for realized volatility perform very well in capturing the dynamics of the respective conditional distributions, both in absolute terms as well as relative to a couple of well-established benchmark models. The models can therefore serve as useful risk management tools for investors trading the futures contracts themselves or various derivative contracts written on realized volatility.
    Date: 2013–08
  7. By: Marius del Giudice Rodriguez; Thomas Wu
    Abstract: Has the recent wave of capital controls and prudential foreign exchange (FX) measures been effective in promoting exchange rate stability? We tackle this question by studying a panel of 25 countries/currencies from July 1, 2009, to June 30, 2011. We calculate daily measures of exchange rate volatility, absolute crash risk, and tail risk implied in currency option prices, and we construct indices of capital controls and prudential FX measures taking into account the exact date when policy changes are implemented. Using a difference-in-differences approach, we find evidence that (i) tightening controls on non-residents suppresses daily exchange rate fluctuations at the cost of increasing the frequency of outliers, (ii) easing controls on residents truly improves exchange rate stability over all dimensions, and (iii) tightening prudential FX measures not specific to derivative markets reduces absolute crash risk and tail risk, with no effect on volatility.
    Keywords: Foreign exchange
    Date: 2013
  8. By: D. S. Grebenkov; J. Serror
    Abstract: We investigate how price variations of a stock are transformed into profits and losses (P&Ls) of a trend following strategy. In the frame of a Gaussian model, we derive the probability distribution of P&Ls and analyze its moments (mean, variance, skewness and kurtosis) and asymptotic behavior (quantiles). We show that the asymmetry of the distribution (with often small losses and less frequent but significant profits) is reminiscent to trend following strategies and less dependent on peculiarities of price variations. At short times, trend following strategies admit larger losses than one may anticipate from standard Gaussian estimates, while smaller losses are ensured at longer times. Simple explicit formulas characterizing the distribution of P&Ls illustrate the basic mechanisms of momentum trading, while general matrix representations can be applied to arbitrary Gaussian models. We also compute explicitly annualized risk adjusted P&L and strategy turnover to account for transaction costs. We deduce the trend following optimal timescale and its dependence on both auto-correlation level and transaction costs. Theoretical results are illustrated on the Dow Jones index.
    Date: 2013–08
  9. By: Su, EnDer
    Abstract: This paper studies the risk hedging between stock index and underlying futures. The hedging ratios are optimized using the mean-variance utility function as considering the hedging cost. The trend of returns and variance are estimated by the model of regime switch on both vector autoregression (VAR) and GARCH(1,1) compared to three restricted models: VAR switch only, GARCH(1,1) switch only, and no switch. The hedge portfolio is constructed by Morgan Stanley Taiwan Index (MSTI) and Singapore Traded MSTI futures. The hedge horizon is set as a week to reduce the hedging cost and the weekly in-sample data cover from 08/09/2001 to 05/31/2007. The rolling window technique is used to evaluate the hedge performances of out-of-sample period spanning subprime, Greek debt, and post-risk durations. The subprime period indeed is evidenced very vital to achieve the hedge performance. All models perform surprisingly far above average during subprime period. The hedge ratios indeed are the tradeoff between maximum expected return and minimum variance. It is demonstrated challenging for all models to increase returns and reduce risk together. The hedge context is further classified into four hedge states: uu, ud, du, and dd (u and d denote respectively usual and down) using the state probabilities of series. The regime switch models are found to have much greater wealth increase when in dd state. It is decisive to hedge risk in dd state when volatility is extensively higher as observed recurrently in subprime period. Remarkably, the trend switch is found having larger wealth increase while the volatility switch is not found prominent between models. While the no switch model has larger utility increase in uu state as most observed in Greek debt or post risk period, its performance is far below average like other models.
    Keywords: stock index, regime switch, hedging cost, hedging ratio
    JEL: C13 C51
    Date: 2013–01–09
  10. By: Su, EnDer
    Abstract: In this paper, three copula GARCH models i.e. Gaussian, Student-t, and Clayton are used to estimate and test the tail dependence measured by Kendall’s tau between six stock indices. Since the contagion risk spreads from large markets to small markets, the tail dependence is studied for smaller Taiwanese and South Korean stock markets, i.e. Taiex and Kospi against four larger stock markets, i.e. S&P500, Nikkei, MSCI China, and MSCI Europe. The vector autoregression result indicates that S&P500 and MSCI China indeed impact mostly and significantly to the other four stock markets. However, the tail dependence of both Taiex and Kospi against S&P500 and MSCI Chia are lower due to unilateral impacts from US and China. Using Clayton copula GARCH, the threshold tests of Kendall’s tau between most stock markets except China are significant during both subprime and Greek debt crises. The tests of Student-t copula GARCH estimated Kendall’s taus are only acceptable for subprime crisis but not for Greek debt crisis. Thus, Clayton copula GARCH is found appropriate to estimate Kendall’s taus as tested by threshold regression.
    Keywords: contagion risk, tail dependence, copula GARCH, threshold test
    JEL: C0 C13
    Date: 2013–01–30
  11. By: Soumik Pal; Ting-Kam Leonard Wong
    Abstract: We introduce a framework to analyze the relative performance of a portfolio with respect to a benchmark market index. We show that this relative performance has three components: a term that can be interpreted as energy coming from the market fluctuations, a relative entropy term that measures "distance" between the portfolio holdings and the market capital distribution, and another entropy term that can be controlled by the trader by choosing a suitable strategy. The first aids growth in the portfolio value, and the second poses as relative risk of being too far from the market. We give several explicit controls of the third term that allows one to outperform a diverse volatile market in the long run. Named energy-entropy portfolios, these strategies work in both discrete and continuous time, and require essentially no probabilistic or structural assumptions. They are well-suited to analyze a hierarchical portfolio of portfolios and attribute relative risk and reward to different levels of the hierarchy. We also consider functionally generated portfolios (introduced by Fernholz) in the case of two assets and the binary tree model and give a novel explanation of their efficacy.
    Date: 2013–08
  12. By: Ilya Tkachev; Alessandro Abate
    Abstract: We study the ruin problem over a risk process described by a discrete-time Markov model. In contrast to previous studies that focused on the asymptotic behaviour of ruin probabilities for large values of the initial capital, we provide a new technique to compute the quantity of interest for any initial value, and with any given precision. Rather than focusing on a particular model for risk processes, we give a general characterization of the ruin probability by providing corresponding recursions and fixpoint equations. Since such equations for the ruin probability are ill-posed in the sense that they do not allow for unique solutions, we approximate the ruin probability by a two-barrier ruin probability, for which fixpoint equations are well-posed. We also show how good the introduced approximation is by providing an explicit bound on the error and by characterizing the cases when the error converges to zero. The presented technique and results are supported by two computational examples over models known in the literature, one of which is extremely heavy-tailed.
    Date: 2013–08
  13. By: Kyong-Hui Kim; Myong-Guk Sin
    Abstract: An investor faced with a contingent claim may eliminate risk by perfect hedging, but as it is often quite expensive, he seeks partial hedging (quantile hedging or efficient hedging) that requires less capital and reduces the risk. Efficient hedging for European call option was considered in the standard Black-Scholes model with constant drift and volatility coefficients. In this paper we considered the efficient hedging for European call option in general Black-Scholes model $dX_t=X_t(m(t)dt+\sigma (t)dw(t))$ with time-varying drift and volatility coefficients and in fractional Black-Scholes model $dX_t=X_t(mdt+\sigma dB_H(t))$ with constant coefficients.
    Date: 2013–08
  14. By: Peter Fuleky (UHERO, University of Hawaii at Manoa); Luigi Ventura (Department of Economics and Law, Sapienza, University of Rome); Qianxue Zhao (UHERO, University of Hawaii at Manoa)
    Abstract: Existing studies of risk pooling among groups of countries are predicated upon the highly restrictive assumption that all countries have symmetric responses to aggregate shocks. We show that the conventional risk sharing test fails to isolate idiosyncratic fluctuations within countries and produces spurious results. To avoid these problems, we propose an alternative form of the risk sharing test that is robust to heterogeneous country characteristics. In our empirical example, we provide estimates using the proposed approach for various groupings of 158 countries.
    Keywords: Panel data, Cross-sectional dependence, International risk sharing, Consumption insurance
    JEL: C23 C51 E21 F36
    Date: 2013–03
  15. By: Daniele Bianchi (Bocconi University); Massimo Guidolin (IGIER Bocconi University); Francesco Ravazzolo (Norges Bank (Central Bank of Norway) and BI Norwegian Business School)
    Abstract: This paper proposes a Bayesian estimation framework for a typical multi-factor model with time-varying risk exposures to macroeconomic risk factors and corresponding premia to price U.S. stocks and bonds. The model assumes that risk exposures and idiosynchratic volatility follow a break-point latent process, allowing for changes at any point in time but not restricting them to change at all points. An empirical application to 40 years of U.S. data and 23 portfolios shows that the approach yields sensible results compared to previous two-step methods based on naive recursive estimation schemes, as well as a set of alternative model restrictions. A variance decomposition test shows that although most of the predictable variation comes from the market risk premium, a number of additional macroeconomic risks, including real output and inflation shocks, are significantly priced in the cross-section. A Bayes factor analysis decisively favors the proposed change-point model.
    Keywords: Change-point model, Stochastic volatility, Multi-factor linear models
    JEL: G11 C53
    Date: 2013–08–22
  16. By: Ammann, Manuel; Buesser, Ralf
    Abstract: Based on the theory of static replication of variance swaps we assess the sign and magnitude of variance risk premiums in foreign exchange markets. We find significantly negative risk premiums when realized variance is computed from intraday data with low frequency. As a likely consequence of microstructure effects however, the evidence is ambiguous when realized variance is based on high-frequency data. Common to all estimates, variance risk premiums are highly time-varying and inversely related to the risk-neutral expectation of future variance. When we test whether variance risk premiums can be attributed to classic risk factors or fear of jump risk, we find that conditional premiums remain significantly negative. However, we observe a strong relationship between the size of log variance risk premiums and the VIX, the TED spread and the general shape of the implied volatility function of the corresponding currency pair. Overall, we conclude that there is a separately priced variance risk factor which commands a highly time-varying premium.
    Keywords: Foreign exchange, variance risk premium, variance swap, intraday data, risk- neutral expectation, jump risk.
    JEL: C12 C13 F31 G12 G13 G15
    Date: 2013–04
  17. By: Olivier Bruno (GREDEG - Groupe de Recherche en Droit, Economie et Gestion - CNRS : UMR7321 - Université Nice Sophia Antipolis [UNS]); André Cartapanis (CHERPA - Croyance, Histoire, Espace, Régulation Politique et Administrative - Institut d'Études Politiques [IEP] - Aix-en-Provence - Aix-Marseille Université - AMU); Eric Nasica (GREDEG - Groupe de Recherche en Droit, Economie et Gestion - CNRS : UMR7321 - Université Nice Sophia Antipolis [UNS])
    Abstract: We analyse the determinants of banks' balance-sheet and leverage-ratio dynamics and their role in increasing financial fragility. Our results are twofold. First, we show that there is a value of bank's leverage that minimises financial fragility. Second, we show that this value depends on the overall business climate, the expected value of the collateral and the riskless interest rate. This result leads us to advocate the establishment of anadjustableleverage ratio, depending on economic conditions, rather than the fixed ratio provided for under the new Basel III regulation.
    Keywords: Bank Leverage, Leverage ratios, Financial Instability, Prudential Regulation
    Date: 2013–08–23
  18. By: Morgan, Peter J. (Asian Development Bank Institute); Pontines, Victor (Asian Development Bank Institute)
    Abstract: The purpose of this study is to better understand the likely impact on Asian economies and financial institutions of various recent global financial reforms, including Basel III capital adequacy and liquidity rules. Overall, the authors find that the Basel III capital adequacy rules are likely to have limited impacts on economic growth in Asia, but other financial regulations, including liquidity standards and rules for over-the-counter (OTC) derivatives, could have stunting effects on financial development in the region.
    Keywords: asian economies; financial institutions; global financial reforms; basel iii; capital adequacy rules; liquidity rules; otc derivatives
    JEL: E17 G01 G18 G21
    Date: 2013–08–22
  19. By: Marcello Basili; Luca Pratelli
    Abstract: We consider an aggregation scheme of opinions expressed through different probability distributions or multiple priors decision model. The decision-maker adopts entropy maximization as a measure of risk diversification and a rational form of prudence for valuing uncertain outcomes. We show a new aggregation rule formalization based on the idea that the decision-maker has a more reliable set of outcomes called ordinary and two fat tails that include more ambiguous and extreme events.
    Keywords: Ambiguity, Aggregation, Entropy, Multiple Priors, Quantiles
    JEL: D81
    Date: 2013–06

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