New Economics Papers
on Risk Management
Issue of 2013‒09‒13
seven papers chosen by

  1. Volatility of volatility and tail risk premiums By Yang-Ho Park
  2. The ‘Celtic Crisis’: Guarantees, Transparency and Systemic Liquidity Risk By Philipp König; Kartik Anand; Frank Heinemann
  3. OECD Risk Management: Strategic Crisis Management By Charles Baubion
  4. Pricing Bounds on Barrier Options (forthcoming in “Journal of Futures Marketsâ€) By Yukihiro Tsuzuki
  5. Time Varying Risk Aversion By Luigi Guiso; Paola Sapienza; Luigi Zingales
  6. A polynomial expansion to approximate the ultimate ruin probability in the compound Poisson ruin model By Pierre-Olivier Goffard; Stéphane Loisel; Denys Pommeret
  7. Stock Investments for Old-Age: Less Return, More Risk, and Unexpected Timing By Dirk Ulbricht

  1. By: Yang-Ho Park
    Abstract: This paper reports on tail risk premiums in two tail risk hedging strategies: the S&P 500 puts and the VIX calls. As a new measure of tail risk, we suggest using a model-free, risk-neutral measure of the volatility of volatility implied by a cross section of the VIX options, which we call the VVIX index. The tail risk measured by the VVIX index has forecasting power for future tail risk hedge returns. Specifically, consistent with the literature on rare disasters, an increase in the VVIX index raises the current prices of tail risk hedges and thus lowers their subsequent returns over the next three to four weeks. Furthermore, we find that volatility of volatility risk and its associated risk premium both significantly contribute to the forecasting power of the VVIX index, and that the predictability largely results from the integrated volatility of volatility rather than volatility jumps.
    Date: 2013
  2. By: Philipp König; Kartik Anand; Frank Heinemann
    Abstract: Bank liability guarantee schemes have traditionally been viewed as costless measures to shore up investor confidence and prevent bank runs. However, as the experiences of some European countries, most notably Ireland, have demonstrated, the credibility and effectiveness of these guarantees are crucially intertwined with the sovereign’s funding risks. Employing methods from the literature on global games, we develop a simple model to explore the systemic linkage between the rollover risks of a bank and a government, which are connected through the government’s guarantee of bank liabilities. We show the existence and uniqueness of the joint equilibrium and derive its comparative static properties. In solving for the optimal guarantee numerically, we show how its credibility can be improved through policies that promote balance-sheet transparency. We explain the asymmetry in risk transfer between the sovereign and the banking sector, following the introduction of a guarantee as being attributed to the resolution of strategic uncertainties held by bank depositors and the opacity of the banks’ balance sheets.
    Keywords: Financial stability; Financial system regulation and policies
    JEL: G01 G28 D89
    Date: 2013
  3. By: Charles Baubion
    Abstract: Governments are confronted with crises that may spread beyond national borders and trigger significant economic knock-on effects. Managing crises is a key responsibility for governments, which have a crucial role to play to strengthen the resilience of their population, communities and critical infrastructure networks.<P> The paper highlights the changing landscape of crises with which governments are confronted today, discussing new approaches to deal with both traditional and novel crises. The paper invites a reflection on how best governments can adapt to change while still maintaining capabilities to deal with more classic crises.<P> It concludes with identifying five cross-cutting issues in crisis management where government should pay attention when framing their policies and practices: an overall crisis governance framework, the role of science and expertise, leadership issues, the governance of response networks, and international cooperation. International exchange of experiences among governments and the development of shared best practices are core objectives for the OECD High Level Risk Forum under which the paper was prepared.
    Date: 2013–08–29
  4. By: Yukihiro Tsuzuki (The University of Tokyo)
    Abstract: This paper proposes the optimal pricing bounds on barrier options in an environment where plain-vanilla options and no-touch options can be used as hedging instruments. Super-hedging and sub-hedging portfolios are derived without specifying any underlying processes, which are static ones consisting of not only plain-vanilla options but also cash-paying no-touch options and/or asset paying no-touch options that pay one cash or one underlying asset respectively if the barrier has not been hit. Moreover, the prices of these portfolios turn out to be the optimal pricing bounds through finding risk-neutral measures under which the barrier option price is equal to the hedging portfolio's value. The model-independent pricing bounds are useful because a price of a barrier option is significantly dependent on a model. It is demonstrated through numerical examples that prices outside the pricing bounds can be produced by models which are calibrated to market prices of plain-vanilla options, but not to that of a no-touch option.
    Date: 2013–09
  5. By: Luigi Guiso (EIEF and CEPR); Paola Sapienza (Northwestern University, NBER and CEPR); Luigi Zingales (University of Chicago, NBER and CEPR)
    Abstract: We use a repeated survey of a large sample of clients of an Italian bank to measure possible changes in investors’ risk aversion following the 2008 financial crisis. We find that both a qualitative and a quantitative measure of risk aversion increase substantially after the crisis. These changes are correlated with changes in portfolio choices, but do not seem to be correlated with “standard” factors that affect risk aversion, such as wealth, consumption habit, and background risk. This opens the possibility that psychological factors might be driving it. To test whether a scary experience (as the financial crisis) can trigger large increases in risk aversion, we conduct a lab experiment. We find that indeed students who watched a scary video have a certainty equivalent that is 27% lower than the ones who did not. Following a sharp drop in stock prices,a fear model predicts that individuals should sell stocks, while the habit model has the opposite implications; people should actively buy stocks to bring the risky assets to the new optimal level. We show that after the drop in stock prices in 2008 individuals rebalanced their portfolio in a way consistent to a fear model.
    Date: 2013
  6. By: Pierre-Olivier Goffard (IML - Institut de mathématiques de Luminy - CNRS : UMR6206 - Université de la Méditerranée - Aix-Marseille II, AXA France - AXA); Stéphane Loisel (SAF - Laboratoire de Sciences Actuarielle et Financière - Université Claude Bernard - Lyon I : EA2429); Denys Pommeret (IML - Institut de mathématiques de Luminy - CNRS : UMR6206 - Université de la Méditerranée - Aix-Marseille II)
    Abstract: A numerical method to approximate ruin probabilities is proposed within the frame of a compound Poisson ruin model. The defective density function associated to the ruin probability is projected in an orthogonal polynomial system. These polynomials are orthogonal with respect to a probability measure that belongs to Natural Exponential Family with Quadratic Variance Function (NEF-QVF). The method is convenient in at least four ways. Firstly, it leads to a simple analytical expression of the ultimate ruin probability. Secondly, the implementation does not require strong computer skills. Thirdly, our approximation method does not necessitate any preliminary discretisation step of the claim sizes distribution. Finally, the coefficients of our formula do not depend on initial reserves.
    Keywords: Compound Poisson model; ultimate ruin probability; natural exponential families with quadratic variance functions; orthogonal polynomials; Gamma series expansion; Laplace transform inversion.
    Date: 2013–08–23
  7. By: Dirk Ulbricht
    Abstract: Returns merely based on one purchasing price of an asset are uninformative for people regularly contributing to their old-age provision. Here, each purchase has an influence on the outcome. Still, they are commonly used in finance literature, giving an overly optimistic view of expected long-term stock market returns and risks. Moreover, around business cycle turning points when volatility is high, these differences are accentuated so that the timing of market entries and exists differ substantially. This article compares risk and returns for regular and lump-sum investors for all possible intervals of investments in the Dow Jones Industrial Average ranging from one to 480 months from January 1934 to April 2013. Moreover, the optimal timing for the two types of investors in the run-up to business cycle turning points are contrasted. Lump-sum returns for forty year-horizons overstate regular contributors yields by 1.4 percentage points implying a forty percent higher terminal value. The Sharpe ratio of lump-sum investments is about 260 percent higher than for regular contributors, and the risk of negative returns disappears for horizons that are six years shorter. Increasing contributions deteriorate risk and returns. While lump-sum investors have eight months more time to switch to riskless assets before a contraction, regular contributors may return five months earlier to the stock market than lump-sum investors.
    Keywords: Retirement Accounts, Risk and Return, Business Cycle, Investment Management, Dollar-Cost Averaging
    JEL: G11 G10 E44
    Date: 2013

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NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.