nep-rmg New Economics Papers
on Risk Management
Issue of 2013‒11‒16
twenty-two papers chosen by
Stan Miles
Thompson Rivers University

  1. Business Cycles with Revolutions By Lance Kent; Toan Phan
  2. VaR-implied tail-correlation matrices By Mittnik, Stefan
  3. Efficient versus inefficient hedging strategies in the presence of financial and longevity (value at) risk By Elisa Luciano; Luca Regis
  4. A Systematic approach to identify systemically important firms By Natasha Agarwal et al
  5. Bank ratings: What determines their quality? By Harald Hau; Sam Langfield; David Marques-Ibanez
  6. Disentangling the bond-CDS nexus: a stress test model of the CDS market By Vuillemey, Guillaume; Peltonen, Tuomas A.
  7. Sudden stop of capital flows and the consequences for the banking sector and the real economy By Neagu, Florian; Mihai, Irina
  8. An analysis of portfolio selection with multiplicative background risk By Guo, Xu; Wong, Wing-Keung; Zhu, Lixing
  9. Basel III: Some costs will outweigh the benefits By Paul H. Kupiec
  10. Interbank contagion and resolution procedures: inspecting the mechanism By Edoardo Gaffeo; Massimo Molinari
  11. Procese decizionale în cadrul managementului riscurilor By Stefanescu, Razvan; Dumitriu, Ramona
  12. Option Prices in a Model with Stochastic Disaster Risk By Sang Byung Seo; Jessica A. Wachter
  13. Komponenten und Determinanten des Credit Spreads: Empirische Untersuchung während Phasen von Marktstress By Odermann, Alexander; Cremers, Heinz
  14. Competition And Bank Risk: The Role Of Securitization And Bank Capital By Yener Altunbas; Michiel van Leuvensteijn; David Marques-Ibanez
  15. Risk-Return Trade-Off for European Stock Markets By Nektarios Aslanidis; Charlotte Christiansen; Christos S. Savva
  16. Setting countercyclical capital buffers based on early warning models: would it work? By Behn, Markus; Detken, Carsten; Peltonen, Tuomas A.; Schudel, Willem
  17. Gaussian kernel GARCH models By Xibin Zhang; Maxwell L. King
  18. Panel Data Nonparametric Estimation of Production Risk and Risk Preferences: An Application to Polish Dairy Farms By Tomasz Gerard Czekaj; Arne Henningsen
  19. Measures of uncertainty in market network analysis By V. A. Kalyagin; A. P. Koldanov; P. A. Koldanov; P. M. Pardalos; V. A. Zamaraev
  20. Unbiased community detection for correlation matrices By Mel MacMahon; Diego Garlaschelli
  21. Interest rate swaps and corporate default By Jermann, Urban J.; Yue, Vivian Z.
  22. Sovereign Wealth and Risk Management. A New Framework for Optimal Asset Allocation of Sovereign Wealth By Bodie, Zvi; Brière, Marie

  1. By: Lance Kent (Department of Economics, College of William and Mary); Toan Phan (Department of Economics, UNC-Chapel Hill)
    Abstract: This paper develops an empirical macroeconomic framework to analyze the relationship between major political disruptions and business cycles of a country. We combine a new dataset of political revolutions (mass domestic political campaigns to remove dictators and juntas) across the world since 1960, with coup data and traditional macro data (of output, investment, trade, inflation and exchange rate). We then build a panel vector-autoregression model with two novel ingredients: (1) political disruptions and (2) an estimated probability of such disruptions. We find that both terms have statistically and economically significant impacts on business cycles. Interestingly, the impacts of the second term dominate those of the first, both statistically and economically. This suggests that our measure of political risk captures an important source of time-varying uncertainty and volatility in many countries.
    Keywords: business cycles, political risk, time-varying uncertainty, panel VAR
    Date: 2013–11–05
  2. By: Mittnik, Stefan
    Abstract: Empirical evidence suggests that asset returns correlate more strongly in bear markets than conventional correlation estimates imply. We propose a method for determining complete tail-correlation matrices based on Value-at-Risk (VaR) estimates. We demonstrate how to obtain more effi cient tail-correlation estimates by use of overidenti cation strategies and how to guarantee positive semidefi niteness, a property required for valid risk aggregation and Markowitz-type portfolio optimization. An empirical application to a 30-asset universe illustrates the practical applicability and relevance of the approach in portfolio management. --
    Keywords: Downside risk,Estimation efficiency,Portfolio optimization,Positive semidefiniteness,Solvency II,Value-at-Risk
    JEL: C1 G11
    Date: 2013
  3. By: Elisa Luciano; Luca Regis
    Abstract: This paper provides a closed-form Value-at-Risk (VaR) for the net exposure of an annuity provider, taking into account both mortality and interest-rate risk, on both assets and liabilities. It builds a classical risk- return frontier and shows that hedging strategies - such as the transfer of longevity risk - may increase the overall risk while decreasing expected returns, thus resulting in inefficient outcomes. Once calibrated to the 2010 UK longevity and bond market, the model gives conditions under which hedging policies become inefficient.
    JEL: G22 G32
    Date: 2013
  4. By: Natasha Agarwal et al (Indira Gandhi Institute of Development Research)
    Abstract: This paper uses the average of the percentile ranking of three measures of systemic risk - Granger Causality, Marginal Expected Shortfall, and Conditional Value at Risk - to calculate a single systemic risk index (SRI) for a lrm. The SRI is used to identify systemically important lrms (SIFs) among the 50 largest lrms in a quarter. This has the advantage of identifying SIFs on a regular basis using readily available data. The paper uses this approach to identify SIFs by SRI each quarter from 2000 to 2012, and lnds that the cumulative risk of the SIFs tracks the changes in systemic risk in India during the 2008 crisis. The paper also lnds merit in monitoring non-lnancial lrms by their SRI, particularly when bank loan portfolios have concentrated exposures in these firms.
    Keywords: Systemic Risk Measures, Systemically Important Firms
    JEL: G12 G29 C13 G31
    Date: 2013–10
  5. By: Harald Hau (University of Geneva, Swiss Finance Institute and CEPR); Sam Langfield (European Systemic Risk Board Secretariat and UK Financial Services Authority); David Marques-Ibanez (European Central Bank)
    Abstract: This paper examines the quality of credit ratings assigned to banks in Europe and the United States by the three largest rating agencies over the past two decades. We interpret credit ratings as relative assessments of creditworthiness, and define a new ordinal metric of rating error based on banks’ expected default frequencies. Our results suggest that rating agencies assign more positive ratings to large banks and to those institutions more likely to provide the rating agency with additional securities rating business (as indicated by private structured credit origination activity). These competitive distortions are economically significant and help perpetuate the existence of ‘too-big-to-fail’ banks. We also show that, overall, differential risk weights recommended by the Basel accords for investment grade banks bear no significant relationship to empirical default probabilities.
    Keywords: Rating Agencies, Credit Ratings, Conflicts of Interest, Prudential Regulation
    JEL: G21 G23 G28
  6. By: Vuillemey, Guillaume; Peltonen, Tuomas A.
    Abstract: This paper presents a stress test model for the CDS market, with a focus on the interplay between banks’ bond and CDS holdings. The model enables the analysis of credit risk transfer mechanisms, includes features of market and liquidity risk, and allows for contagious propagation of counterparty failures. As an illustration, we calibrate the model using sovereign bond and CDS data for 65 major European banks. The model simulation shows that, in case of a sovereign credit event, banks’ losses due to direct and correlated bond exposures are significantly higher than losses due to CDS exposures. The main risk for CDS sellers is found to be sudden increases in collateral requirements on multiple correlated CDS exposures. Close-out netting considerably reduces the extent to which contagion may occur. JEL Classification: G21, H63, G15
    Keywords: collateral, Contagion, credit default swap, credit event, liquidity risk, market risk, stress test
    Date: 2013–10
  7. By: Neagu, Florian; Mihai, Irina
    Abstract: The paper develops a macro-prudential liquidity stress-testing tool in order to capture the possible consequences of a capital outflow (including a run of deposits). The tool includes a feedback from the banking sector to the real economy, incorporates a link between liquidity risk and solvency risk, and is tailored for emerging market features. The stress-testing tool aims to: (i) test the capacity of the banking sector to withstand the sudden stop of capital flows, and to gauge the consequences of the liquidity stress to the solvency ratio; (ii) quantify the liquidity deficit that a central bank should accommodate; (iii) assess the impact on credit supply when the sudden stop occurs; and (iv) support the implementation of an orderly disintermediation process. The macro-prudential tool is applied on the Romanian banking sector. JEL Classification: G21, F32
    Keywords: banks, emerging markets, macro-prudential tool, stress-testing, systemic liquidity
    Date: 2013–09
  8. By: Guo, Xu; Wong, Wing-Keung; Zhu, Lixing
    Abstract: This paper investigates the impact of multiplicative background risk on an investor's portfolio choice in a mean-variance framework. We also study the efficient boundary frontiers with and without risk-free security.
    Keywords: Background risk; Portfolio selection; VaR; CVaR
    JEL: C02 G11
    Date: 2013–11–08
  9. By: Paul H. Kupiec (American Enterprise Institute)
    Abstract: The new Basel III regulations will require significantly higher minimum capital levels for banks and bank holding companies. Although many applaud higher capital levels for large institutions, it is unclear that there are good economic reasons to apply these rules to small banks.
    Keywords: financial services outlook,capital requirements,Basel III,Basel Committee on Banking Supervision
    JEL: A G
    Date: 2013–11
  10. By: Edoardo Gaffeo; Massimo Molinari
    Abstract: This paper develops a network model of a stylized banking system in which banks are connected to one another through interbank claims, which allows us to study the diffusion of default avalanches triggered by an exogenous shock under a number of different assumptions on the degree of interconnectedness, level of capitalization, liquidity buffers, the size of the interbank market and fire-sales. We expand upon the existing literature by embedding two alternative resolution mechanisms. First, liquidations triggered by either illiquidity or insolvency-related distress implying asset sales and compensation of creditors. Second, a bail-in mechanism avoiding bank closure by forcing a recapitalization provided by bank creditors. Our model speaks to how contagion dynamics unravel via illiquidity-driven defaults in the first case and higher-order losses in the latter one. Within this framework, we show how counter-party liquidity risk externality can be resolved and put forward a macro-criterion to assess the adequacy of the liquidity ratio introduced with Basel III.
    Keywords: Systemic Risk, Banking Network, Resolution Procedures
    JEL: D85 G28 G33
    Date: 2013
  11. By: Stefanescu, Razvan; Dumitriu, Ramona
    Abstract: This paper approaches the risk management as a decision making process in which the best solution to an exposure is found and implemented. Such a process includes five stages: identifying the risk, assessment of exposure, analysis of the alternatives to deal with the exposure, adopting the optimum alternative and the implementation of the adopted solution.
    Keywords: Risk Management, Uncertainty, Business Environment, Decision Making Process
    JEL: D81 D89 G32
    Date: 2013–10–17
  12. By: Sang Byung Seo; Jessica A. Wachter
    Abstract: Large rare shocks to aggregate consumption, namely, disasters, have been proposed as an explanation for the equity premium. However, recent work suggests that the consumption distribution required by this mechanism is inconsistent with the average implied volatility curve derived from option prices. We show that this apparent inconsistency can be resolved in a model with stochastic disaster risk. That is, we show that a model with a stochastic probability of disaster can explain average implied volatilities, despite being calibrated to consumption and aggregate market data alone. We also extend the stochastic disaster risk model to one that allows for variation in the risk of disaster at different time scales. We show that this extension allows the model to match variation in the level and slope of implied volatilities, as well as the average implied volatility curve.
    JEL: G12 G13
    Date: 2013–11
  13. By: Odermann, Alexander; Cremers, Heinz
    Abstract: -- The credit crisis and the following sovereign debt crisis during 2007 and 2012 led to an increasing volatility of European corporate bond credit spreads. European investment grade credit spreads rose in 2007 and 2008 from 50 BP to over 350 BP. In the years after the credit spreads declined to 100 BP caused by global central bank interventions. Since 2010 the sovereign debt crisis in the eurozone intensified and credit spreads simultaneously widened to 200 BP. This paper defines the components of the credit spread by analysing different risk factors of corporate bonds such as credit risk, market risk and residual spread risk. To specify the proper credit spread level, various mesurement methods like the yield to maturity, zero rate, z-spread and credit default swaps are compared. To better understand the changes of credit spreads over time this paper further discusses the determining drivers of the credit spread. Backed by a theoretical framework the relevant drivers of the credit spread changes are the term structure of interest rates, the economic cycle, the enterprise value and the market liquidity. The credit spread drivers are empirically tested in a regression analysis using European investment grade corporate bond data during 2007 and 2012.
    Keywords: Credit Spread,Present value,Credit Spread components,Default risk,Credit Spread risk,Liquidity risk,Risk free rate,Yield-to-maturity,Zero rate,Z-Spread,Structured Model,Reduced Form Model,Credit Spread drivers
    JEL: G01 G11 G12 G32 C15
    Date: 2013
  14. By: Yener Altunbas (Bangor University); Michiel van Leuvensteijn (APG); David Marques-Ibanez (European Central Bank)
    Abstract: We find that the increased use of securitization activity in the banking sector augmented the effect of competition on realized bank risk during the 2007-2009 crisis. Our results suggest that securitization by itself does not lead to augmented risk while higher levels of capital do not buffer the impact of competition on realized risk. It follows that cooperation between supervisory and competition authorities would be beneficial when acting on the financial stability implications of financial innovation and the effects of bank capital regulation.
    Keywords: securitization; competition; bank risk
    JEL: G21 D22
    Date: 2013–10
  15. By: Nektarios Aslanidis (Department of Economics, FCEE, University Rovira Virgili); Charlotte Christiansen (Cyprus University of Technology); Christos S. Savva (Aarhus University and CREATES)
    Abstract: This paper adopts dynamic factor models with macro-fi?nance predictors to revisit the intertemporal risk-return relation in ?five large European stock markets. We identify country specifi?c, Euro area, and global factors to determine the conditional moments of returns considering the role of higher-order moments as additional measures of risk. The preferred combination of factors varies across countries. In the linear model, there is a strong but negative relation between conditional returns and conditional volatility. A Markov switching model describes the risk-return trade-off well. A number of variables have explanatory power for the states of the European stock markets.
    Keywords: Risk-return trade-off, Dynamic factor model, Markov switching, Macro-?nance predictors, Higher order moments
    JEL: C22 G11 G12 G17
    Date: 2013–07–29
  16. By: Behn, Markus; Detken, Carsten; Peltonen, Tuomas A.; Schudel, Willem
    Abstract: This paper assesses the usefulness of private credit variables and other macrofinancial and banking sector indicators for the setting of Basel III / CRD IV countercyclical capital buffers (CCBs) in a multivariate early warning model framework, using data for 23 EU Members States from 1982 Q2 to 2012 Q3. We find that in addition to credit variables, other domestic and global financial factors such as equity and house prices as well as banking sector variables help to predict vulnerable states of the economy in EU Member States. We therefore suggest that policy makers take a broad approach in their analytical models supporting CCB policy measures. JEL Classification: G01, G21, G28
    Keywords: banking crises, Basel III, countercyclical capital buffer, CRD IV, early warning model, financial regulation
    Date: 2013–11
  17. By: Xibin Zhang; Maxwell L. King
    Abstract: This paper aims to investigate a Bayesian sampling approach to parameter estimation in the GARCH model with an unknown conditional error density, which we approximate by a mixture of Gaussian densities centered at individual errors and scaled by a common standard deviation. This mixture density has the form of a kernel density estimator of the errors with its bandwidth being the standard deviation. This study is motivated by the lack of robustness in GARCH models with a parametric assumption for the error density when used for error-density based inference such as value-at-risk (VaR) estimation. A contribution of the paper is to construct the likelihood and posterior of the model and bandwidth parameters under the kernel-form error density, and to derive the one-step-ahead posterior predictive density of asset returns. We also investigate the use and benefit of localized bandwidths in the kernel-form error density. A Monte Carlo simulation study reveals that the robustness of the kernel-form error density compensates for the loss of accuracy when using this density. Applying this GARCH model to daily return series of 42 assets in stock, commodity and currency markets, we find that this GARCH model is favored against the GARCH model with a skewed Student t error density for all stock indices, two out of 11 currencies and nearly half of the commodities. This provides an empirical justification for the value of the proposed GARCH model.
    Keywords: Bayes factors, Gaussian kernel error density, localized bandwidths, Markov chain Monte Carlo, value-at-risk
    Date: 2013
  18. By: Tomasz Gerard Czekaj (Department of Food and Resource Economics, University of Copenhagen); Arne Henningsen (Department of Food and Resource Economics, University of Copenhagen)
    Abstract: We apply nonparametric panel data kernel regression to investigate production risk, out-put price uncertainty, and risk attitudes of Polish dairy farms based on a firm-level unbalanced panel data set that covers the period 2004–2010. We compare different model specifications and different approaches for obtaining firm-specific measures of risk attitudes. We found that Polish dairy farmers are risk averse regarding production risk and price uncertainty. According to our results, Polish dairy farmers perceive the production risk as being more significant than the risk related to output price uncertainty.
    Keywords: production risk, price uncertainty, nonparametric econometrics, panel data, Polish dairy farms
    JEL: C14 C23 D24 Q12
    Date: 2013–10
  19. By: V. A. Kalyagin; A. P. Koldanov; P. A. Koldanov; P. M. Pardalos; V. A. Zamaraev
    Abstract: Statistical uncertainty of different filtration techniques for market network analysis is studied. Two measures of statistical uncertainty are discussed. One is based on conditional risk for multiple decision statistical procedures and another one is based on average fraction of errors. It is shown that for some important cases the second measure is a particular case of the first one. Statistical uncertainty for some popular market network structures is analyzed. Results of numerical evaluation of statistical uncertainty for minimum spanning tree, market graph, maximum cliques and maximum independent sets are given. The most stable structures are derived.
    Date: 2013–11
  20. By: Mel MacMahon; Diego Garlaschelli
    Abstract: A challenging problem in the study of large complex systems is that of resolving, without prior information, the emergent mesoscopic organization determined by groups of units whose dynamical activity is more strongly correlated internally than with the rest of the system. The existing techniques to filter correlations are not explicitly oriented at identifying such modules and suffer from an unavoidable information loss. A promising alternative is that of employing community detection techniques developed in network theory. Unfortunately, the attempts made so far have merely replaced network data with correlation matrices, a procedure that we show to be fundamentally biased due to its inconsistency with the null hypotheses underlying the existing algorithms. Here we introduce, via a consistent redefinition of null models based on Random Matrix Theory, the unbiased correlation-based counterparts of the most popular community detection techniques. After successfully benchmarking our methods, we apply them to several time series from financial markets around the globe. Remarkably, the communities we detect are internally correlated and at the same time anti-correlated with the other communities, a property of great value for portfolio optimization and risk management. Moreover, stocks from the same industry sector are often found across anti-correlated communities, confirming the emergence of mesoscopic groups that are irreducible to a standard sectorial taxonomy.
    Date: 2013–11
  21. By: Jermann, Urban J.; Yue, Vivian Z.
    Abstract: This paper studies firms’ usage of interest rate swaps to manage risk in a model economy driven by aggregate productivity shocks, inflation shocks, and counter-cyclical idiosyncratic productivity risk. Consistent with empirical evidence, firms in the model are fixed-rate payers, and swap positions are negatively correlated with the term spread. In the model, swaps affect firms’ investment decisions and debt pricing only very moderately, and the availability of swaps generates only small economic gains for the typical firm. JEL Classification: E44, G12
    Keywords: corporate default, debt pricing, Interest rate swaps, risk management, swap position
    Date: 2013–09
  22. By: Bodie, Zvi; Brière, Marie
    Abstract: This paper sets out a new analytical framework for optimal asset allocation of sovereign wealth, based on the theory of contingent claim ana lysis (CCA) applied to the sovereign’s economic balance sheet. A country solves an asset-l iability management (ALM) problem between its sources of income and its expenditures. We derive analytically the optimal asset allocation of sovereign wealth, taking explic it account of all sources of risks affecting the sovereign’s balance sheet. The optima l composition of sovereign wealth should involve a performance-seeking portfolio and three hedging demand terms for the variability of the fiscal surplus, and external and domestic debt. Our results provide guidance for sovereign wealth management, particula rly with respect to sovereign wealth funds and foreign exchange reserves. A real-life ap plication of our model in the case of Chile shows that at least 60% of the Chilean asset allocation should be dedicated to emerging bonds, developed and emerging equities. Ch ile’s current sovereign investment is under-diversified.
    Keywords: Central Bank Reserves; Sovereign Wealth Funds; Asset-Liability Management; Contingent Claim Analysis; Balance Sheet;
    JEL: H63 H50 H11 G18 G11
    Date: 2013–05

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