nep-rmg New Economics Papers
on Risk Management
Issue of 2014‒01‒17
nineteen papers chosen by
Stan Miles
Thompson Rivers University

  1. Basel III and CEO compensation in banks: Pay structures as a regulatory signal By Eufinger, Christian; Gill, Andrej
  2. Risk Modelling and Management: An Overview By Chang, C-L.; Allen, D.E.; McAleer, M.J.; Pérez-Amaral, T.
  3. The Impact of Systemic Risk on the Diversification Benefits of a Risk Portfolio By Busse, Marc; Dacorogna, Michel; Kratz, Marie
  4. Systemic risk in the financial sector: What can se learn from option markets? By Kraft, Holger; Schmidt, Alexander
  5. Measuring capital adequacy supervisory stress tests in a Basel world By Wall, Larry D.
  6. A Capital Adequacy Buffer Model By Allen, D.E.; Powell, R.J.; Singh, A.K.
  7. Determinants of Systemic Risk and Information Dissemination By Marcelo Bianconi; Xiaxin Hua; Chih Ming Tan
  8. Taking the risk out of systemic risk measurement I By Paul H. Kupiec; Levent Guntay
  9. An integrated risk estimation methodology: Ship specific incident type risk By Knapp, S.
  11. Option-implied information and predictability of extreme returns By Vilkovz, Grigory; Xiaox, Yan
  12. Realized volatility risk By David E. Allen; Michael McAleer; Marcel Scharth
  13. Weather Derivatives and Crop Insurance in China By Baojing Sun; Changhao Guo; G. Cornelis van Kooten
  14. Diversifying Risks in Bond Portfolios: A Cross-border Approach By Sun, David; Tsai, Shih-Chuan
  15. Spillover effects among financial institutions: A state-dependent sensitivity value-at-risk approach By Adams, Zeno; Füss, Roland; Gropp, Reint
  16. Optimal Hedging for Fund & Insurance Managers with Partially Observable Investment Flows By Masaaki Fujii; Akihiko Takahashi
  17. European Equity Investing through the Financial Crisis: Can Risk Parity, Momentum or Trend Following Help to Reduce Tail Risk? By Andrew Clare; James Seaton; Peter N. Smith; Stephen Thomas
  18. Four Points Beginner Risk Managers Should Learn from Jeff Holman's Mistakes in the Discussion of Antifragile By Nassim Nicholas Taleb
  19. Recent Developments in Financial Economics and Econometrics: An Overview By Chang, C-L.; Allen, D.E.; McAleer, M.J.

  1. By: Eufinger, Christian; Gill, Andrej
    Abstract: This paper proposes a new regulatory approach that implements capital requirements contingent on managerial compensation. We argue that excessive risk taking in the financial sector originates from the shareholder moral hazard created by government guarantees rather than from corporate governance failures within banks. The idea of the proposed regulation is to utilize the compensation scheme to drive a wedge between the interests of top management and shareholders to counteract shareholder risk-shifting incentives. The decisive advantage of this approach compared to existing regulation is that the regulator does not need to be able to properly measure the bank investment risk, which has been shown to be a difficult task during the 2008-2009 financial crisis. --
    Keywords: Basel III,capital regulation,compensation,leverage,risk
    JEL: G21 G28 G30 G32 G38
    Date: 2013
  2. 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: BRICS, Basel Accord, VIX futures, country risk ratings, currency hedging strategies, extreme market risks, extreme value methodologies, fast clustering, forecasting, mixture models, risk management, value-at-risk, volatility spillovers
    JEL: C14 C32 C53 G11 G32
    Date: 2013–06–01
  3. By: Busse, Marc (SCOR Switzerland); Dacorogna, Michel (SCOR Switzerland); Kratz, Marie (ESSEC Business School)
    Abstract: Risk diversification is the basis of insurance and investment. It is thus crucial to study the effects that could limit it. One of them is the existence of systemic risk that affects all the policies at the same time. We introduce here a probabilistic approach to examine the consequences of its presence on the risk loading of the premium of a portfolio of insurance policies. This approach could be easily generalized for investment risk. We see that, even with a small probability of occurrence, systemic risk can reduce dramatically the diversification benefits. It is clearly revealed via a non-diversifiable term that appears in the analytical expression of the variance of our models. We propose two ways of introducing it and discuss their advantages and limitations. By using both VaR and TVaR to compute the loading, we see that only the latter captures the full effect of systemic risk when its probability to occur is low.
    Keywords: diversification; expected shortfall; investment risk; premium; risk loading; risk measure; risk management; risk portfolio; stochastic model; systemic risk; value-at-risk
    JEL: G11 G12 G17 G22
    Date: 2013–12
  4. By: Kraft, Holger; Schmidt, Alexander
    Abstract: In this paper, we propose a novel approach on how to estimate systemic risk and identify its key determinants. For all US financial companies with publicly traded equity options, we extract their option-implied value-at-risks (VaRs) and measure the spillover effects between individual company VaRs and the option-implied VaR of an US financial index. First, we study the spillover effect of increasing company risks on the financial sector. Second, we analyze which companies are most affected if the tail risk of the financial sector increases. We find that key accounting and market valuation metrics such as size, leverage, balance sheet composition, market-to-book ratio and earnings have a significant influence on the systemic risk profile of a financial institution. In contrast to earlier studies, the employed panel vector autoregression (PVAR) estimator allows for a causal interpretation of the results. --
    Keywords: Systemic risk,Value-at-risk,Equity options,Implied volatility
    JEL: G01 G28 G32
    Date: 2013
  5. By: Wall, Larry D. (Federal Reserve Bank of Atlanta)
    Abstract: The United States is now committed to using two relatively sophisticated approaches to measuring capital adequacy: Basel III and stress tests. This paper shows how stress testing could mitigate weaknesses in the way Basel III measures credit and interest rate risk, the way it measures bank capital, and the way it creates countercyclical capital buffers. However, this paper also emphasizes the extent to which stress tests add value will depend upon the exercise of supervisor discretion in the design of stress scenarios. Whether supervisors will use this discretion more effectively than they have used other tools in the past remains to be seen.
    Keywords: capital adequacy; Basel capital ratios; stress test
    JEL: E50 G01 G21 G28
    Date: 2013–12–01
  6. By: Allen, D.E.; Powell, R.J.; Singh, A.K.
    Abstract: __Abstract__ In this paper, we develop a new capital adequacy buffer model (CABM) which is sensitive to dynamic economic circumstances. The model, which measures additional bank capital required to compensate for fluctuating credit risk, is a novel combination of the Merton structural model which measures distance to default and the timeless capital asset pricing model (CAPM) which measures additional returns to compensate for additional share price risk.
    Keywords: credit risk, capital buffer, distance to default, conditional value at risk, Capital adequacy buffer model
    JEL: G01 G21 G28
    Date: 2013–10–01
  7. By: Marcelo Bianconi (Department of Economics, Tufts University, USA); Xiaxin Hua (Department of Economics, Clark University, USA); Chih Ming Tan (Department of Economics, University of North Dakota, USA)
    Abstract: We study the effects of two measures of information dissemination on the determination of systemic risk. One measure is print-media consumer sentiment based while the other is volatility based. We find evidence that while the volatility measure (VIX) of future expectations has a more significant direct impact upon systemic risk of financial firms under distress, a consumer sentiment measure based on print-media news does impact upon firm’s financial stress via the externality of other firm’s financial stress. This latter effect is robust even though the VIX and the consumer sentiment have dynamic feedback in the short one and two-day horizon in levels, and contemporaneously in volatility. In reference to the internet bubble of the 1990s, the consumer sentiment measure predicts larger systemic risk in the whole period of exuberance while the VIX predicts a sharp larger systemic risk in the height of the bubble. Our evidence suggests that print-media consumer sentiment might be dominated by the VIX when predicting systemic risk.
    Keywords: conditional value-at-risk, VIX, externality, consumer sentiment
    JEL: G00 G14
    Date: 2013–12
  8. By: Paul H. Kupiec (American Enterprise Institute); Levent Guntay
    Abstract: An emerging literature proposes using conditional value at risk and marginal expected shortfall to measure financial institution systemic risk. We identify two weaknesses in this literature: (1) it lacks formal statistical hypothesis tests; and, (2) it confounds systemic and systematic risk. We address these weaknesses by introducing a null hypothesis that stock returns are normally distributed.
    Keywords: AEI Economic Policy Working Paper Series
    JEL: A G
    Date: 2014–01
  9. By: Knapp, S.
    Abstract: Shipping activity has increased worldwide, including parts of Australia, and maritime administrations are trying to gain a better understanding of total risk exposure in order to mitigate risk. Total risk exposure integrates risk at the individual ship level, risk due to vessel traffic densities, physical environmental criteria, and environmental sensitivities. A comprehensive and robust risk exposure metric can be beneficial to maritime administrations to enhance mitigation of potential harm and reduce vulnerability to the marine environment as well as to safeguard lives and property. This report outlines an integrated methodology to estimate total risk exposure, with specific attention for the ship specific risk for different types of incident. Some related application aspects of the models are discussed.
    Keywords: binary logistic model, company risk estimation, incident models, total risk exposure, visualization of risk dimensions
    Date: 2013–04–01
  10. By: Daniel Felix Ahelegbey (Department of Economics, University of Venice Ca' Foscari); Paolo Giudici (Department of Economics and Management, University of Pavia)
    Abstract: The latest financial crisis has stressed the need of understanding the world financial system as a network of interconnected institutions, where financial linkages play a fundamental role in the spread of systemic risks. In this paper we propose to enrich the topological perspective of network models with a more structured statistical framework, that of Bayesian graphical Gaussian models. From a statistical viewpoint, we propose a new class of hierarchical Bayesian graphical models, that can split correlations between institutions into country specific and idiosyncratic ones, in a way that parallels the decomposition of returns in the well-known Capital Asset Pricing Model. From a financial economics viewpoint, we suggest a way to model systemic risk that can explicitly take into account frictions between different financial markets, particularly suited to study the on-going banking union process in Europe. From a computational viewpoint, we develop a novel Markov Chain Monte Carlo algorithm based on Bayes factor thresholding.
    Keywords: Applied Bayesian models, Graphical Gaussian Models, Systemic financial risk
    Date: 2014–01
  11. By: Vilkovz, Grigory; Xiaox, Yan
    Abstract: We study whether prices of traded options contain information about future extreme market events. Our option-implied conditional expectation of market loss due to tail events, or tail loss measure, predicts future market returns, magnitude, and probability of the market crashes, beyond and above other option-implied variables. Stock-specific tail loss measure predicts individual expected returns and magnitude of realized stock-specific crashes in the cross-section of stocks. An investor that cares about the left tail of her wealth distribution benefits from using the tail loss measure as an information variable to construct managed portfolios of a risk-free asset and market index. --
    Keywords: extreme value theory,tail measure,implied correlation,variance risk premium,option-implied distribution,predictability,portfolio optimization
    JEL: G11 G12 G13 G17
    Date: 2013
  12. By: David E. Allen (School of Accounting, Finance and Economics Edith Cowan University, Australia.); Michael McAleer (Econometric Institute, Erasmus School of Economics, Erasmus University Rotterdam and Tinbergen Institute, The Netherlands, Department of Quantitative Economics, Complutense University of Madrid, and Institute of Economic Research, Kyoto University.); Marcel Scharth (Department of Econometrics Faculty of Economics and Business Administration VU University Amsterdam De Boelelaan 1105 1081 HV Amsterdam The Netherlands)
    Abstract: In this paper we document that realized variation measures constructed from high-frequency returns reveal a large degree of volatility risk in stock and index returns, where we characterize volatility risk by the extent to which forecasting errors in realized volatility are substantive. Even though returns standardized by ex post quadratic variation measures are nearly gaussian, this unpredictability brings considerably more uncertainty to the empirically relevant ex ante distribution of returns. Explicitly modeling this volatility risk is fundamental. We propose a dually asymmetric realized volatility model, which incorporates the fact that realized volatility series are systematically more volatile in high volatility periods. Returns in this framework display time varying volatility, skewness and kurtosis. We provide a detailed account of the empirical advantages of the model using data on the S&P 500 index and eight other indexes and stocks.
    Keywords: Realized volatility, volatility of volatility, volatility risk, value-at-risk, forecasting, conditional heteroskedasticity.
    Date: 2013
  13. By: Baojing Sun; Changhao Guo; G. Cornelis van Kooten
    Abstract: The effectiveness of financial weather derivatives to hedge against risk in agriculture has not been well demonstrated; therefore, this risk hedging instrument has only been slowly adopted. The current study analyzes the hedging efficiency of weather index derivatives for corn production in Northeast China. It has two purposes: (1) to identify potential weather variables, such as cumulative rainfall or growing degree days, that impact corn yields; and (2) to analyze the efficiency of financial weather derivatives under varying strike values, where efficiency is defined in terms of its benefit to farmers. Regression results indicate that cumulative rainfall is important for crop production in the study region, and that, under some circumstances, it is efficient to use a weather-indexed financial derivatives to hedge the corresponding risk.
    Keywords: financial weather derivatives, climate risk, corn production, rainfall
    JEL: Q14 Q15 Q18
    Date: 2013–02
  14. By: Sun, David; Tsai, Shih-Chuan
    Abstract: This study recalibrates corporate bond idiosyncratic risks in an international context. Applying a statistically powerful risk decomposition scheme, we show in this study that diversification is improved by the addition of a global risk benchmark. We build a long-run stationary yield spread decomposition scheme which provides better diversification effect. In addition to global liquidity and default risk factors, we also include country-specific default risk component, and all of them are free of measurement or availability issues. The idiosyncratic risk component is estimated as a fixed effect along with all the parameter estimates, rather than separately from an exogenous generating process. Our linear model is simple, yet it can be easily and promptly applied by practitioners.
    Keywords: bond pricing; credit spread; systematic risk; diversification; global risk; heterogeneous panel; pooled mean group.
    JEL: F34 G12 G15
    Date: 2013–12–14
  15. By: Adams, Zeno; Füss, Roland; Gropp, Reint
    Abstract: In this paper, we develop a state-dependent sensitivity value-at-risk (SDSVaR) approach that enables us to quantify the direction, size, and duration of risk spillovers among financial institutions as a function of the state of financial markets (tranquil, normal, and volatile). Within a system of quantile regressions for four sets of major financial institutions (commercial banks, investment banks, hedge funds, and insurance companies) we show that while small during normal times, equivalent shocks lead to considerable spillover effects in volatile market periods. Commercial banks and, especially, hedge funds appear to play a major role in the transmission of shocks to other financial institutions. Using daily data, we can trace out the spillover effects over time in a set of impulse response functions and find that they reach their peak after 10 to 15 days. --
    Keywords: Risk spillovers,state-dependent sensitivity value-at-risk (SDSVaR),quantile regression,financial institutions,hedge funds
    JEL: G01 G10 G24
    Date: 2013
  16. By: Masaaki Fujii (The University of Tokyo); Akihiko Takahashi (The University of Tokyo)
    Abstract: All the financial practitioners are working in incomplete markets full of unhedgeable risk-factors. Making the situation worse, they are only equipped with the imperfect information on the relevant processes. In addition to the market risk, fund and insurance managers have to be prepared for sudden and possibly contagious changes in the investment flows from their clients so that they can avoid the over- as well as under-hedging. In this work, the prices of securities, the occurrences of insured events and (possibly a network of) the investment flows are used to infer their drifts and intensities by a stochastic filtering technique. We utilize the inferred information to provide the optimal hedging strategy based on the mean-variance (or quadratic) risk criterion. A BSDE approach allows a systematic derivation of the optimal strategy, which is shown to be implementable by a set of simple ODEs and the standard Monte Carlo simulation. The presented framework may also be useful for manufactures and energy firms to install an efficient overlay of dynamic hedging by financial derivatives to minimize the costs.
    Date: 2014–01
  17. By: Andrew Clare; James Seaton; Peter N. Smith; Stephen Thomas
    Abstract: A growing body of literature suggests that over widely varying historical eras and across a wide range of asset classes momentum investing, often accompanied by a trend following overlay, provides superior risk-adjusted returns. We examine the effectiveness of applying these methodologies to pan-European equity asset allocation through periods of potentially substantial market dislocation, in particular, with the advent of the single currency and the equity market crashes of the early 2000’s and 2008.With the introduction of the Euro there has been much discussion of the benefits of diversification via country based portfolios versus industry sector portfolios. Early studies simply looked at changing return correlations over time. The simple conclusion that increasing country correlations over time drives superior risk-adjusted portfolios towards diversification across sectors has been increasingly challenged. Our approach is different in that we apply momentum and trend following investing strategies and assess whether it is sectoral or country indices which dominate our portfolios through periods of structural changes and extreme volatility. Diversification via sectors is clearly the best strategy in times of equity market stress. In addition, the application of trend following offers a substantial improvement in risk-adjusted performance compared to traditional buy-and-hold portfolios. The terms momentum and trend following have often been used interchangeably although the former is a relative concept and the latter absolute. By combining the two we find that one can achieve the higher return levels associated with momentum portfolios but with much reduced volatility, tail risk and drawdowns due to trend following. We observe that a flexible asset allocation strategy that allocates capital to the best performing instruments irrespective of asset class enhances this further. Such methodologies offer superior risk adjusted returns, especially through periods of raised market volatility.
    Keywords: Trend following; Momentum investing; tail risk; European equity sectors, Financial Crisis
    JEL: E44 G12
    Date: 2014–01
  18. By: Nassim Nicholas Taleb
    Abstract: Using Jeff Holman's comments in Quantitative Finance to illustrate 4 critical errors students should learn to avoid: 1) Mistaking tails (4th moment) for volatility (2nd moment), 2) Missing Jensen's Inequality, 3) Analyzing the hedging wihout the underlying, 4) The necessity of a numeraire in finance.
    Date: 2014–01
  19. By: Chang, C-L.; Allen, D.E.; McAleer, M.J.
    Abstract: Research papers in empirical finance and financial econometrics are among the most widely cited, downloaded and viewed articles in the discipline of Finance. The special issue presents several papers by leading scholars in the field on “Recent Developments in Financial Economics and Econometrics”. The breadth of coverage is substantial, and includes original research and comprehensive review papers on theoretical, empirical and numerical topics in Financial Economics and Econometrics by leading researchers in finance, financial economics, financial econometrics and financial statistics. The purpose of this special issue on “Recent Developments in Financial Economics and Econometrics” is to highlight several novel and significant developments in financial economics and financial econometrics, specifically dynamic price integration in the global gold market, a conditional single index model with local covariates for detecting and evaluating active management, whether the Basel Accord has improved risk management during the global financial crisis, the role of banking regulation in an economy under credit risk and liquidity shock, separating information maximum likelihood estimation of the integrated volatility and covariance with micro-market noise, stress testing correlation matrices for risk management, whether bank relationship matters for corporate risk taking, with evidence from listed firms in Taiwan, pricing options on stocks denominated in different currencies, with theory and illustrations, EVT and tail-risk modelling, with evidence from market indices and volatility series, the economics of data using simple model free volatility in a high frequency world, arbitrage-free implied volatility surfaces for options on single stock futures, the non-uniform pricing effect of employee stock options using quantile regression, nonlinear dynamics and recurrence plots for detecting financial crisis, how news sentiment impacts asset volatility, with evidence from long memory and regime-switching approaches, quantitative evaluation of contingent capital and its applications, high quantiles estimation with Quasi-PORT and DPOT, with an application to value-at-risk for financial variables, evaluating inflation targeting based on the distribution of inflation and inflation volatility, the size effects of volatility spillovers for firm performance and exchange rates in tourism, forecasting volatility with the realized range in the presence of noise and non-trading, using CARRX models to study factors affecting the volatilities of Asian equity markets, deciphering the Libor and Euribor spreads during the subprime crisis, information transmission between sovereign debt CDS and other financial factors for Latin America, time-varying mixture GARCH models and asymmetric volatility, and diagnostic checking for non-stationary ARMA models with an application to financial data.
    Keywords: asymmetry, contingent capital, corporate risk taking, credit risk, diagnostic checking, dynamic price integration, equity markets, exchange rates, global financial crisis, inflation targeting, liquidity shock, local covariates, micro-market noise, mixture models, news sentiment, options, quantiles, realized range, risk management, size effects, sovereign debt CDS, sub-prime crisis, value-at-risk, volatility
    JEL: G11 G13 G15 G18
    Date: 2013–01–01

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