New Economics Papers
on Risk Management
Issue of 2014‒03‒15
seventeen papers chosen by

  1. World gold prices and stock returns in China: insights for hedging and diversification strategies By Mohamed El Hedi Arouri; Amine Lahiani; Duc Khuong Nguyen
  2. Intrinsic Prices Of Risk By Truc Le
  3. A Dynamic AutoRegressive Expectile for Time-Invariant Portfolio Protection Strategies By Benjamin Hamidi; Bertrand Maillet; Jean-Luc Prigent
  4. A Simple and Precise Method for Pricing Convertible Bond with Credit Risk By Xiao, Tim
  5. Modelling Credit Default Swaps: Market-Standard Vs Incomplete-Market Models By Michael B. Walker
  6. Introduction to Risk Parity and Budgeting By Thierry Roncalli
  8. Investor fears and risk premia for rare events By Schwarz, Claudia
  9. Performance of Utility Based Hedges By John Cotter; Jim Hanly
  10. Capital Requirements, Banking Supervision and Lending Behavior: Evidence from Tunisia By Guizani, Brahim
  11. Timing a Hedge Decision: The Development of a Composite Technical Indicator for White Maize By Susari Geldenhuys, Frans Dreyer and Chris van Heerden
  12. The Evolution of Risk Premiums in Emerging Stock Markets: The Case of Latin America and Asia Region By Salma Fattoum; Khaled Guesmi; Bruno-Laurent Moschetto
  13. The Conditional Pricing of Systematic and Idiosyncratic Risk in the UK Equity Market By John Cotter; Niall O'Sullivan; Francesco Rossi
  14. Exploration Risk in Oil & Gas Shareholder Returns By Misund, Bard; Mohn, Klaus
  15. Basel III, Clubs and Eurozone Asymmetries By Michele Fratianni; John Pattison
  16. Risk Assessment of the Brazilian FX Rate By Wagner Piazza Gaglianone; Jaqueline Terra Moura Marins
  17. On the Frequency of Drawdowns for Brownian Motion Processes By David Landriault; Bin Li; Hongzhong Zhang

  1. By: Mohamed El Hedi Arouri; Amine Lahiani; Duc Khuong Nguyen
    Abstract: In this paper we make use of several multivariate GARCH models to investigate both return and volatility spillovers between world gold prices and stock market in China over the period from March 22, 2004 through March 31, 2011. We also analyze the optimal weights and hedge ratios for gold-stock portfolio holdings and show how empirical results can be used to build effective diversification and hedging strategy. Our results show evidence of significant return and volatility cross effects between gold prices and stock prices in China. In particular, past gold returns play a crucial role in explaining the dynamics of conditional return and volatility of Chinese stock market and should thus be accounted for when forecasting future stock returns. Our portfolio analysis suggests that adding gold to a portfolio of Chinese stocks improves its risk-adjusted return and helps to effectively hedge against stock risk exposure over time. Finally, we show that the VAR-GARCH model performs better than the other multivariate GARCH models.
    Keywords: Stock markets, gold prices, diversification and hedging effectiveness, GARCH models
    JEL: G12 F3 Q43
    Date: 2014–02–25
  2. By: Truc Le
    Abstract: We examine the nature of some well-known phenomena such as volatility smiles, convexity adjustments and parallel markets. We propose that the market is incomplete and postulate the existence of an intrinsic risk in every contingent claim as a basis for understanding the phenomena. In a continuous time framework, we bring together the notion of intrinsic risk and the martingale theory to derive a martingale measure, namely risk-subjective measure, for pricing and hedging financial derivatives. The risk-subjective measure provides an internal consistency in pricing and hedging contingent claims and explains the phenomena.
    Date: 2014–03
  3. By: Benjamin Hamidi; Bertrand Maillet; Jean-Luc Prigent
    Abstract: Among the most popular techniques for portfolio insurance strategies that are used nowadays, the so-called \Constant Proportion Portfolio In- surance" (CPPI) allocation simply consists in reallocating the risky part of a portfolio according to the market conditions. This general method crucially depends upon a parameter - called the multiple - guaranteeing a predetermined oor whatever the plausible market evolutions. However, the unconditional multiple is dened once and for all in the traditional CPPI setting; we propose in this article an alternative to the standard CPPI method, based on the determination of a conditional multiple. In this time-varying framework, the multiple is conditionally determined in order the risk exposure to remain constant, but depending on market con- ditions. We thus propose to dene the multiple as a function of Expected Shortfall. After brie y recalling the portfolio insurance principles, the CPPI framework and the main properties of the conditional or unconditional multiples, we present a Dynamic AutoRegressive Expectile (DARE) class of models for the conditional multiple in a time-varying strategy whose aim is to adapt the current exposition to market conditions following a traditional risk management philosophy. We illustrate this approach in a Time-Invariant Portfolio Protection (TIPP) strategy, as introduced by Estep and Kritzman (1988), which aims to increase the protected oor according to the insured portfolio performance. Finally, we use an option valuation approach for measuring the gap risk in both conditional and unconditional approaches.
    Keywords: CPPI, Expectile, VaR, CAViaR, Quantile Regression, Dy- namic Quantile Model, Expected Shortfall, Extreme Value.
    JEL: G11 C13 C14 C22 C32
    Date: 2014–02–25
  4. By: Xiao, Tim
    Abstract: This paper presents a new framework for valuing hybrid defaultable financial instruments, for example, convertible bonds. In contrast to previous studies, the model relies on the probability distribution of a default jump rather than the default jump itself, as the default jump is usually inaccessible. As such, the model can back out the market prices of convertible bonds. A prevailing belief in the market is that convertible arbitrage is mainly due to convertible underpricing. Empirically, however, we do not find evidence supporting the underpricing hypothesis. Instead, we find that convertibles have relatively large positive gammas. As a typical convertible arbitrage strategy employs delta-neutral hedging, a large positive gamma can make the portfolio highly profitable, especially for a large movement in the underlying stock price.
    Keywords: hybrid financial instrument, convertible bond, convertible underpricing, convertible arbitrage, default time approach (DTA), default probability approach (DPA), jump diffusion.
    JEL: G1 G12
    Date: 2014–02–18
  5. By: Michael B. Walker
    Abstract: Recently, incomplete-market techniques have been used to develop a model applicable to credit default swaps (CDSs) with results obtained that are quite different from those obtained using the market-standard model. This article makes use of the new incomplete-market model to further study CDS hedging and extends the model so that it is capable treating single-name CDS portfolios. Also, a hedge called the vanilla hedge is described, and with it, analytic results are obtained explaining the striking features of the plot of no-arbitrage bounds versus CDS maturity for illiquid CDSs. The valuation process that follows from the incomplete-market model is an integrated modelling and risk management procedure, that first uses the model to find the arbitrage-free range of fair prices, and then requires risk management professionals for both the buyer and the seller to find, as a basis for negotiation, prices that both respect the range of fair prices determined by the model, and also benefit their firms. Finally, in a section on numerical results, the striking behavior of the no-arbitrage bounds as a function of CDS maturity is illustrated, and several examples describe the reduction in risk by the hedging of single-name CDS portfolios.
    Date: 2014–03
  6. By: Thierry Roncalli
    Abstract: Although portfolio management didn't change much during the 40 years after the seminal works of Markowitz and Sharpe, the development of risk budgeting techniques marked an important milestone in the deepening of the relationship between risk and asset management. Risk parity then became a popular financial model of investment after the global financial crisis in 2008. Today, pension funds and institutional investors are using this approach in the development of smart indexing and the redefinition of long-term investment policies. Introduction to Risk Parity and Budgeting provides an up-to-date treatment of this alternative method to Markowitz optimization. It builds financial exposure to equities and commodities, considers credit risk in the management of bond portfolios, and designs long-term investment policy. This book contains the solutions of tutorial exercices which are included in Introduction to Risk Parity and Budgeting.
    Date: 2014–03
    Date: 2014
  8. By: Schwarz, Claudia
    Abstract: This paper uses the method developed by Bollerslev and Todorov (2011b) to estimate risk premia for extreme events for the US and the German stock markets. The method extracts jump tail measures from high-frequency futures price data and from options data. In a second step, jump tail distributions are approximated using the extreme value theory. Applying the method to German data yields very similar results to the ones shown for the US data. The risk premia for rare events constitute a considerable part of the total equity and variance risk premia for both markets. When using the results to build an investor fear index for the US and Germany, I find that the correlation of the fear index for the US with the VIX is 89.5% and that of the fear index for Germany with the VDAX is 90.6%. --
    Keywords: crisis indicator,extreme value theory,implied moments
    JEL: C13 G10 G12
    Date: 2014
  9. By: John Cotter (UCD School of Business, University College Dublin); Jim Hanly (UCD School of Business, University College Dublin)
    Abstract: Hedgers as investors are concerned with both risk and return; however the literature has generally neglected the role of both returns and investor risk aversion by its focus on minimum variance hedging. In this paper we address this by using utility based performance metrics to evaluate the hedging effectiveness of utility based hedges for hedgers with both moderate and high risk aversion together with the more traditional minimum variance approach. We apply our approach to two asset classes, equity and energy, for three different hedging horizons, daily,weekly and monthly. We find significant differences between the minimum variance and utility based hedges and their attendant performance in-sample for all frequencies. However out of sample performance differences persist for the monthly frequency only.
    Keywords: Energy, Hedging Performance; Utility, Risk Aversion
    JEL: G10 G12 G15
    Date: 2014–02–19
  10. By: Guizani, Brahim
    Abstract: This paper represents a contribution to the still meager literature on the impact of prudential regulation bank behavior in Tunisia. It aims to examine the effect of the capital requirements on bank credits during the period from 1999 through 2010 and to assess the effectiveness of the banking supervision policy in containing banking system’s risk. For this purpose a dynamic model is built and then an empirical regression is estimated. The results shows that regulatory capital framework has been binding bank lending in Tunisia during the period of study; well-capitalized banks have lent more than less-capitalized ones. Despite the apparent stringency of the bank regulator in Tunisia, banking supervision has been weakly effective in restraining banks’ overall risk. Further strengthening of the banking supervision policy is still needed on the part of the central bank of Tunisia; i.e., the bank regulator.
    Keywords: capital requirements, Basel Accords, dynamic model, banking supervision, non-performing loans.
    JEL: C63 D92 G21 G28
    Date: 2014–03–08
  11. By: Susari Geldenhuys, Frans Dreyer and Chris van Heerden
    Abstract: South African white maize is considered to be significantly more volatile than any other agricultural product traded on the South African Futures Exchange (SAFEX). This accentuates the need to effectively manage price risk, by means of hedging, to ensure a more profitable and sustainable maize production sector (Geyser, 2013: 39; Jordaan et al., 2007: 320). This paper attempts to address this challenge by making use of technical analysis, focusing on the development of a practical and applicable composite technical indicator with the purpose of improving the timing of price risk management decisions identified by individual technical indicators. This substantiated the compilation of a composite indicator that takes both leading and lagging indicators into account to more accurately identify hedging opportunities. The results validated the applicability of such a composite indicator, as the composite indicator outperformed the individual technical indicators in the white maize market over the period under investigation.
    Keywords: Agricultural commodity market, efficient market, composite indicator, hedging, technical analysis, trading market, trending market, South Africa, white maize
    JEL: G13 G14 G32
    Date: 2014
  12. By: Salma Fattoum; Khaled Guesmi; Bruno-Laurent Moschetto
    Abstract: This paper employs a conditional version of the International Capital Asset Pricing Model (ICAPM) to investigate the determinants of regional integration of stock markets in the Latin America and Asia over the period 1996-2008. This model allows for three sources of time-varying risks: common international market risk, exchange rate risk and regional market risk. At the empirical level, we make use of the asymmetric multivariate BEKK-GARCH of Baba et al. (1990) process to simultaneously estimate the ICAPM. Our results show that the currency risk premium is the most important component of the total premium followed by the global market premium. As for the regional risk, our findings show that it is significantly priced for our studied emerging regions but its contribution to the total risk premium is weak.
    Keywords: ICAPM, stock market integration, exchange rate risk
    JEL: G12 F31 C3
    Date: 2014–02–25
  13. By: John Cotter (UCD School of Business, University College Dublin); Niall O'Sullivan (School of Economics and Centre for Investment Research, University College Cork); Francesco Rossi (UCD School of Business, University College Dublin)
    Abstract: We test whether firm idiosyncratic risk is priced in a large cross-section of U.K. stocks. A distinguishing feature of our paper is that our tests allow for a conditional relationship between systematic risk (beta) and returns in our tests, i.e., conditional on whether the excess market return is positive or negative. We find strong evidence in support of a conditional beta/return relationship which in turn reveals conditionality in the pricing of idiosyncratic risk. We find that idiosyncratic risk is significantly negatively priced in stock returns in down-markets. Although perhaps initially counter-intuitive, we describe the theoretical support for such a finding in the literature. Our results also reveal a strong role for liquidity, size and momentum factors in explaining the cross-section of U.K. stock returns.
    Keywords: asset pricing; idiosyncratic risk; turnover; conditional beta.
    JEL: G11 G12
    Date: 2014–02–19
  14. By: Misund, Bard (UiS); Mohn, Klaus (UiS)
    Abstract: Previous research clearly suggests that the explanation of excess asset returns is not fully captured by excess return on the market portfolio and the CAPM beta, as implied by Fama-French (1993) three-factor model. Among the large number of studies following in the footsteps of Fama and French, very few studies include industry-specific variables to explain excess asset returns. Using monthly financial data for 117 oil and gas companies from 1992 to 2006, we supplement the Fama French approach with an industry-specific fundamental factor to capture company exposure to oil and gas exploration risk. Our results indicate that exploration risk contributes significantly to the explanation of oil company excess returns over the period.
    Keywords: Asset pricing; Oil price; Risk factors
    JEL: G12 L71 Q40
    Date: 2014–03–05
  15. By: Michele Fratianni (Indiana University, Kelly School of Business, Bloomington US, Univ. Plitecnica Marche and MoFiR); John Pattison (retired banker)
    Abstract: Financial regulation has shifted from a system managed as an oligopoly dominated by the G2/G5 to expanded clubs like the Basel Committee for Banking Supervision. Expansive clubs have to agree to terms that are closer to the preferences of soft-regulation members. Yet, once a global agreement on minimum standards, such as Basel III, is reached, the transposition is left to national or regional regulators. Deviations from the Basel III standards are bound to occur; the complexity of the agreement will facilitate an asymmetric implementation of national regulation and supervision. On the high side, countries like the US, UK, Australia, some Scandinavian countries and Canada have chosen higher standards. On the low side, we should expect deviations to take place in those member countries of the Eurozone that are heterogeneous, have different preferences and tradeoffs between regulatory stringency and economic activity. The requirements of both global clubs and the EU regional club for transparency, monitoring and a level playing field will cause a collision between the interests of the clubs and their members.
    Keywords: Basel III clubs, Eurozone, asymmetries, financial regulation
    JEL: F33 F36 F42
    Date: 2014–03
  16. By: Wagner Piazza Gaglianone; Jaqueline Terra Moura Marins
    Abstract: In this paper, we construct several multi-step-ahead density forecasts for the foreign exchange (FX) rate based on statistical, financial data and economic-driven approaches. The objective is to go beyond the standard conditional mean investigation of the FX rate and (for instance) allow for asymmetric responses of covariates (e.g. financial data or economic fundamentals) in respect to exchange rate movements. We also provide a toolkit to evaluate out-of-sample density forecasts and select models for risk analysis purposes. An empirical exercise for the Brazilian FX rate is provided. Overall, the results suggest that no single model properly accounts for the entire density in all considered forecast horizons. Nonetheless, the GARCH model as well as the option-implied approach seem to be more suitable for short-run purposes (until three months), whereas the survey-based and some economic-driven models appear to be more adequate for longer horizons (such as one year)
    Date: 2014–01
  17. By: David Landriault; Bin Li; Hongzhong Zhang
    Abstract: Drawdowns measuring the decline in value from the historical running maxima over a given period of time, are considered as extremal events from the standpoint of risk management. To date, research on the topic has mainly focus on the side of severity by studying the first drawdown over certain pre-specified size. In this paper, we extend the discussion by investigating the frequency of drawdowns, and some of their inherent characteristics. We consider two types of drawdown time sequences depending on whether a historical running maximum {is reset or not}. For each type, we study the frequency rate of drawdowns, the Laplace transform of the $n$-th drawdown time, the distribution of the running maximum and the value process at the $n$-th drawdown time, as well as some other quantities of interest. Interesting relationships between these two drawdown time sequences are also established. Finally, insurance policies protecting against the risk of frequent drawdowns are also proposed and priced.
    Date: 2014–03

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