nep-rmg New Economics Papers
on Risk Management
Issue of 2014‒04‒05
seventeen papers chosen by
Stan Miles
Thompson Rivers University

  1. Rational blinders: strategic selection of risk models and bank capital regulation By Colliard, Jean-Edouard
  2. Distortion Risk Measures or the Transformation of Unimodal Distributions into Multimodal Functions By Dominique Guegan; Bertrand Hassani
  3. Conditional and joint credit risk By Lucas, André; Schwaab, Bernd; Zhang, Xin
  4. Some optimization and decision problems in proportional reinsurance By Anna Castañer; M.Mercè Claramunt; Maite Mármol
  5. Forecasting credit card portfolio losses in the Great Recession: a study in model risk By Canals-Cerda, Jose J.; Kerr, Sougata
  6. Observation driven mixed-measurement dynamic factor models with an application to credit risk By Creal, Drew; Schwaab, Bernd; Koopman, Siem Jan; Lucas, André
  7. Maximum drawdown, recovery, and momentum By Jaehyung Choi
  8. Market pricing of credit rating signals By Grothe, Magdalena
  9. An agent-based computational model for China's stock market and stock index futures market By Hai-Chuan Xu; Wei Zhang; Xiong Xiong; Wei-Xing Zhou
  10. Omega risk model with tax By Zhenyu Cui
  11. Are credit ratings time-homogeneous and Markov? By Pedro Lencastre; Frank Raischel; Pedro G. Lind; Tim Rogers
  12. Market exposure and endogenous firm volatility over the business cycle By Decker, Ryan; D'Erasmo, Pablo; Moscoso Boedo, Herman J.
  13. Growing Risk in the Insurance Sector By Yogo, Motohiro; Koijen, Ralph S.J.
  14. Social Security and the Interactions Between Aggregate and Idiosyncratic Risk By Daniel Harenberg; Alexander Ludwig
  15. Utility indifference pricing of derivatives written on industrial loss indexes By Gunther Leobacher; Philip Ngare
  16. Commonality in hedge fund returns: driving factors and implications By Bussière, Matthieu; Hoerova, Marie; Klaus, Benjamin
  17. Credit Growth and Bank Capital Requirements: Binding or Not? By Labonne, C.; Lamé, G.

  1. By: Colliard, Jean-Edouard
    Abstract: The regulatory use of banks' internal models aims at making capital requirements more accurate and reducing regulatory arbitrage, but may also give banks incentives to choose their risk models strategically. Current policy answers to this problem include the use of risk-weight floors and leverage ratios. I show that banks for which those are binding reduce their credit supply, which drives interest rates up, invites other banks to adopt optimistic models and possibly increases aggregate risk in the banking sector. Instead, the strategic use of risk models can be avoided by imposing penalties on banks with low risk-weights when they suffer abnormal losses or bailing out defaulting banks that truthfully reported high risk measures. If such selective bail-outs are not desirable, second-best capital requirements still rely on internal models, but less than in the first-best. JEL Classification: D82, D84, G21, G32, G38
    Keywords: Basel risk-weights, internal risk models, leverage ratio, tail risk
    Date: 2014–02
  2. By: Dominique Guegan (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Paris 1 - Panthéon-Sorbonne); Bertrand Hassani (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Paris 1 - Panthéon-Sorbonne)
    Abstract: The particular subject of this paper, is to construct a general framework that can consider and analyse in the same time upside and downside risks. This paper offers a comparative analysis of concept risk measures, we focus on quantile based risk measure (ES and VaR), spectral risk measure and distortion risk measure. After introducing each measure, we investigate their interest and limit. Knowing that quantile based risk measure cannot capture correctly the risk aversion of risk manager and spectral risk measure can be inconsistent to risk aversion, we propose and develop a new distortion risk measure extending the work of Wang (2000) [38] and Sereda et al (2010) [34]. Finally, we provide a comprehensive analysis of the feasibility of this approach using the S&P500 data set from o1/01/1999 to 31/12/2011.
    Keywords: Risk; VaR; distorsion measures
    Date: 2014–02
  3. By: Lucas, André; Schwaab, Bernd; Zhang, Xin
    Abstract: We propose an empirical framework to assess joint and conditional probabilities of credit events from CDS prices observed in the market. Our model is based on a dynamic skewed-t distribution that captures many salient features of CDS data, including skewed and heavy-tailed changes in the price of CDS protection, as well as dynamic volatilities and correlations that ensure that uncertainty and risk dependence can increase in times of stress. We apply the framework to euro area sovereign CDS spreads during the euro area debt crisis. Our results reveal significant time-variation in distress dependence and spill-over effects. We investigate in particular market perceptions of joint and conditional risks around announcements of Eurosystem non-standard monetary policy measures, and document strong reductions in joint risk. JEL Classification: C32, G32
    Keywords: financial stability, higher order moments, sovereign credit risk, time-varying parameters
    Date: 2013–12
  4. By: Anna Castañer (Facultat d'Economia i Empresa; Universitat de Barcelona (UB)); M.Mercè Claramunt (Facultat d'Economia i Empresa; Universitat de Barcelona (UB)); Maite Mármol (Facultat d'Economia i Empresa; Universitat de Barcelona (UB))
    Abstract: Reinsurance is one of the tools that an insurer can use to mitigate the underwriting risk and then to control its solvency. In this paper, we focus on the proportional reinsurance arrangements and we examine several optimization and decision problems of the insurer with respect to the reinsurance strategy. To this end, we use as decision tools not only the probability of ruin but also the random variable deficit at ruin if ruin occurs. The discounted penalty function (Gerber & Shiu, 1998) is employed to calculate as particular cases the probability of ruin and the moments and the distribution function of the deficit at ruin if ruin occurs. We consider the classical risk theory model assuming a Poisson process and an individual claim amount phase-type distributed, modified with a proportional reinsurance with a retention level that is not constant and depends on the level of the surplus. Depending on whether the initial surplus is below or above a threshold level, the discounted penalty function behaves differently. General expressions for this discounted penalty function are obtained, as well as interesting theoretical results and explicit expressions for phase-type 2 distribution. These results are applied in numerical examples of decision problems based on the probability of ruin and on different risk measures of the deficit at ruin if ruin occurs (the expectation, the Value at Risk and the Tail Value at Risk).
    Keywords: Deficit at ruin, Gerber-Shiu function, Risk measures.
    JEL: G22
    Date: 2014
  5. By: Canals-Cerda, Jose J. (Federal Reserve Bank of Philadelphia); Kerr, Sougata (Federal Reserve Bank of Philadelphia)
    Abstract: Credit card portfolios represent a significant component of the balance sheets of the largest US banks. The charge‐off rate in this asset class increased drastically during the Great Recession. The recent economic downturn offers a unique opportunity to analyze the performance of credit risk models applied to credit card portfolios under conditions of economic stress. Specifically, we evaluate three potential sources of model risk: model specification, sample selection, and stress scenario selection. Our analysis indicates that model specifications that incorporate interactions between policy variables and core account characteristics generate the most accurate loss projections across risk segments. Models estimated over a time frame that includes a significant economic downturn are able to project levels of credit loss consistent with those experienced during the Great Recession. Models estimated over a time frame that does not include a significant economic downturn can severely under-predict credit loss in some cases, and the level of forecast error can be significantly impacted by model specification assumptions. Higher credit-score segments of the portfolio are proportionally more severely impacted by downturn economic conditions and model specification assumptions. The selection of the stress scenario can have a dramatic impact on projected loss.
    Keywords: Credit cards; Credit risk; Stress test; Regulatory capital
    JEL: G20 G32 G33
    Date: 2014–03–31
  6. By: Creal, Drew; Schwaab, Bernd; Koopman, Siem Jan; Lucas, André
    Abstract: We propose a dynamic factor model for mixed-measurement and mixed-frequency panel data. In this framework time series observations may come from a range of families of parametric distributions, may be observed at different time frequencies, may have missing observations, and may exhibit common dynamics and cross-sectional dependence due to shared exposure to dynamic latent factors. The distinguishing feature of our model is that the likelihood function is known in closed form and need not be obtained by means of simulation, thus enabling straightforward parameter estimation by standard maximum likelihood. We use the new mixed-measurement framework for the signal extraction and forecasting of macro, credit, and loss given default risk conditions for U.S. Moody’s-rated firms from January 1982 until March 2010. Our joint modelling framework allows us to construct predictive (conditional) loss densities for portfolios of corporate bonds in the presence of different sources of credit risk such as frailty effects and systematic recovery risk. JEL Classification: C32, G32
    Keywords: default risk, dynamic beta density, dynamic factor model, dynamic ordered probit, loss given default, panel data
    Date: 2013–12
  7. By: Jaehyung Choi
    Abstract: We develop momentum and contrarian strategies with stock selection rules based on maximum drawdown and consecutive recovery. The alternative strategies in monthly and weekly scales outperform the portfolios constructed by cumulative return regardless of market universe. In monthly periods, the ranking rules associated with the maximum drawdown dominate other momentum strategies. The recovery related selection rules are the best ranking criteria for the weekly contrarian portfolio construction. The alternative portfolios are less riskier in many reward-risk measures such as Sharpe ratio, VaR, CVaR, and maximum drawdown. The outperformance of the alternative strategies leads to the higher factor-neutral alphas in the Fama-French three-factor model.
    Date: 2014–03
  8. By: Grothe, Magdalena
    Abstract: This paper contributes new evidence on market pricing of rating changes. We examine the relation between spreads and ratings for a very large and comprehensive sample of corporate bonds, which allows us to test for country- and industry-specific effects, as well as to explore the differences between the calm and distressed market conditions. The results show that the effects of rating actions on market prices are significant and depend on the current state of the market. While during favourable market conditions rating actions are not crucial for market pricing, they become very significant in the periods of crisis. JEL Classification: G12, G14, G01, G21
    Keywords: corporate bond spreads, credit ratings, pricing of risk
    Date: 2013–12
  9. By: Hai-Chuan Xu (TJU); Wei Zhang (TJU); Xiong Xiong (TJU); Wei-Xing Zhou (ECUST)
    Abstract: This study presents an agent-based computational cross-market model for Chinese equity market structure, which includes both stocks and CSI 300 index futures. In this model, we design several stocks and one index futures to simulate this structure. This model allows heterogeneous investors to make investment decisions with restrictions including wealth, market trading mechanism, and risk management. Investors' demands and order submissions are endogenously determined. Our model successfully reproduces several key features of the Chinese financial markets including spot-futures basis distribution, bid-ask spread distribution, volatility clustering and long memory in absolute returns. Our model can be applied in cross-market risk control, market mechanism design and arbitrage strategies analysis.
    Date: 2014–03
  10. By: Zhenyu Cui
    Abstract: In this paper we study the Omega risk model with surplus-dependent tax payments in a time-homogeneous diffusion setting. The new model incorporates practical features from both the Omega risk model(Albrecher and Gerber and Shiu (2011)) and the risk model with tax(Albrecher and Hipp (2007)). We explicitly characterize the Laplace transform of the occupation time of an Azema-Yor process(e.g. a process refracted by functionals of its running maximum) below a constant level until the first hitting time of another Azema-Yor process or until an independent exponential time. This result unifies and extends recent literature(Li and Zhou (2013) and Zhang (2014)) incorporating some of their results as special cases. We explicitly characterize the Laplace transform of the time of bankruptcy in the Omega risk model with tax and discuss an extension to integral functionals. Finally we present examples using a Brownian motion with drift.
    Date: 2014–03
  11. By: Pedro Lencastre; Frank Raischel; Pedro G. Lind; Tim Rogers
    Abstract: We introduce a simple approach for testing the reliability of homogeneous generators and the Markov property of the stochastic processes underlying empirical time series of credit ratings. We analyze open access data provided by Moody's and show that the validity of these assumptions - existence of a homogeneous generator and Markovianity - is not always guaranteed. Our analysis is based on a comparison between empirical transition matrices aggregated over fixed time windows and candidate transition matrices generated from measurements taken over shorter periods. Ratings are widely used in credit risk, and are a key element in risk assessment; our results provide a tool for quantifying confidence in predictions extrapolated from these time series.
    Date: 2014–03
  12. By: Decker, Ryan (University of Maryland); D'Erasmo, Pablo (Federal Reserve Bank of Philadelphia); Moscoso Boedo, Herman J. (University of Virginia)
    Abstract: First Draft: November 1, 2011 We propose a theory of endogenous firm-level volatility over the business cycle based on endogenous market exposure. Firms that reach a larger number of markets diversify market-specific demand risk at a cost. The model is driven only by total factor productivity shocks and captures the business cycle properties of firm-level volatility. Using a panel of U.S. firms (Compustat), we empirically document the countercyclical nature of firm-level volatility. We then match this panel to Compustat’s Segment data and the U.S. Census’s Longitudinal Business Database (LBD) to show that, consistent with our model, measures of market reach are procyclical, and the countercyclicality of firm-level volatility is driven mostly by those firms that adjust the number of markets to which they are exposed. This finding is explained by the negative elasticity between various measures of market exposure and firm-level idiosyncratic volatility we uncover using Compustat, the LBD, and the Kauffman Firm Survey.
    Keywords: Endogenous idiosyncratic risk; Business cycles; Market exposure;
    JEL: D21 D22 E32 L11 L25
    Date: 2014–03–24
  13. By: Yogo, Motohiro (Federal Reserve Bank of Minneapolis); Koijen, Ralph S.J. (London Business School)
    Abstract: Developing risk in the life insurance industry requires prudent policy response to prevent broader economic damage.
    Keywords: Shadow insurance; Life insurance
    Date: 2014–03–24
  14. By: Daniel Harenberg (ETH Zurich, Switzerland); Alexander Ludwig (CMR & FiFo, University of Cologne)
    Abstract: We ask whether a PAYG-financed social security system is welfare improving in an economy with idiosyncratic and aggregate risk. We argue that interactions between the two risks are important for this question. One is a direct interaction in the form of a countercyclical variance of idiosyncratic income risk. The other indirectly emerges over a household's life-cycle because retirement savings contain the history of idiosyncratic and aggregate shocks. We show that this leads to risk interactions, even when risks are statistically independent. In our quantitative analysis, we find that introducing social security with a contribution rate of two percent leads to welfare gains of 2.2% of lifetime consumption in expectation, despite substantial crowding out of capital. This welfare gain stands in contrast to the welfare losses documented in the previous literature, which studies one risk in isolation. We show that jointly modeling both risks is crucial: 60% of the welfare benefits from insurance result from the interactions of risks.
    Keywords: Social security; idiosyncratic risk; aggregate risk; welfare
    JEL: C68 E27 E62 G12 H55
    Date: 2014–03
  15. By: Gunther Leobacher; Philip Ngare
    Abstract: We consider the problem of pricing derivatives written on some industrial loss index via utility indifference pricing. The industrial loss index is modelled by a compound Poisson process and the insurer can adjust her portfolio by choosing the risk loading, which in turn determines the demand. We compute the price of a CAT(spread) option written on that index using utility indifference pricing.
    Date: 2014–04
  16. By: Bussière, Matthieu; Hoerova, Marie; Klaus, Benjamin
    Abstract: We measure the commonality in hedge fund returns, identify its main driving factor and analyse its implications for financial stability. We find that hedge funds’ commonality increased significantly from 2003 until 2006. We attribute this rise mainly to the increase in hedge funds’ exposure to emerging market equities, which we identify as a common factor in hedge fund returns over this period. Our results show that funds with a high commonality were affected disproportionately by illiquidity and exhibited negative returns during the subsequent financial crisis, thereby providing little diversification benefits to the financial system and to investors. JEL Classification: G01, G10, G11, G23
    Keywords: commonality, financial crisis, hedge funds, liquidity, risk factors
    Date: 2014–03
  17. By: Labonne, C.; Lamé, G.
    Abstract: This paper examines the sensitivity of NFC lending to banks' capital ratios and their supervisory capital requirements. We use a unique database for the French banking sector between 2003 and 2011 combining confidential bank-level Bank Lending Survey answers with the discretionary capital requirements set by the supervisory authority. We find that on average, more capital means more credit. But the elasticity of lending to capital depends on the intensity of the supervisory capital constraint. More supervisory capital constrained banks tend to have a slower credit growth than unconstrained banks. We also find that the ratio of non-performing loans to total loans granted may be considered a transmission channel for supervisory requirements. More supervisory capital constrained banks tend to be more reactive to this ratio than unconstrained banks. The former are more prone to reduce credit allocation after a rise in non-performing loans than the latter.
    Keywords: Lending, Bank Regulation, Capital.
    JEL: G21 G28 G32
    Date: 2014

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