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on Risk Management |
| By: | Danielsson, Jon (London School of Economics); James, Kevin (London School of Economics); Valenzuela, Marcela (University of Chile); Zer, Ilknur (Board of Governors of the Federal Reserve System (U.S.)) |
| Abstract: | This paper evaluates the model risk of models used for forecasting systemic and market risk. Model risk, which is the potential for different models to provide inconsistent outcomes, is shown to be increasing with and caused by market uncertainty. During calm periods, the underlying risk forecast models produce similar risk readings, hence, model risk is typically negligible. However, the disagreement between the various candidate models increases significantly during market distress, with a no obvious way to identify which method is the best. Finally, we discuss the main problems in risk forecasting for macro prudential purposes and propose an evaluation criteria for such models. |
| Keywords: | Value-at-Risk; expected shortfall; systemic risk; financial stability; Basel III; CoVaR; MES |
| Date: | 2014–04–16 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedgfe:2014-34&r=rmg |
| By: | O'Brien, James M. (Board of Governors of the Federal Reserve System (U.S.)); Szerszen, Pawel J. (Board of Governors of the Federal Reserve System (U.S.)) |
| Abstract: | We study the performance and behavior of Value at Risk (VaR) measures used by a number of large banks during and before the financial crisis. Alternative benchmark VaR measures, including GARCH-based measures, are also estimated directly from the banks' trading revenues and help to explain the bank VaR performance results. While highly conservative in the pre-crisis period, bank VaR exceedances were excessive and clustered in the crisis period. All benchmark VaRs were more accurate in the pre-crisis period with GARCH VaR measures the most accurate in the crisis period having lower exceedance rates with no exceedance clustering. Variance decompositions indicate a limited ability of the banks' VaR methodologies to adjust to the crisis-period market conditions. Despite their weaker performance, the bank VaRs exhibited greater predictive power for a measure of realized PnL volatility than benchmark VaR measures. Benchmark Expected Shortfall measures are also considered. |
| Keywords: | Market risk; value at risk; backtesting; profit and loss; financial crisis |
| Date: | 2014–03–07 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedgfe:2014-21&r=rmg |
| By: | Wilmar Cabrera; Jorge Hurtado; Miguel Morales; Juan Sebastián Rojas |
| Abstract: | The most recent global financial crisis (2008-2009) highlighted the importance of systemic risk and promoted academic interest to develop a wide set of warning indicators, which are mechanisms to identify systemically important institutions and global systemic risk indexes. Using the methodology proposed by Holló et al. (2012), along with some considerations from Hakkio & Keeton (2009), this document comprises a Composite Indicator of Systemic Stress (CISS) for Colombia. The index takes into account several dimensions related to financial markets (credit institutions, housing market, external sector, money market and local bond market) and is constructed using portfolio theory, considering the contagion among dimensions. Results suggest the peak of the global financial crisis (September 2008) as the most important episode of systemic risk in Colombia between 2000-2014. Additionally, real activity seems to be adversely affected by an unexpected increase of the systemic risk index. |
| Keywords: | Systemic Risk, Risk Indicators, Financial Stability, Early-Warning-Indicators, Multivariate GARCH. |
| JEL: | G12 G29 C51 |
| Date: | 2014–06–13 |
| URL: | http://d.repec.org/n?u=RePEc:col:000094:011697&r=rmg |
| By: | Roberto Casarin (Department of Economics, University of Venice Cà Foscari); Monica Billio (Department of Economics, University of Venice, Cà Foscari); Anthony Osuntuyi (Department of Mathematics, Obafemi Awolowo University) |
| Abstract: | A new Bayesian multi-chain Markov Switching GARCH model for dynamic hedging in energy futures markets is developed by constructing a system of simultaneous equations for the return dynamics on the hedged portfolio and futures. More specifically, both the mean and variance of the hedged portfolio are assumed to be governed by two unobserved discrete state processes, while the futures dynamics is driven by a univariate hidden state process. The noise in both processes are characterized by a MS-GARCH model. This formulation has two main practical and conceptual advantages. First, the different states of the discrete processes can be identified as different volatility regimes. Secondly, the parameters can be easily interpreted as different hedging components. Our formulation also provides an avenue to analyze the contribution of the volatility dynamics and state probabilities to the optimal hedge ratio at each point in time. Moreover, the combination of the expected utility framework with regime-switching models allows the definition of a robust minimum variance hedging strategy to also account for parameter uncertainty. Evidence of changes in the optimal hedging strategies before and after the financial crisis is found when the proposed robust hedging strategy is applied to crude oil spot and futures markets. |
| Keywords: | Energy futures; GARCH; Hedge ratio; Markov-switching. |
| JEL: | C1 C11 C15 C32 F31 G15 |
| Date: | 2014 |
| URL: | http://d.repec.org/n?u=RePEc:ven:wpaper:2014:07&r=rmg |
| By: | Péter Csóka (Department of Finance, Corvinus University of Budapest and “Momentum” Game Theory Research Group, Centre for Economic and Regional Studies, Hungarian Academy of Sciences, Hungary); P. Jean-Jacques Herings (Department of Economics, Maastricht University, The Netherlands) |
| Abstract: | Risk allocation games are cooperative games that are used to attribute the risk of a financial entity to its divisions. In this paper, we extend the literature on risk allocation games by incorporating liquidity considerations. A liquidity policy specifies state-dependent liquidity requirements that a portfolio should obey. To comply with the liquidity policy, a financial entity may have to liquidate part of its assets, which is costly. The definition of a risk allocation game under liquidity constraints is not straight- forward, since the presence of a liquidity policy leads to externalities. We argue that the standard worst case approach should not be used here and present an alternative definition. We show that the resulting class of transferable utility games coincides with the class of totally balanced games. It follows from our results that also when taking liquidity considerations into account there is always a stable way to allocate risk. |
| Keywords: | Market Microstructure, Coherent Measures of Risk, Market Liquidity, Portfolio Performance Evaluation, Risk Capital Allocation, Totally Balanced Games |
| JEL: | C71 G10 |
| Date: | 2014–04 |
| URL: | http://d.repec.org/n?u=RePEc:fem:femwpa:2014.47&r=rmg |
| By: | Christian Robert (SAF - Laboratoire de Sciences Actuarielle et Financière - Université Claude Bernard - Lyon I (UCBL) : EA2429); Pierre-Emmanuel Thérond (SAF - Laboratoire de Sciences Actuarielle et Financière - Université Claude Bernard - Lyon I (UCBL) : EA2429) |
| Abstract: | We consider the class of concave distortion risk measures to study how choice is influenced by the decision-maker's attitude to risk and provide comparative static results. We also assume ambiguity about the probability distribution of the risk and consider a framework à la Klibanoff, Marinacci and Mukerji (2005) to study the value of information that resolves ambiguity. We show that this value increases with greater ambiguity, with greater ambiguity aversion, and in some cases with greater risk aversion. Finally we examine whether a more risk-averse and a more ambiguity-averse individual will invest in more effort to shift his initial risk distribution to a better target distribution. |
| Keywords: | Ambiguity ; dual theory ; risk measures ;distorsion ; optimal effort |
| Date: | 2014–05 |
| URL: | http://d.repec.org/n?u=RePEc:hal:journl:hal-00813199&r=rmg |
| By: | Buch, Claudia M. (Federal Reserve Bank of New York); Goldberg, Linda S. (Federal Reserve Bank of New York) |
| Abstract: | Activities of international banks have been at the core of discussions on the causes and effects of the international financial crisis. Yet we know little about the actual magnitudes and mechanisms for transmission of liquidity shocks through international banks, including the reasons for heterogeneity in transmission across banks. The International Banking Research Network, established in 2012, brings together researchers from around the world with access to micro-level data on individual banks to analyze issues pertaining to global banks. This paper summarizes the common methodology and results of empirical studies conducted in eleven countries to explore liquidity risk transmission. Among the main results is, first, that explanatory power of the empirical model is higher for domestic lending than for international lending. Second, how liquidity risk affects bank lending depends on whether the banks are drawing on official-sector liquidity facilities. Third, liquidity management across global banks can be important for liquidity risk transmission into lending. Fourth, there is substantial heterogeneity in the balance sheet characteristics that affect banks’ responses to liquidity risk. Overall, balance sheet characteristics of banks matter for differentiating their lending responses, mainly in the realm of cross-border lending. |
| Keywords: | international banking; liquidity; transmission; central bank liquidity; uncertainty; regulation; crises |
| JEL: | F34 G01 G21 |
| Date: | 2014–05–01 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fednsr:675&r=rmg |
| By: | Correa, Ricardo (Federal Reserve Bank of New York); Goldberg, Linda S. (Federal Reserve Bank of New York); Rice, Tara (Federal Reserve Bank of New York) |
| Abstract: | While the balance sheet structure of U.S. banks influences how they respond to liquidity risks, the mechanisms for the effects on and consequences for lending vary widely across banks. We demonstrate fundamental differences across banks without foreign affiliates versus those with foreign affiliates. Among the nonglobal banks (those without a foreign affiliate), cross-sectional differences in response to liquidity risk depend on the banks’ shares of core deposit funding. By contrast, differences across global banks (those with foreign affiliates) are associated with ex ante liquidity management strategies as reflected in internal borrowing across the global organization. This intra-firm borrowing by banks serves as a shock absorber and affects lending patterns to domestic and foreign customers. The use of official-sector emergency liquidity facilities by global and nonglobal banks in response to market liquidity risks tends to reduce the importance of ex ante differences in balance sheets as drivers of cross-sectional differences in lending. |
| Keywords: | international banking; global banking; liquidity; transmission; internal capital market |
| JEL: | F42 G01 G21 |
| Date: | 2014–06–01 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fednsr:676&r=rmg |
| By: | Sofiene El Aoud (FiQuant - Chaire de finance quantitative - Ecole Centrale Paris, MAS - Mathématiques Appliquées aux Systèmes - EA 4037 - Ecole Centrale Paris); Frédéric Abergel (FiQuant - Chaire de finance quantitative - Ecole Centrale Paris, MAS - Mathématiques Appliquées aux Systèmes - EA 4037 - Ecole Centrale Paris) |
| Abstract: | We present in our work a continuous time Capital Asset Pricing Model where the volatilities of the market index and the stock are both stochastic. Using a singular perturbation technique, we provide approximations for the prices of european options on both the stock and the index. These approximations are functions of the model parameters. We show then that existing estimators of the parameter beta, proposed in the recent literature, are biased in our setting because they are all based on the assumption that the idiosyncratic volatility of the stock is constant. We provide then an unbiased estimator of the parameter beta using only implied volatility data. This estimator is a forward measure of the parameter beta in the sense that it represents the information contained in derivatives prices concerning the forward realization of this parameter, we test then its capacity of prediction of forward beta and we draw a conclusion concerning its predictive power. |
| Date: | 2014–02–28 |
| URL: | http://d.repec.org/n?u=RePEc:hal:wpaper:hal-01006405&r=rmg |
| By: | Matthew Ames; Gareth W. Peters; Guillaume Bagnarosa; Ioannis Kosmidis |
| Abstract: | Currency carry trade is the investment strategy that involves selling low interest rate currencies in order to purchase higher interest rate currencies, thus profiting from the interest rate differentials. This is a well known financial puzzle to explain, since assuming foreign exchange risk is uninhibited and the markets have rational risk-neutral investors, then one would not expect profits from such strategies. That is, according to uncovered interest rate parity (UIP), changes in the related exchange rates should offset the potential to profit from such interest rate differentials. However, it has been shown empirically, that investors can earn profits on average by borrowing in a country with a lower interest rate, exchanging for foreign currency, and investing in a foreign country with a higher interest rate, whilst allowing for any losses from exchanging back to their domestic currency at maturity. This paper explores the financial risk that trading strategies seeking to exploit a violation of the UIP condition are exposed to with respect to multivariate tail dependence present in both the funding and investment currency baskets. It will outline in what contexts these portfolio risk exposures will benefit accumulated portfolio returns and under what conditions such tail exposures will reduce portfolio returns. |
| Date: | 2014–06 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1406.4322&r=rmg |
| By: | Rao, Harish Venkatesh; Dutta, Goutam; Basu, Sankarshan |
| Abstract: | We introduce a stochastic optimization based decision support system (DSS) for asset-liability management of a life insurance firm using a multi-stage, stochastic optimization model. The DSS is based on a multi-stage stochastic linear program (SLP) with recourse for strategic planning. The model can be used with little or no knowledge of management sciences. The model maximizes the expected value of total reserve (policy holders’ reserve and shareholders’ reserve) at the end of the time period of planning. We discuss the issues related to database design structure, DSS interface design, database updating procedure, and solution reporting. |
| URL: | http://d.repec.org/n?u=RePEc:iim:iimawp:12897&r=rmg |