New Economics Papers
on Risk Management
Issue of 2014‒06‒28
seventeen papers chosen by

  1. Dynamic Portfolio Insurance Strategies: Risk Management under Johnson Distributions By Naceur Naguez; Jean-Luc Prigent
  2. Neue regulatorische Konzepte der Bankenaufsicht und ihre Auswirkungen auf die Gesamtbanksteuerung By Noack, Tim; Cremers, Heinz; Mala, Julia
  3. Hedging of unit-linked life insurance contracts with unobservable mortality hazard rate via local risk-minimization By Claudia Ceci; Katia Colaneri; Alessandra Cretarola
  4. On the Depletion Problem for an Insurance Risk Process: New Non-ruin Quantities in Collective Risk Theory By Zied Ben-Salah; H\'el\`ene Gu\'erin; Manuel Morales; Hassan Omidi Firouzi
  5. Credit Risk in a Geometric Arbitrage Perspective By Simone Farinelli
  6. Moral Hazard in Dynamic Risk Management By Jak\v{s}a Cvitani\'c; Dylan Possama\"i; Nizar Touzi
  7. Systemic risk through contagion in a core-periphery structured banking network By Oliver Kley; Claudia Kl\"uppelberg; Lukas Reichel
  8. Reduction of systemic risk by means of Pigouvian taxation By Vinko Zlati\'c; Giampaolo Gabbi; Hrvoje Abraham
  9. Exact fit of simple finite mixture models By Dirk Tasche
  10. THE MARKET RISK PERCEPTIONS AND MANAGEMENT OF IRISH DAIRY FARMERS By Loughrey, J.; Thorne, F.; Kinsella, A.; Hennessy, T.; McDonnell, J.; O’Donoghue, C.; Vollenweider, X.
  11. Assessing the costs of risk management tools: A crop insurance scenario based on a stochastic partial equilibrium model approach By Feng, Siyi; Patton, Myles; Binfield, Julian; Davis, John
  12. Measuring the Risk-Return Tradeoff with Time-Varying Conditional Covariances By Esben Hedegaard; Robert J. Hodrick
  13. Sovereign and bank CDS spreads: two sides of the same coin for European bank default predictability? By Avino, Davide; Cotter, John
  14. Commons as a risk-management tool: theoretical predictions and an experimental test By Marielle Brunette; Philippe Delacote; Serge Garcia; Jean-Marc Rousselle
  15. Risk management activities of a non-industrial private forest owner with a bivariate utility function By Marielle Brunette; Stéphane Couture
  16. A fear index to predict oil futures returns By Julien Chevallier; Benoit Sevi
  17. How to hedge extrapolated yield curves By Andreas Lager{\aa}s

  1. By: Naceur Naguez; Jean-Luc Prigent
    Abstract: The purpose of this paper is to analyze the gap risk of dynamic portfo- lio insurance strategies which generalize the "Constant Proportion Port- folio Insurance " (CPPI) method by allowing the multiple to vary. We illustrate our theoretical results for conditional CPPI strategies indexed on hedge funds. For this purpose, we provide accurate estimations of hedge funds returns by means of Johnson distributions. We introduce also an EGARCH type model with Johnson innovations to describe dy- namics of risky logreturns. We use both VaR and Expected Shortfall as downside risk measures to control gap risk. We provide accurate upper bounds on the multiple in order to limit this gap risk. We illustrate our theoretical results on Credit Suisse Hedge Fund Index. The time period of the analysis lies between December 1994 and December 2013.
    Keywords: Portfolio insurance; CPPI; Hedge funds; Johnson distribu- tion, gap risk, VaR, CVaR.
    JEL: C6 G11 G24
    Date: 2014–06–16
  2. By: Noack, Tim; Cremers, Heinz; Mala, Julia
    Abstract: -- The Basel III framework represents the response to the regulation deficits of the financial cri-sis and the immense losses of many banks in years 2007/2008. The aim of the framework is to increase the level of capital in financial institutions and to improve the loss absorption and risk coverage of capital. With its' implementation in the European Union in form of a Regulation, which came into force in January 2014, the framework will cause massive capital short-falls, forcing banks to rethink their capital structure and improve their capital management. Furthermore the Basel III implementation will have noticeable effects on banks' profitability, their costs of capital as well as their business models. This Working Paper presents the measures of the new regulatory framework and discusses potential impacts on the overall bank management.
    Keywords: Basel III,CRR,own funds,Leverage Ratio,Liquidity Coverage Ratio,Net Stable Funding Ratio,Monitoring Tools,CVA Charge,Central Counterparty,Counterparty Credit Risk,basel committee on banking supervision,EPE models,capital requirements,capital conservation buffer,additional capital buffers,additional capital buffers for G-SIFIS,transitional arrangement,consequences on solvability,consequences on liquidity,consequences Leverage Ratio
    JEL: G00 G01 G18 G28 G29 F33
    Date: 2014
  3. By: Claudia Ceci; Katia Colaneri; Alessandra Cretarola
    Abstract: In this paper we investigate the local risk-minimization approach for a combined financial-insurance model where there are restrictions on the information available to the insurance company. In particular we assume that, at any time, the insurance company may observe the number of deaths from a specific portfolio of insured individuals but not the mortality hazard rate. We consider a financial market driven by a general semimartingale and we aim to hedge unit-linked life insurance contracts via the local risk-minimization approach under partial information. The F\"ollmer-Schweizer decomposition of the insurance claim and explicit formulas for the optimal strategy for pure endowment and term insurance contracts are provided in terms of the projection of the survival process on the information flow. Moreover, in a Markovian framework, we reduce to solve a filtering problem with point process observations.
    Date: 2014–06
  4. By: Zied Ben-Salah; H\'el\`ene Gu\'erin; Manuel Morales; Hassan Omidi Firouzi
    Abstract: The field of risk theory has traditionally focused on ruin-related quantities. In particular, the socalled Expected Discounted Penalty Function has been the object of a thorough study over the years. Although interesting in their own right, ruin related quantities do not seem to capture path-dependent properties of the reserve. In this article we aim at presenting the probabilistic properties of drawdowns and the speed at which an insurance reserve depletes as a consequence of the risk exposure of the company. These new quantities are not ruin related yet they capture important features of an insurance position and we believe it can lead to the design of a meaningful risk measures. Studying drawdowns and speed of depletion for L\'evy insurance risk processes represent a novel and challenging concept in insurance mathematics. In this paper, all these concepts are formally introduced in an insurance setting. Moreover, using recent results in fluctuation theory for L\'evy processes, we derive expressions for the distribution of several quantities related to the depletion problem. Of particular interest are the distribution of drawdowns and the Laplace transform for the speed of depletion. These expressions are given for some examples of L\'evy insurance risk processes for which they can be calculated, in particular for the classical Cramer-Lundberg model.
    Date: 2014–06
  5. By: Simone Farinelli
    Abstract: Geometric Arbitrage Theory, where a generic market is modelled with a principal fibre bundle and arbitrage corresponds to its curvature, is applied to credit markets to model default risk and recovery, leading to closed form no arbitrage characterizations for corporate bonds.
    Date: 2014–06
  6. By: Jak\v{s}a Cvitani\'c; Dylan Possama\"i; Nizar Touzi
    Abstract: We consider a contracting problem in which a principal hires an agent to manage a risky project. When the agent chooses volatility components of the output process and the principal observes the output continuously, the principal can compute the quadratic variation of the output, but not the individual components. This leads to moral hazard with respect to the risk choices of the agent. Using a recent theory of singular changes of measures for Ito processes, we formulate a principal-agent problem in this context, and solve it in the case of CARA preferences. In that case, the optimal contract is linear in these factors: the contractible sources of risk, including the output, the quadratic variation of the output and the cross-variations between the output and the contractible risk sources. Thus, like sample Sharpe ratios used in practice, path-dependent contracts naturally arise when there is moral hazard with respect to risk management. We also provide comparative statistics via numerical examples, showing that the optimal contract is sensitive to the values of risk premia and the initial values of the risk exposures.
    Date: 2014–06
  7. By: Oliver Kley; Claudia Kl\"uppelberg; Lukas Reichel
    Abstract: We contribute to the understanding of how systemic risk arises in a network of credit-interlinked agents. Motivated by empirical studies we formulate a network model which, despite its simplicity, depicts the nature of interbank markets better than a homogeneous model. The components of a vector Ornstein-Uhlenbeck process living on the vertices of the network describe the financial robustnesses of the agents. For this system, we prove a LLN for growing network size leading to a propagation of chaos result. We state properties, which arise from such a structure, and examine the effect of inhomogeneity on several risk management issues and the possibility of contagion.
    Date: 2014–06
  8. By: Vinko Zlati\'c; Giampaolo Gabbi; Hrvoje Abraham
    Abstract: We analyze the possibility of reduction of systemic risk in financial markets through Pigouvian taxation of financial institutions which is used to support the rescue fund. We introduce the concept of the cascade risk with a clear operational definition as a subclass and a network related measure of the systemic risk. Using financial networks constructed from real Italian money market data and using realistic parameters, we show that the cascade risk can be substantially reduced by a small rate of taxation and by means of a simple strategy of the money transfer from the rescue fund to interbanking market subjects. Furthermore, we show that while negative effects on the return on investment ($ROI$) are direct and certain, an overall positive effect on risk adjusted return on investments ($ROI^{RA}$) is visible. Please note that \emph{the taxation} is introduced as a monetary/regulatory, not as a fiscal measure, as the term could suggest. \emph{The rescue fund} is implemented in a form of a common reserve fund.
    Date: 2014–06
  9. By: Dirk Tasche
    Abstract: How to forecast next year's portfolio-wide credit default rate based on last year's default observations and the current score distribution? A classical approach to this problem consists of fitting a mixture of the conditional score distributions observed last year to the current score distribution. This is a special (simple) case of a finite mixture model where the mixture components are fixed and only the weights of the components are estimated. The optimum weights provide a forecast of next year's portfolio-wide default rate. We point out that the maximum-likelihood (ML) approach to fitting the mixture distribution not only gives an optimum but even an exact fit if we allow the mixture components to vary but keep their density ratio fix. From this observation we can conclude that the standard default rate forecast based on last year's conditional default rates will always be located between last year's portfolio-wide default rate and the ML forecast for next year. We also discuss how the mixture model based estimation methods can be used to forecast total loss. This involves the reinterpretation of an individual classification problem as a collective quantification problem.
    Date: 2014–06
  10. By: Loughrey, J.; Thorne, F.; Kinsella, A.; Hennessy, T.; McDonnell, J.; O’Donoghue, C.; Vollenweider, X.
    Abstract: The abolition of the milk quota regime in April 2015 will provide the opportunity for many profitable Irish dairy farms to increase their production levels. Market risk will influence the decision-making process at the farm level. Dairy farmers have acquired more recent experience of market risk through highly volatile market prices. This has the potential to affect risk attitudes and the selection of tools available to manage market risk. In this paper, we examine the market risk perceptions and management of Irish dairy farmers using 2011 Teagasc National Farm Survey data. We utilise experimental data in relation to forward contracting in order to examine the risk aversion and adoption rates for this particular risk management tool. Our findings suggest that recent price history and future price expectations have significant effects on decision-making in the area of forward contracting. Within the farm-gate diversification and the number of children in particular age categories have a positive and significant association with the adoption of forward contracting.
    Keywords: Market Risk, Risk Perception, Risk Management, Forward Contracts, Risk Aversion, Agribusiness, Farm Management, Livestock Production/Industries, Marketing, Risk and Uncertainty, D81, Q12, Q18,
    Date: 2014–04
  11. By: Feng, Siyi; Patton, Myles; Binfield, Julian; Davis, John
    Abstract: Following the move from a situation of stable, administratively determined prices and production linked subsidies to freely moving prices and decoupled subsidies, risk is of increasing concern within the EU agricultural sector. Also, significant increases in global market prices have further contributed to volatility. There are increasing interests in developing programmes aiming at providing assistance in risk management, which already exist in other countries such as the US on a large scale. The operation of these programmes is similar to insurance to some extent and therefore entails complex design issues. At the same time, these programmes generally involve policy support due to the presence of systematic risks within the sector. Thus, careful assessment is required. This paper examines a hypothetical scheme that provides protection against crop yield falls within the UK using the stochastic FAPRI-UK and EU-GOLD modelling system. The two key aspects investigated are the level of aggregation and the definition of reference. The choice of level of aggregation is closely related to the trade-offs between programme cost and its effectiveness in risk reduction. Furthermore, the definition of reference also has implications on programme costs and their variability.
    Keywords: stochastic modelling, risk management tool, Agricultural Finance, Demand and Price Analysis, Research Methods/ Statistical Methods, Risk and Uncertainty, Q1,
    Date: 2014–04
  12. By: Esben Hedegaard; Robert J. Hodrick
    Abstract: We examine the prediction of Merton’s intertemporal CAPM that time varying risk premiums arise from the conditional covariances of returns on assets with the return on the market and other state variables. We find a positive and significant price of risk for the covariance with the market return that is driven by the time series variation in the conditional covariances, and the risk-premium on the market remains positive and significant after controlling for additional state variables. Our method estimates the risk-return tradeoff in the ICAPM using multiple portfolios as test assets.
    JEL: G12
    Date: 2014–06
  13. By: Avino, Davide; Cotter, John
    Abstract: This paper investigates the relationship between sovereign and bank CDS spreads with reference to their ability to convey timely signals on the default risk of European sovereign countries and their banking systems. For a sample including six major European economies, we find that sovereign and bank CDS spreads are cointegrated variables at the country level. We then perform a more in-depth investigation of the underlying price discovery mechanisms, and find that both variables have an important price discovery role in the period preceding the financial crisis of 2007-2009. However, during the global financial crisis and the subsequent European sovereign debt crisis, sovereign CDS spreads dominate the price discovery process. Our findings strongly suggest that, especially during crisis periods, sovereign CDS spreads incorporate more timely information on the default probability of European banks than their corresponding bank CDS spreads. Price discovery measures based on CDS prices could be used as market triggers to increase equity levels at financial institutions and in the various forms of contingent capital
    Keywords: Credit default swap spreads; price discovery; information flow; financial crisis; banks; sovereign risk; bank capital; contingent capital
    JEL: D8 G01 G12 G14 G20
    Date: 2013–06
  14. By: Marielle Brunette (Laboratoire d'Economie Forestière, INRA - AgroParisTech); Philippe Delacote (Laboratoire d'Economie Forestière, INRA - AgroParisTech; Climate Economic Chair); Serge Garcia (Laboratoire d'Economie Forestière, INRA - AgroParisTech); Jean-Marc Rousselle (INRA, UMR 1135 LAMETA)
    Abstract: The impact of the safety-net use of Common-pool resources (CPR) on the individual investment into and extraction from the commons is analyzed in this paper. Agents of the community first choose to invest in their private project and in the CPR; second, they choose how much to extract from their private project and the commons. The model compares two types of risk management tool: CPR as risk-coping and risk-diversification mechanisms. It also compares two types of risk: risk on a private project and risk on CPR investment by other community members. The theoretical predictions are empirically tested with experimental economics. In this view, we propose an original CPR game composed of two periods, an investment one and an extraction one. Our result clearly shows that risk reduction in the private project unambiguously decreases investment in the CPR, while it does not impact CPR extraction. We also show that a risk-coping strategy is well understood as more flexible and influenced by the outcome in terms of private project yield.
    Keywords: Common-pool resource, Common-pool resource game, deforestation, experimental economics.
    JEL: Q15 Q23 D71 D81
    Date: 2014–04
  15. By: Marielle Brunette (Laboratoire d'Economie Forestière, INRA - AgroParisTech); Stéphane Couture (INRA, UR 875 Applied Mathematics and Computer Science laboratory)
    Abstract: In this paper, we propose to analyse the choice of risk management activity made by a non-industrial private forest owner who derives utility from consumption and from the sentimental value of the forest that bears a risk of disaster. We consider a bivariate utility function depending on consumption and sentimental value of forest. In this context, we analyse insurance and/or self-insurance decisions. We show that, under fair premium, full insurance is optimal only if the cross derivative of the utility function equals zero. Under-insurance and over-insurance may also be optimal depending on the sign of this cross derivative. We also show that, under a positive loading factor, optimal partial insurance is validated only if the cross derivative is positive; otherwise full insurance may be optimal even with a loading insurance. We also observe that risk aversion increases the level of insurance demand and selfinsurance activity, extending this standard result obtained with an univariate utility function to a bivariate utility function. Moreover, when the forest owner can simultaneously insure and invest in self-insurance activity, full insurance is never optimal if the cross derivative is positive. Finally, we prove that insurance and selfinsurance may be substitutes, and if preferences are separable and exhibit decreasing absolute risk aversion, then insurance and self-insurance are always considered as substitutes.
    Keywords: Forest management, insurance, self-insurance, bivariate utility, risk.
    JEL: D81 Q26 Q23
    Date: 2014–01
  16. By: Julien Chevallier; Benoit Sevi
    Abstract: This paper evaluates the predictability of WTI light sweet crude oil futures by us- ing the variance risk premium, i.e. the difference between model-free measures of implied and realized volatilities. Additional regressors known for their ability to ex- plain crude oil futures prices are also considered, capturing macroeconomic, finan- cial and oil-specific influences. The results indicate that the explanatory power of the (negative) variance risk premium on oil excess returns is particularly strong (up to 25% for the adjusted R-squared across our regressions). It complements other fi- nancial (e.g. default spread) and oil-specific (e.g. US oil stocks) factors highlighted in previous literature.
    Keywords: Oil Futures, Variance Risk Premium, Forecasting
    JEL: C32 G17 Q47
    Date: 2014–06–16
  17. By: Andreas Lager{\aa}s
    Abstract: We present a framework on how to hedge the interest rate sensitivity of liabilities discounted by an extrapolated yield curve. The framework is based on functional analysis in that we consider the extrapolated yield curve as a functional of an observed yield curve and use its G\^ateaux variation to understand the sensitivity to any possible yield curve shift. We apply the framework to analyse the Smith-Wilson method of extrapolation that is proposed by the European Insurance and Occupational Pensions Authority (EIOPA) in the coming EU legislation Solvency II, and the method recently introduced, and currently prescribed, by the Swedish Financial Supervisory Authority.
    Date: 2014–06

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