nep-rmg New Economics Papers
on Risk Management
Issue of 2014‒08‒09
eleven papers chosen by
Stan Miles
Thompson Rivers University

  1. Properties of risk capital allocation methods: Core Compatibility, Equal Treatment Property and Strong Monotonicity By Balog, Dóra; Bátyi, Tamás László; Csóka, Péter; Pintér, Miklós
  2. On the impossibility of fair risk allocation By Csóka, Péter; Pintér, Miklós
  3. Global Systemically Important Insurers By Carlos Guiné
  4. Leverage, return, volatility and contagion: Evidence from the portfolio framework By el Alaoui, AbdelKader; Masih, Mansur; Bacha, Obiyathulla; Asutay, Mehmet
  5. Banks and capital requirements: channels of adjustment By Benjamin H Cohen; Michela Scatigna
  6. Heterogeneous effects of risk-taking on bank efficiency : a stochastic frontier model with random coefficients By Miguel Sarmiento; Jorge E. Galán
  7. A simple model of local prices and associated risk evaluation By Krzysztof Urbanowicz; Peter Richmond; Janusz A. Hołyst
  8. Derivatives and Non-Financial Companies: Lessons from the Financial Crisis By Rodrigo M. Zeidan
  9. Robust valuation and risk measurement under model uncertainty By Yuhong Xu
  10. Portafolio óptimo y productos estructurados en mercados alpha-estables: un enfoque de minimización de riesgo By Climent-Hernández, José Antonio; Venegas-Martínez, Francisco; Ortiz-Arango, Francisco
  11. Envelope Condition Method with an Application to Default Risk Models By Cristina Arellano; Lilia Maliar; Serguei Maliar; Viktor Tsyrennikov

  1. By: Balog, Dóra; Bátyi, Tamás László; Csóka, Péter; Pintér, Miklós
    Abstract: In finance risk capital allocation raises important questions both from theoretical and practical points of view. How to share risk of a portfolio among its subportfolios? How to reserve capital in order to hedge existing risk and how to assign this to different business units? We use an axiomatic approach to examine risk capital allocation, that is we call for fundamental properties of the methods. Our starting point is Csóka and Pintér (2011) who show by generalizing Young (1985)'s axiomatization of the Shapley value that the requirements of Core Compatibility, Equal Treatment Property and Strong Monotonicity are irreconcilable given that risk is quantified by a coherent measure of risk. In this paper we look at these requirements using analytic and simulations tools. We examine allocation methods used in practice and also ones which are theoretically interesting. Our main result is that the problem raised by Csóka and Pintér (2011) is indeed relevant in practical applications, that is it is not only a theoretical problem. We also believe that through the characterizations of the examined methods our paper can serve as a useful guide for practitioners.
    Keywords: Coherent Measures of Risk, Risk Capital Allocation, Shapley value, Core, Simulation
    JEL: C71 G10
    Date: 2014–07–23
  2. By: Csóka, Péter; Pintér, Miklós
    Abstract: Measuring and allocating risk properly are crucial for performance evaluation and internal capital allocation of portfolios held by banks, insurance companies, investment funds and other entities subject to financial risk. We show that by using coherent measures of risk it is impossible to allocate risk satisfying simultaneously the natural requirements of Core Compatibility, Equal Treatment Property and Strong Monotonicity. To obtain the result we characterize the Shapley value on the class of totally balanced games and also on the class of exact games.
    Keywords: Coherent Measures of Risk, Risk Allocation Games, Totally Balanced Games, Exact Games, Shapley value, Core
    JEL: C71 G10
    Date: 2014–07–23
  3. By: Carlos Guiné (EIOPA)
    Abstract: This paper addresses the issue of systemic risk in the financial sector and its relevance with regard to insurance activities. The initiatives which followed the 2008 global financial crisis to address the risks posed by Systemically Important Financial Institutions are analyzed, with a focus on the Global Systemically Important Insurers Designation Process and Policy Measures, developed by the International Association of Insurance Supervisors and adopted by the Financial Stability Board in July 2013. The potential consequences of the SIFI project for financial stability, in general, and the Global Systemically Important Insurers framework, in particular, are also discussed. The incentives which are being introduced for the reduction of systemic risk may have unintended consequences, such as an increase of moral hazard and intensified uncertainty. The ongoing work regarding the design, calibration and, in some cases, implementation of such policy measures is, therefore, of capital importance.
    Keywords: Systemically Important Financial Institutions, SIFI, systemic risk, insurance
    JEL: G22 G28
    Date: 2014–06
  4. By: el Alaoui, AbdelKader; Masih, Mansur; Bacha, Obiyathulla; Asutay, Mehmet
    Abstract: When regulating the financial system, the volatility phenomenon seems to emerge, practically, as a phenomenon which is intrinsic to the capital market behaviour. Theoretically, the leverage of the firms appears to be a major determinant of the volatility of prices and returns. At the same time, the leverage has also got a role at both levels: the capital structure of the firm and the investors’ strategy. We examine the return and volatility in relation to leverage by considering different sized portfolios constructed based on the firm’s level of debt and taken from a panel of 320 firms distributed over eight European countries and classified by their level of debt and their size. The optimal portfolio weights are computed for each quarter by maximizing the value of Sharpe ratio. We analyze the return, the volatility and the Value at Risk (VaR) based on different investors’ strategies with a view to taking into account the capital structure and the level of the debt of the firms. Our findings tend to indicate that in the case of two separate equity funds (low debt and high debt), the optimal portfolio is obtained for a weight with high low debt fund. Overall, the leverage seems to have a big role for the portfolio return, volatility and value at risk (VaR). The high leverage is indicative of having a big role in making worse the portfolio return and volatility under shocks. Finally, we explore the value of systematic risk in the case of several portfolio strategies based on high and low debt in regard to the benchmark index (the MSCI Europe index). The presence of these effects is further explored through the response of the model's variables to market-wide return and volatility shocks.
    Keywords: Volatility, leverage, contagion, Mean Variance Efficient Frontier, Wavelet Time–frequency analysis
    JEL: C58 G12 G15
    Date: 2014–07–12
  5. By: Benjamin H Cohen; Michela Scatigna
    Abstract: Bank capital ratios have increased steadily since the financial crisis. For a sample of 94 large banks from advanced and emerging economies, retained earnings account for the bulk of their higher risk-weighted capital ratios, with reductions in risk weights playing a lesser role. On average, banks continued to expand their lending, though lending growth was relatively slower among European banks. Lower dividend payouts and (for advanced economy banks) wider lending spreads have contributed to banks’ ability to use retained earnings to build capital. Banks that came out of the crisis with higher capital ratios and stronger profitability were able to expand lending more.
    Keywords: banks, bank capital, regulation, capital ratios, Basel III
    Date: 2014–03
  6. By: Miguel Sarmiento; Jorge E. Galán
    Abstract: We estimate a stochastic frontier model with random inefficiency parameters, which allows us not only to identify the role of bank risk-taking on driving cost and profit inefficiency, but also to recognize heterogeneous effects of risk exposure on banks with different characteristics. We account for an integral group of risk exposure covariates including credit, liquidity, capital and market risk, as well as bank-specific characteristics of size and affiliation. The model is estimated for the Colombian banking sector during the period 2002-2012. Results suggest that risk-taking drives inefficiency and its omission leads to over (under) estimate cost (profit) efficiency. Risk-taking is also found to have different effects on efficiency of banks with different size and affiliation, and those involved in mergers and acquisitions. In particular, greater exposures to credit and market risk are found to be key profit efficiency drivers.Likewise, lower liquidity risk and capital risk lead to higher efficiency in both costs and profits. Large, foreign and merged banks benefit more when assuming credit risk, while small, domestic and non-merged banks institutions take advantage of assuming higher market risk
    Keywords: Bank efficiency, Bayesian Inference, Heterogeneity, Random Parameters, Risk-Taking, Stochastic frontier models
    JEL: C11 C23 C51 D24 G21 G32
    Date: 2014–07
  7. By: Krzysztof Urbanowicz; Peter Richmond; Janusz A. Hołyst
    Abstract: A simple spin system is constructed to simulate dynamics of asset prices and studied numerically. The outcome for the distribution of prices is shown to depend both on the dimension of the system and the introduction of price into the link measure. For dimensions below 2, the associated risk is high and the price distribution is bimodal. For higher dimensions, the price distribution is Gaussian and the associated risk is much lower. It is suggested that the results are relevant to rare assets or situations where few players are involved in the deal making process.
    Date: 2014–08
  8. By: Rodrigo M. Zeidan (Fundação Dom Cabral)
    Abstract: The paper identifies failures of corporate governance that allow non-financial companies around the world to develop hedging strategies that lead to hefty losses in the aftermath of the financial crisis. The sample is comprised of 346 companies from 10 international markets, of which 49 companies (and a subsample of 13 distressed companies) lose a combined US$18.9 billion. An event study shows that most companies that present losses in derivatives experience negative abnormal returns, including a number of companies in which the effect is persistent after a year. The results of a probit model indicate that the lack of a formal hedging policy, no monitoring to the CFOs, and considerations of hubris and remuneration contribute to the mismanagement of hedging policies.
    Keywords: Risk Management; Hedging; Derivatives; Corporate Governance; Event Study
    JEL: G32 G34 G01
    Date: 2014–07
  9. By: Yuhong Xu
    Abstract: Model uncertainty is a type of inevitable financial risk. Mistakes on the choice of pricing model may cause great financial losses. In this paper we investigate financial markets with mean-volatility uncertainty. Models for stock markets and option markets with uncertain prior distribution are established by Peng's G-stochastic calculus. The process of stock price is described by generalized geometric G-Brownian motion in which the mean uncertainty may move together with or regardless of the volatility uncertainty. On the hedging market, the upper price of an (exotic) option is derived following the Black-Scholes-Barenblatt equation. It is interesting that the corresponding Barenblatt equation does not depend on the risk preference of investors and the mean-uncertainty of underlying stocks. Hence under some appropriate sublinear expectation, neither the risk preference of investors nor the mean-uncertainty of underlying stocks pose effects on our super and subhedging strategies. Appropriate definitions of arbitrage for super and sub-hedging strategies are presented such that the super and sub-hedging prices are reasonable. Especially the condition of arbitrage for sub-hedging strategy fills the gap of the theory of arbitrage under model uncertainty. Finally we show that the term $K$ of finite-variance arising in the super-hedging strategy is interpreted as the max Profit\&Loss of being short a delta-hedged option. The ask-bid spread is in fact the accumulation of summation of the superhedging $P\&L$ and the subhedging $P\&L $.
    Date: 2014–07
  10. By: Climent-Hernández, José Antonio; Venegas-Martínez, Francisco; Ortiz-Arango, Francisco
    Abstract: This paper is aimed at studying the optimal portfolio problem when the assets have returns from -stable distributions. The optimal portfolio contains a riskless asset and various risky assets, including structured notes. The basic statistics of the assets are calculated and both the -stable distribution parameters and the covariation matrix are estimated through maximum likelihood. Finally, it is shown that by including structured notes in the -stable optimal portfolio it is obtained higher returns, lower risk and better performance than Gaussian optimal portfolio.
    Keywords: Optimal portfolio, risk aversion, alpha-stable distribution.
    JEL: G11
    Date: 2014–08–03
  11. By: Cristina Arellano (Federal Reserve Bank of Minneapolis); Lilia Maliar (Department of Economics, Stanford University); Serguei Maliar (Leavey School of Business, Santa Clara University); Viktor Tsyrennikov (Department of Economics, Cornell University)
    Abstract: We develop an envelope condition method (ECM) for dynamic programming problems –a tractable alternative to expensive conventional value function iteration. ECM has two novel features: First, to reduce the cost, ECM replaces expensive backward iteration on Bellman equation with relatively cheap forward iteration on an envelope condition. Second, to increase the accuracy of solutions, ECM solves for derivatives of a value function jointly with a value function itself. We complement ECM with other computational techniques that are suitable for high-dimensional problems, such as simulation-based grids, monomial integration rules and derivative-free solvers. The resulting value-iterative ECM method can accurately solve models with at least upto 20 state variables and can successfully compete in accuracy and speed with state-of-the-art Euler equation methods. We also use ECM to solve a challenging default risk model with a kink in value and policy functions, and we …nd it to be fast, accurate and reliable.
    Keywords: Dynamic programming, Value function iteration, Bellman equation, Endogenous grid, Envelope condition, Curse of dimensionality, Large scale, Sovereign debt, Default risk
    JEL: C6 C61 C63 C68
    Date: 2014–07

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