New Economics Papers
on Risk Management
Issue of 2014‒08‒16
ten papers chosen by

  1. Assessing the solvency of insurance portfolios via a continuous time cohort model By Petar Jevtic'; Luca Regis
  2. Asymmetric Realized Volatility Risk By David E. Allen; Michael McAleer; Marcel Scharth
  3. Value-at-Risk time scaling for long-term risk estimation By Luca Spadafora; Marco Dubrovich; Marcello Terraneo
  4. Risk management, the subprime crisis and financialisation: the role of risk management in the generation and transmission of the subprime crisis By Sergio Lagoa; Emanuel Leao; Ricardo Barradas
  5. Dynamics in two networks based on stocks of the US stock market By Leonidas Sandoval Junior
  6. Banks, Government Bonds, and Default: What do the Data Say? By Nicola Gennaioli; Alberto Martin; Stefano Rossi
  7. The Impact of Crude Oil Price on Islamic Stock Indices of South East Asian (SEA) Countries: A Comparative Analysis By Abdullah, Ahmad Monir; Saiti, Buerhan; Masih, Abul Mansur M.
  8. Backtesting and Evaluation of Different Trading Schemes for the Portfolio Management of Natural Gas By Popov, Maxim; Madlener, Reinhard
  9. The Economics of Collateral By Ronald W.Anderson; Karin Jõeveer
  10. The risk of financial crises: Is it in real or financial factors? By Karolin Kirschenmann; Tuomas Malinen; Henri Nyberg

  1. By: Petar Jevtic' (Department of Mathematics and Statistics, McMaster University); Luca Regis (IMT Lucca Institute for Advanced Studies)
    Abstract: This paper evaluates the solvency of a portfolio of assets and liabilities of an insurer subject to both longevity and financial risks. Liabilities are evaluated at fair-value and, as a consequence, interest-rate risk can affect both the assets and the liabilities. Longevity risk is described via a continuous-time cohort model. We evaluate the effects of natural hedging strategies on the risk profile of an insurance portfolio in run-off. Numerical simulations, calibrated to UK historical data, show that systematic longevity risk is of particular importance and needs to be hedged. Natural hedging can improve the solvency of the insurer, if interest-rate risk is appropriately managed. We stress that asset allocation choices should not be independent of the composition of the liability portfolio of the insurer.
    Keywords: longevity risk; natural hedging; continuous-time cohort models for longevity; solvency of insurance portfolios; solvency requirements; longevity and interest-rate risk
    JEL: G22 G32
    Date: 2014–07
  2. By: David E. Allen (School of Accounting, Finance and Economics Edith Cowan University, Australia.); Michael McAleer (Econometric Institute, Erasmus School of Economics, Erasmus University Rotterdam and Tinbergen Institute, The Netherlands, Department of Quantitative Economics, Complutense University of Madrid, and Institute of Economic Research, Kyoto University.); Marcel Scharth (Post Doctoral Fellow, Australian School of Business, University of New South Wales)
    Abstract: In this paper we document that realized variation measures constructed from high-frequency returns reveal a large degree of volatility risk in stock and index returns, where we characterize volatility risk by the extent to which forecasting errors in realized volatility are substantive. Even though returns standardized by ex post quadratic variation measures are nearly gaussian, this inpredictability brings considerably more uncertainty to the empirically relevant ex ante distribution of returns. Explicitly modeling this volatility risk is fundamental. We propose a dually asymmetric realized volatility model, which incorporates the fact that realized volatility series are systematically more volatile in high volatility periods. Returns in this framework display time varying volatility, skewness and kurtosis. We provide a detailed account of the empirical advantages of the model using data on the S&P 500 index and eight other indexes and stocks.
    Keywords: Realized volatility; Volatility of volatility; Volatility risk; Value-at-risk; Forecasting; Conditional heteroskedasticity.
    JEL: C58 G12
    Date: 2014–06
  3. By: Luca Spadafora; Marco Dubrovich; Marcello Terraneo
    Abstract: In this paper we discuss a general methodology to compute the market risk measure over long time horizons and at extreme percentiles, which are the typical conditions needed for estimating Economic Capital. The proposed approach extends the usual market-risk measure, ie, Value-at-Risk (VaR) at a short-term horizon and 99% confidence level, by properly applying a scaling on the short-term Profit-and-Loss (P&L) distribution. Besides the standard square-root-of-time scaling, based on normality assumptions, we consider two leptokurtic probability density function classes for fitting empirical P&L datasets and derive accurately their scaling behaviour in light of the Central Limit Theorem, interpreting time scaling as a convolution problem. Our analyses result in a range of possible VaR-scaling approaches depending on the distribution providing the best fit to empirical data, the desired percentile level and the time horizon of the Economic Capital calculation. After assessing the different approaches on a test equity trading portfolio, it emerges that the choice of the VaR-scaling approach can affect substantially the Economic Capital calculation. In particular, the use of a convolution-based approach could lead to significantly larger risk measures (by up to a factor of four) than those calculated using Normal assumptions on the P&L distribution.
    Date: 2014–08
  4. By: Sergio Lagoa (Instituto Universitário de Lisboa (ISCTE-IUL), DINAMIA’CET-IUL); Emanuel Leao (Instituto Universitário de Lisboa (ISCTE-IUL), DINAMIA’CET-IUL); Ricardo Barradas (Instituto Universitário de Lisboa (ISCTE-IUL), DINAMIA’CET-IUL)
    Abstract: Over time the financial sector has gained greater relevance in the economy, a phenomenon that some call financialisation. Contrary to the mainstream view, financialisation literature emphasises that risk management by financial corporations will not be socially efficient in a context of deregulated markets and will ultimately lead to an increase of aggregate risk and crises. To assess the validity of such claim, in this paper we review the literature on risk management during the Subprime crisis. These failures fall into three categories: technique and methodology, corporate governance and strategy, and regulation and external factors. These failures can be interpreted in the light of the financialisation perspective, which is therefore a valuable approach when addressing regulatory changes in the financial system.
    Keywords: risk management, financial crisis, financialisation.
    JEL: G01 G18 G21 G28
  5. By: Leonidas Sandoval Junior
    Abstract: We follow the main stocks belonging to the New York Stock Exchange and to Nasdaq from 2003 to 2012, through years of normality and of crisis, and study the dynamics of networks built on two measures expressing relations between those stocks: correlation, which is symmetric and measures how similar two stocks behave, and Transfer Entropy, which is non-symmetric and measures the influence of the time series of one stock onto another in terms of the information that the time series of one stock transmits to the time series of another stock. The two measures are used in the creation of two networks that evolve in time, revealing how the relations between stocks and industrial sectors changed in times of crisis. The two networks are also used in conjunction with a dynamic model of the spreading of volatility in order to detect which are the stocks that are most likely to spread crises, according to the model. This information may be used in the building of policies aiming to reduce the effect of financial crises.
    Date: 2014–08
  6. By: Nicola Gennaioli; Alberto Martin; Stefano Rossi
    Abstract: We analyze holdings of public bonds by over 20,000 banks in 191 countries, and the role of these bonds in 20 sovereign defaults over 1998-2012. Banks hold many public bonds (on average 9% of their assets), particularly in less financially-developed countries. During sovereign defaults, banks increase their exposure to public bonds, especially large banks and when expected bond returns are high. At the bank level, bondholdings correlate negatively with subsequent lending during sovereign defaults. This correlation is mostly due to bonds acquired in pre-default years. These findings shed light on alternative theories of the sovereign default-banking crisis nexus.
    Keywords: Banks;Government securities;Bonds;Sovereign risk;Return on investment;Sovereign debt defaults;Banking crisis;Sovereign Risk, Sovereign Default, Government Bonds
    Date: 2014–07–08
  7. By: Abdullah, Ahmad Monir; Saiti, Buerhan; Masih, Abul Mansur M.
    Abstract: An understanding of how volatilities of and correlations between commodity returns and Islamic stock indices change over time including their directions and size are of crucial importance for both the domestic and international investors with a view to diversifying their portfolios for hedging against unforeseen risks. This paper is the first attempt to add value to the existing literature by empirically testing for the ‘time-varying’ and ‘scale dependent’ volatilities of and correlations between the selected Islamic stock indices of South East Asian countries and selected commodities for enhancing portfolio diversification benefits. The methodologies appropriate to achieving the objectives were the recently introduced dynamic conditional correlations and wavelet decompositions. Our findings tend to suggest that there is a theoretical relationship between the selected Islamic stock indices and the selected commodities and that the Islamic stock indices of Singapore, Philippines and Indonesia are leading the other Islamic stock indices and the commodities (as evidenced in the Vector Error-Correction models). Consistent with these results, our analysis based on the application of the recent wavelet technique MODWT tends to indicate that the Singapore Islamic index is leading the other Islamic indices and the commodities. From the point of view of portfolio diversification benefits based on the extent of dynamic correlations between variables, our results tend to suggest that an investor should be aware that the Philippine Islamic stock index is less correlated with the crude oil in the short run (as evidenced in the continuous wavelet transform analysis) and that an investor holding the crude oil can gain by including the Malaysian Islamic stock index in his/her portfolio (as evidenced in the Dynamic conditional correlations analysis).
    Keywords: Commodity, Islamic Stock Index Returns (ISIR), MODWT, CWT, DCC-MGARCH, Diversification, Causality
    JEL: C58 Q43
    Date: 2014–06–28
  8. By: Popov, Maxim (Nexus Energie GmbH); Madlener, Reinhard (E.ON Energy Research Center, Future Energy Consumer Needs and Behavior (FCN))
    Abstract: The aim of our research is to test and evaluate the technical indicators and oscillators, which are commonly used on other stocks and commodity markets (e.g. moving averages, stochastic oscillator, etc.) in terms of their efficiency at the present European natural gas virtual trading points (VTPs). The decisive factors are the achievable cost savings in purchases. The scope of our work includes the testing of trading systems on historical prices of European natural gas VTPs. These trading systems will be compared with each other and evaluated in terms of their efficiency and long-term stability. The results show that in more than half of the cases, the average buying price of natural gas is lower than the median price; hence the use of technical-indicator-based trading systems in natural gas procurement portfolio management would be beneficial.
    Keywords: Portfolio management; Virtual trading point; Title transfer facility; Backtesting; Natural gas
    JEL: C63 D22 F14 G11 Q37
    Date: 2014–05
  9. By: Ronald W.Anderson; Karin Jõeveer
    Abstract: In this paper we study how the use of collateral is evolving under the influence of regulatory reform and changing market structure. We start with a critical review of the recent empirical literature on the supply and demand of collateral which has focussed on the issue of ‘collateral scarcity’. We argue that while limited data availability does not allow a comprehensive view of the market for collateral, it is unlikely that there is an overall shortage of collateral. However, it is quite possible that there may be bottlenecks within the system which mean that available collateral is immobilized in one part of the system and unattainable by credit-worthy borrowers. We then describe how these problems sometimes can be overcome by improved information systems and collateral transformation. We discuss how collateral management techniques differ between banks and derivatives markets infrastructures including, in particular, CCPs. In order to assess the impact of alternative institutional arrangements on collateral demand, we introduce a theoretical model of an OTC derivatives market consisting of investors and banks arrayed in several regions or market segments. We simulate this model under alternative forms meant to capture the implications of moving to mandatory CCP clearing and mandatory initial margin requirements for non-cleared OTC derivatives.
    Date: 2014
  10. By: Karolin Kirschenmann (Aalto University School of Business, Helsinki, Finland); Tuomas Malinen (Helsinki Center of Economic Research, University of Helsinki, Finland); Henri Nyberg (Helsinki Center of Economic Research, University of Helsinki, Finland)
    Abstract: Are macroeconomic factors such as income inequality the real root causes of financial crises? We explore a variety of financial and macroeconomic variables to find the most reliable predictors for financial crises in 14 developed countries over a period of more than 100 years. Our results, based on a general-to-specific model selection process, indicate that the power to predict financial crises is distributed among several predictors, including income inequality and growth of bank credit. This is in line with the argument that the best predictive factors tend to vary in time.
    Keywords: bank loans, income inequality, fixed effects logit.
    JEL: C33 C53 E44 G01
    Date: 2014–06

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