nep-rmg New Economics Papers
on Risk Management
Issue of 2014‒08‒25
thirteen papers chosen by
Stan Miles
Thompson Rivers University

  1. Critical Evaluation of Basel III as Prudential Regulation and its Consequences in Developing Countries’ Credit Needs By Dawa Sherpa
  2. Stochastic Intensity Models of Wrong Way Risk: Wrong Way CVA Need Not Exceed Independent CVA By Ghamami, Samim; Goldberg, Lisa R.
  3. Quantile Hedging in a Semi-Static Market with Model Uncertainty By Erhan Bayraktar; Gu Wang
  4. Diversification and Endogenous Financial Networks By Jean-Cyprien H\'eam; Erwan Koch
  5. Risk-sharing versus risk-transfer in finance: A critique By Hasan, Zubair
  6. Sector-Based Factor Models for Asset Returns By Angela Gu; Patrick Zeng
  7. Age effects in mortality risk valuation By Pinto Prades, Jose Luis; Brey Sanchez, Raul
  8. Who Bears Firm-Level Risk? Implications for Cash Flow Volatility By Xiaolan Zhang
  9. Weather Data Grids for Agriculture Risk Management : The Case of Honduras and Guatemala By World Bank
  10. Interest Rate Swaps and Corporate Default By Urban J. Jermann; Vivian Z. Yue
  11. A Tale of Two Option Markets: Pricing Kernels and Volatility Risk By Song, Zhaogang; Xiu, Dacheng
  12. Exponential Smoothing, Long Memory and Volatility Prediction By Tommaso Proietti
  13. Pension Risk and Risk Based Supervision in Defined Contribution Pension Funds By Tony Randle; Heinz P. Rudolph

  1. By: Dawa Sherpa (Centre for Economic Studies, Jawaharlal Nehru University, New Delhi, India)
    Abstract: This paper seeks to critically evaluate the nature and motivation for the regulatory frame sought in the Basel III norms and its consequences on the credit needs of developing countries. After the failure of previous two Basel accords (I and II), to act as the effective prudential regulation of large financial institutions operating on global scale, the new Basel III accord is hailed as the new regulatory rule which has successfully taken into consideration of all the lacunas of earlier accord. But structurally all Basel accords are market mediated regulation, which tries to contain systemic crisis of financial institution by imposing better liquidity and capital requirements on financial institutions. It was unable to deal with strong elements of regulatory capture, which virtually makes it ineffective. All Basel accords at best tries to stop bank insolvency issues during crisis period but it does not prevent the crisis from occurring altogether (like Glass Steagall act, at 1933 in US). Not only it is micro prudential in nature, it also ignores endogenous evolution of risk of underlying assets of financial institutions. Also non-binding character and ‘one size fit for all’ approach of the recommendation makes it very hard to implement. And for developing nations new Basel III has the potential to make flow of credit more volatile and pro-cyclical and additionally it raises the cost of financing and reduces the level of credit available for developmental purposes. It is unable to deal with the issue of regulatory arbitrage and consequent rise of shadow banking activities in developing countries which are raising serious concern of systemic risk in financial system of these countries.
    Keywords: Basel III, Macro Prudential Regulation, Shadow Banking, Structural Regulation
    JEL: G1 G2
    Date: 2013
  2. By: Ghamami, Samim (Board of Governors of the Federal Reserve System (U.S.)); Goldberg, Lisa R. (University of California, Berkely)
    Abstract: Wrong way risk can be incorporated in Credit Value Adjustment (CVA) calculations in a reduced form model. Hull and White [2012] introduced a CVA model that captures wrong way risk by expressing the stochastic intensity of a counterparty's default time in terms of the financial institution's credit exposure to the counterparty. We consider a class of reduced form CVA models that includes the formulation of Hull and White and show that wrong way CVA need not exceed independent CVA. This result is based on some general properties of the model calibration scheme and a formula that we derive for intensity models of dependent CVA (wrong or right way). We support our result with a stylized analytical example as well as more realistic numerical examples based on the Hull and White model. We conclude with a discussion of the implications of our findings for Basel III CVA capital charges, which are predicated on the assumption that wrong way risk increases CVA.
    Keywords: Credit value adjustment; stochastic intensity modeling; wrong way and right way risk; Basel III; counterparty credit risk
    Date: 2014–07–30
  3. By: Erhan Bayraktar; Gu Wang
    Abstract: With model uncertainty characterized by a convex, possibly non-dominated set of probability measures, the investor minimizes the cost of hedging a path dependent contingent claim with a given expected success ratio, in a discrete-time, semi-static market of stocks and options. We prove duality results that link the problem of quantile hedging to a randomized composite hypothesis test. Then by assuming a compact path space, an arbitrage-free discretization of the market is proposed as an approximation. The discretized market has a dominating measure, which enables us to calculate the quantile hedging price and the associated hedging strategy by using the generalized Neyman-Pearson Lemma. Finally, the performance of the approximate hedging strategy in the original market and the convergence of the quantile hedging price are analyzed.
    Date: 2014–08
  4. By: Jean-Cyprien H\'eam; Erwan Koch
    Abstract: We propose to test the assumption that interconnections across financial institutions can be explained by a diversification motive. This idea stems from the empirical evidence of the existence of long-term exposures that cannot be explained by a liquidity motive (maturity or currency mismatch). We model endogenous interconnections of heterogenous financial institutions facing regulatory constraints using a maximization of their expected utility. Both theoretical and simulation-based results are compared to a stylized genuine financial network. The diversification motive appears to plausibly explain interconnections among key players. Using our model, the impact of regulation on interconnections between major banks -currently discussed at the Basel Committee on Banking Supervision- is analyzed.
    Date: 2014–08
  5. By: Hasan, Zubair
    Abstract: Some recent writings on Islamic finance have resuscitated the old ‘no risk, no gain’ precept from the earlier literature in the wake of current financial crisis. They argue that the basic reason for the recurrence of such crises is the conventional interest-based financial system that rests purely on transfer of risks. In contrast, Islam shuns interest and promotes sharing of risks, not their transfer. The distinction is used to make a case for replacing the conventional system with the Islamic; for that alone is the way to ensuring the establishment of a just and stable crisis free economic system. Islamic banks have faced the current crisis better than the conventional is cited as evidence. This paper is a critique of this line of argument and concludes that the case is for reform not for replacement of the current system marked with increasing duality.
    Keywords: Financial crisis; Risk-Sharing; Risk-Transfer; Islamic system; KL Declaration
    JEL: E6 G2 G28
    Date: 2014–08–18
  6. By: Angela Gu; Patrick Zeng
    Abstract: Factor analysis is a statistical technique employed to evaluate how observed variables correlate through common factors and unique variables. While it is often used to analyze price movement in the unstable stock market, it does not always yield easily interpretable results. In this study, we develop improved factor models by explicitly incorporating sector information on our studied stocks. We add eleven sectors of stocks as defined by the IBES, represented by respective sector-specific factors, to non-specific market factors to revise the factor model. We then develop an expectation maximization (EM) algorithm to compute our revised model with 15 years' worth of S&P 500 stocks' daily close prices. Our results in most sectors show that nearly all of these factor components have the same sign, consistent with the intuitive idea that stocks in the same sector tend to rise and fall in coordination over time. Results obtained by the classic factor model, in contrast, had a homogeneous blend of positive and negative components. We conclude that results produced by our sector-based factor model are more interpretable than those produced by the classic non-sector-based model for at least some stock sectors.
    Date: 2014–08
  7. By: Pinto Prades, Jose Luis (Glasgow Caledonian University, Glasgow, Scotland); Brey Sanchez, Raul (University Pablo de Olavide, Sevilla, Spain)
    Abstract: We provided more evidence on the functional relationship between willingness to pay for risk reductions and age (the senior discount). We overcome many of the limitations of previous literature that has dealt with this problem, namely, the influence of the assumptions used in statistical models on the final results. Given our large sample size (n=6024) we can use models that are very demanding on sample size. We show that all models predict the same inverse U-shaped relationship between WTO for risk reductions and age. We use several models, parametric (linear, cuadratic, dummies), semi-nonparametric and non-parametric. Results are consistent under all the different models. We also compare the marginal and the total approach and we show that they provide similar results. However, we also overcome one of the limitations of the total approach, that is, it includes the effects of all socioeconomic characteristics that are correlated with age. Given our sample size, we compare age groups that are similar in education and income. We observe that the seniority effect is only present for low income people.
    Keywords: 2014-04
    Date: 2014–04
  8. By: Xiaolan Zhang (UCLA, Anderson School of Management)
    Abstract: Public firms in the United States that provide better insurance against productivity shocks to their workers experience higher cash flow volatility. Difference in intra-firm risk sharing between workers and capital owners accounts for more than 50\% of the variation in firm-level cash flow volatility. I develop a theory in which wages can act either as a hedge or as leverage, depending on the history of the productivity shocks the firm has faced. Heterogeneous roles of workers in the firm are derived by analyzing the dynamic equilibrium wage contracts between risk-neutral owners and risk-averse workers who can leave with a fraction of the accumulated human capital. Owners of the firm will optimally bear more risk when the current value of the firm's human capital is lower than the peak value it has reached. The model successfully explains the joint distribution of cash flow volatility and the wage-output sensitivity. Also, the model produces predictions for the dynamics of cash flow volatility that are consistent with the time series properties of the firm-level data.
    Date: 2014
  9. By: World Bank
    Keywords: Environment - Climate Change Mitigation and Green House Gases Science and Technology Development - Science of Climate Change Geographical Information Systems Environment - Global Environment Facility Environment - Climate Change Impacts
    Date: 2013–01
  10. By: Urban J. Jermann; Vivian Z. Yue
    Abstract: This paper studies firms' usage of interest rate swaps to manage risk in a model economy driven by aggregate productivity shocks, inflation shocks, and counter-cyclical idiosyncratic productivity risk. Consistent with empirical evidence, firms in the model are fixed-rate payers, and swap positions are negatively correlated with the term spread. In the model, swaps affect firms' investment decisions and debt pricing very moderately, and the availability of swaps generates only small economic gains for the typical firm.
    Date: 2014–08
  11. By: Song, Zhaogang (Board of Governors of the Federal Reserve System (U.S.)); Xiu, Dacheng (University of Chicago)
    Abstract: Using prices of both S&P 500 options and recently introduced VIX options, we study asset pricing implications of volatility risk. While pointing out the joint pricing kernel is not identified nonparametrically, we propose model-free estimates of marginal pricing kernels of the market return and volatility conditional on the VIX. We find that the pricing kernel of market return exhibits a decreasing pattern given either a high or low VIX level, whereas the unconditional estimates present a U-shape. Hence, stochastic volatility is the key state variable responsible for the U-shape puzzle documented in the literature. Finally, our estimates of the volatility pricing kernel feature a U-shape, implying that investors have high marginal utility in both high and low volatility states.
    Keywords: Pricing kernel; volatility risk; VIX option; state-price density
    JEL: G12 G13
    Date: 2014–01–30
  12. By: Tommaso Proietti (DEF and CEIS, Università di Roma "Tor Vergata")
    Abstract: Extracting and forecasting the volatility of financial markets is an important empirical problem. Time series of realized volatility or other volatility proxies, such as squared returns, display long range dependence. Exponential smoothing (ES) is a very popular and successful forecasting and signal extraction scheme, but it can be suboptimal for long memory time series. This paper discusses possible long memory extensions of ES and finally implements a generalization based on a fractional equal root integrated moving average (FerIMA) model, proposed originally by Hosking in his seminal 1981 article on fractional differencing. We provide a decomposition of the process into the sum of fractional noise processes with decreasing orders of integration, encompassing simple and double exponential smoothing, and introduce a lowpass real time filter arising in the long memory case. Signal extraction and prediction depend on two parameters: the memory (fractional integration) parameter and a mean reversion parameter. They can be estimated by pseudo maximum likelihood in the frequency domain. We then address the prediction of volatility by a FerIMA model and carry out a recursive forecasting experiment, which proves that the proposed generalized exponential smoothing predictor improves significantly upon commonly used methods for forecasting realized volatility.
    Keywords: Realized Volatility. Signal Extraction. Permanent-Transitory Decomposition. Fractional equal-root IMA model
    JEL: C22 C53 G17
    Date: 2014–07–30
  13. By: Tony Randle; Heinz P. Rudolph
    Keywords: Finance and Financial Sector Development - Financial Literacy Finance and Financial Sector Development - Debt Markets Pensions and Retirement Systems Finance and Financial Sector Development - Mutual Funds Private Sector Development - Emerging Markets Social Protections and Labor
    Date: 2014–03

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