nep-rmg New Economics Papers
on Risk Management
Issue of 2014‒10‒22
nineteen papers chosen by

  1. Stress-testing banks’ corporate credit portfolio By O. de Bandt; N. Dumontaux; V. Martin; D. Médée
  2. Dependence and extreme dependence of crude oil and natural gas prices with applications to risk management By Riadh Aloui; Mohamed Safouane Ben Aïssa; Shawkat Hammoudeh; Duc Khuong Nguyen
  3. Currency hedge – walking on the edge? By Fabio Filipozzi; Kersti Harkmann
  4. A General Duality Relation with Applications in Quantitative Risk Management By Raphael Hauser; Sergey Shahverdyan; Paul Embrechts
  5. Forward looking banking stress in EMU countries By Manish K. Singh; Marta Gómez-Puig; Simón Sosvilla-Rivero
  6. The Real Effects of Bank Capital Requirements By M. Brun; H. Fraisse; D. Thesmar
  7. Evaluating the performance of VaR models in energy markets By Sasa Zikovic; Rafal Weron; Ivana Tomas Zikovic
  8. Credit Booms and Busts in Emerging Markets: The Role of Bank Governance and Risk Managment By Andries, Alin Marius; Brown, Martin
  9. Network Formation and Systemic Risk By Selman Erol; Rakesh Vohra
  10. Mean of Ratios or Ratio of Means: statistical uncertainty applied to estimate Multiperiod Probability of Defaul By Matteo Formenti
  11. Capital Structure, Product Market Competition and Default Risk By Magali Pedro Costa; Cesaltina Pires
  12. Support mechanisms for renewables: How risk exposure influences investment incentives By Lena Kitzing; Christoph Weber
  13. Date stamping historical oil price bubbles: 1876 - 2014 By Itamar Caspi; Nico Katzke; Rangan Gupta
  15. Propagation of Systemic Risk in Interbank Networks By Vanessa Hoffmann de Quadros; Juan Carlos Gonz\'alez-Avella; Jos\'e Roberto Iglesias
  16. Volatility as a new class of assets? The advantages of using volatility index futures in investment strategies By Juliusz Jabłecki; Ryszard Kokoszczyński; Paweł Sakowski; Robert Ślepaczuk; Piotr Wójcik
  17. Discrete choice estimation of risk aversion By Jose Apesteguia; Miguel A. Ballester
  18. The risks associated with cloud computing. By Andries M.; Cassin G.; Bahhaouy A.; Philippe F.; Foratier Y.; Lopez Vernaza A.; Rigodanzo F.
  19. Entropy and Optimization of Portfolios By Krzysztof Urbanowicz

  1. By: O. de Bandt; N. Dumontaux; V. Martin; D. Médée
    Abstract: The paper describes the methods used by the French Banking Supervision Authority (ACP) to run stress tests for the corporate credit portfolio, through credit migration matrices (or transition matrices). This approach is currently used for “top-down” stress tests exercises. Developed for Basel II, it is still relevant under the Basel III framework. It includes sufficient flexibility to accommodate the severe crisis period observed recently. The paper introduces the basic model underlying the approach, largely based on Merton’s model; it then describes carefully the different steps for its practical implementation, providing hints on how it can be extended to other banking sectors. Finally the paper comments a few outputs of a stress testing exercise.
    Keywords: credit risk, corporate, stress tests, migration matrices.
    JEL: G21 G28 G32 E44
    Date: 2013
  2. By: Riadh Aloui; Mohamed Safouane Ben Aïssa; Shawkat Hammoudeh; Duc Khuong Nguyen
    Abstract: In this article, we show how the copula-GARCH approach can be appro- priately used to investigate the conditional dependence structure between the crude oil and natural gas markets as well as to derive implications for port- folio risk management in extreme economic conditions. Using daily price data from January 1997 to October 2011, our in-sample results show evi- dence of asymmetric dependence between the two markets. The crude oil and gas markets tend to co-move closely together during bullish periods, but not at all during bearish periods. Moreover, taking the extreme comovement into account leads to an improvement in the accuracy of the out-of-sample Value-at-Risk forecasts.
    Keywords: Copulas, extreme dependence measures, crude oil, natural gas, VaR.
    JEL: C51 C58 Q41 Q47
    Date: 2014–09–25
  3. By: Fabio Filipozzi; Kersti Harkmann
    Abstract: We study whether it is possible to find optimal hedge ratios for a foreign currency bond portfolio to lower significantly the risk and increase the risk adjusted return of a portfolio. The analysis is conducted from the perspective of euro area based investors to whom short-selling restrictions might apply. The ordinary least squares approach is challenged with the optimal hedge ratios found by the DCC-GARCH approach in order to investigate whether time-varying hedging is superior to the standard constant hedge ratios found by OLS. We find that hedging significantly lowers the portfolio risk in domestic currency terms and improves the Sharpe ratios for both single instrument and equally weighted multi asset portfolios. Optimal hedging using the standard OLS approach and using time-varying hedging give similar results, the latter being superior to the first in terms of risk-adjusted return.
    Keywords: optimal hedge ratios, portfolio risk hedging
    JEL: C32 C58 G11 G15 G23 G32
    Date: 2014–10–10
  4. By: Raphael Hauser; Sergey Shahverdyan; Paul Embrechts
    Abstract: A fundamental problem in risk management is the robust aggregation of different sources of risk in a situation where little or no data are available to infer information about their dependencies. A popular approach to solving this problem is to formulate an optimization problem under which one maximizes a risk measure over all multivariate distributions that are consistent with the available data. In several special cases of such models, there exist dual problems that are easier to solve or approximate, yielding robust bounds on the aggregated risk. In this chapter we formulate a general optimization problem, which can be seen as a doubly infinite linear programming problem, and we show that the associated dual generalizes several well known special cases and extends to new risk management models we propose.
    Date: 2014–10
  5. By: Manish K. Singh (Department of Economic Theory, Universitat de Barcelona); Marta Gómez-Puig (Department of Economic Theory, Universitat de Barcelona); Simón Sosvilla-Rivero (Department of Quantitative Economics, Universidad Complutense de Madrid)
    Abstract: Based on contingent claims analysis(CCA), this paper tries to estimate the systemic risk build-up in the European Economic and Monetary Union (EMU) countries using a market based measure "distance-to-default"(DtD). It analyzes the individual and aggregated series for a comprehensive set of banks in each eurozone country over the period 2004-Q4 to 2013-Q2. Given the structural differences in financial sector and banking regulations at national level, the indices provide a useful indicator for monitoring country specific banking vulnerability and stress. We find that average DtD indicators are intuitive, forward-looking and timely risk indicators. The underlying trend, fluctuations and correlations among indices help us analyze the interdependence while cross-sectional differences in DtD prior to crisis suggest banking sector fragility in peripheral EMU countries.
    Keywords: contingent claim analysis, distance-to-default, systemic risk
    JEL: G01 G21 G28
    Date: 2014–10
  6. By: M. Brun; H. Fraisse; D. Thesmar
    Abstract: We measure the impact of bank capital requirements on corporate borrowing and business activity. We use loan-level data and take advantage of the transition from Basel 1 to Basel 2. While under Basel 1 the capital charge was the same for all firms, under Basel 2, it depends in a predictable way on both the bank's model and the firm's risk. We exploit this two-way variation to empirically estimate the semi-elasticity of bank lending to capital requirement. This rich identification allows us to control for firm-level credit demand shocks and bank-level credit supply shocks. We find very large effects of capital requirements on bank lending: a one percentage point increase in capital requirements leads to a reduction in lending by approximately 10%. At the firm level, borrowing is reduced, as well as total assets (mostly working capital); we provide some evidence of the impact on employment and investment. Overall, however, because Basel 2 reduced the capital requirements for the average firm, our results suggest that the transition to Basel 2 supported firm activity during the crisis period.
    Keywords: Bank capital ratios, Bank regulation, Credit supply.
    JEL: E51 G21 G28
    Date: 2013
  7. By: Sasa Zikovic; Rafal Weron; Ivana Tomas Zikovic
    Abstract: In this paper we analyze the relative performance of 13 VaR models using daily returns of WTI, Brent, natural gas and heating oil one-month futures contracts. After obtaining VaR estimates we evaluate the statistical significance of the differences in performance of the analyzed VaR models. We employ the simulation-based methodology proposed by Zikovic and Filer (2013), which allows us to rank competing VaR models. Somewhat surprisingly, the obtained results indicate that for a large number of different VaR models there is no statistical difference in their performance, as measured by the Lopez size adjusted score. However, filtered historical simulation (FHS) and the semiparametric BRW model stand out as robust and consistent approaches that – in most cases – significantly outperform the remaining VaR models.
    Keywords: Energy markets; Risk management; Value at Risk; Multicriteria classification
    JEL: C14 C22 C52 C53 G24
    Date: 2014–10–03
  8. By: Andries, Alin Marius; Brown, Martin
    Abstract: This paper investigates to what extent risk management and corporate governance mitigate the involvement of banks in credit boom and bust cycles. Using a unique, handcollected dataset on 156 banks from Central and Eastern Europe during 2005-2012, we assess whether banks with stronger risk management and corporate governance display more moderate credit growth in the pre-crisis credit boom as well as a smaller credit contraction and fewer credit losses in the crisis period. With respect to bank governance we document that a higher share of financial experts on the supervisory board is associated with more rapid credit growth in the pre-crisis period and a larger contraction of credit in the crisis period, but not with larger credit losses. With respect to risk management we document that a strong risk committee is associated with more moderate pre-crisis credit growth but not with fewer credit losses in the crisis. We find no evidence of an organizational learning process among crisishit banks: those banks with the largest credit losses during the crisis are least likely to improve their risk management in the aftermath of the crisis
    Keywords: Credit boom and busts, corporate governance, risk management
    JEL: G21 G32 P34
  9. By: Selman Erol (Department of Economics, University of Pennsylvania); Rakesh Vohra (Department of Economics and Department of Electrical & Systems Engineering, University of Pennsylvania)
    Abstract: This paper introduces a model of endogenous network formation and systemic risk. In it, agents form networks that efficiently trade-off the possibility of systemic risk with the benefits of trade. Second, fundamentally ‘safer’ economies generate higher interconnectedness, which in turn leads to higher systemic risk. Third, the structure of the network formed depends on whether the shocks to the system are believed to be correlated or independent of each other. In particular, when shocks are perfectly correlated, the network formed is a complete graph, i.e., a link between every pair of agents. This underlines the importance of specifying the shock structure before investigating a given network because a given network and shock structure could be incompatible.
    Keywords: Network Formation, Systemic Risk, Contagion, Rationalizability, Core
    JEL: D85 G01
    Date: 2014–08–24
  10. By: Matteo Formenti
    Abstract: The estimate of a Multiperiod probability of default applied to residential mortgages can be obtained using the mean of the observed default, so called the Mean of ratios estimator, or aggregating the default and the issued mortgages and computing the ratio of their sum, that is the Ratio of means. This work studies the statistical properties of the two estimators with the result that the Ratio of means has a lower statistical uncertainty. The application on a private residential mortgage portfolio leads to a lower probability of default on the overall portfolio by eleven basis points.
    Date: 2014–09
  11. By: Magali Pedro Costa (CEFAGE-UE and ESTG, Instituto Politécnico de Leiria, Portugal); Cesaltina Pires (CEFAGE-UE and Departamento de Gestão, Universidade de Évora, Portugal)
    Abstract: The aim of this paper is to analyze the equilibrium default risk in a two-stage duopoly model, where firms decide their financial structure in the first stage of the game and take their output market decisions in the second stage of the game. Using the framework of Brander and Lewis (1986) we analyze the impact of changing the parameters of the model (level of demand uncertainty, parameters that affect both firms and firm specific parameters) on the equilibrium default probabilities. This analysis is done both for the Nash equilibrium in the second stage of the game (for fixed debt levels) as well as for the subgame perfect equilibrium. Our results show that both direct and indirect effects (through changes in the equilibrium capital structure and product market decisions) need to be considered and that, in some cases, the total impact of parameters changes on the default risk may be counterintuitive.
    Keywords: Capital structure; Product market competition; Default risk.
    JEL: D43 G32 L13
    Date: 2014
  12. By: Lena Kitzing; Christoph Weber (Chair for Management Sciences and Energy Economics, University of Duisburg-Essen)
    Abstract: We analyse quantitatively how risk exposure from different support mechanisms, such as feed-in tariffs and premiums, can influence the investment incentives for private investors. We develop a net cash flow approach that takes systematic and unsystematic risks into account through cost of capital and the Capital Asset Pricing Model as well as through active liquidity management. Applying the model to a specific case, a German offshore wind park, we find that the support levels required to give adequate investment incentives are for a feed-in tariff scheme approximately 5-7% lower than for a feed-in premium scheme. The effect of differences in risk exposure from the support schemes is significant and cannot be neglected in policy making, especially when deciding between support instruments or when determining adequate support levels.
    Keywords: investment risk, support policies, unsystematic risk, liquidity management, offshore wind, feed-in tariffs
    Date: 2014–08
  13. By: Itamar Caspi; Nico Katzke; Rangan Gupta
    Abstract: This paper sets out to date-stamp periods of historic oil price explosivity (or bubbles) us- ing the Generalized sup ADF (GSADF) test procedure suggested by Phillips et al. (2013). The date-stamping strategy used in this paper is effective at identifying periodically col- lapsing bubbles; a feature found lacking with previous bubble detecting methods. We set out to identify bubbles in the real price and the nominal price-supply ratio of oil for the period 1876 - 2014. The recursive identification algorithms used in this study identifies several periods of significant explosivity, and as such provides future researchers with a reference for studying the macroeconomic impact of historical periods of significant oil price build-ups.
    Keywords: Oil-prices; Date-Stamping Strategy; Periodically Collapsing Bubbles; Explosivity; Flexible Window; GSADF Test; Commodity Price Bubbles.
    JEL: C15 C22
    Date: 2014–09–25
  14. By: Dumitru-Catalin BURSUC (National Defense University “Carol I”); Cristian TEODORESCU (National Defense University “Carol I”)
    Abstract: In the processuality of military actions hazard and uncertainty represent major factors in carrying out missions. The array of risks that accompany military actions are complex and characterized by a very high degree of danger, in comparison with other organizations. The decision of the commander or the courses of action elaborated by the staff must be based on the instruments offered by the risk management in order to ensure the avoidance of risk, in order to increase the rate of mission success, in order to shift the centre of gravity of actions from managing undesired consequences to preventing them. The attainment of objectives regardless of costs and efficiency raised to the level of current practice no longer constitute a model to be followed. Risk management provides decision support elements based on the identification, evaluation and management of risks, threats and vulnerabilities from the perspectives of the effects assumed in order to balance consumption, efforts and losses with the objectives of the mission.Thus, efficiency replaces effectiveness and the assuming of risks for the entire process is done while taking into consideration the consequences identified and assumed
    Date: 2013–11
  15. By: Vanessa Hoffmann de Quadros; Juan Carlos Gonz\'alez-Avella; Jos\'e Roberto Iglesias
    Abstract: This work explores the characteristics of financial contagion in networks whose links distributions approaches a power law, using a model that defines banks balance sheets from information of network connectivity. By varying the parameters for the creation of the network, several interbank networks are built, in which the concentrations of debts and credits are obtained from links distributions during the creation networks process. Three main types of interbank network are analyzed for their resilience to contagion: i) concentration of debts is greater than concentration of credits, ii) concentration of credits is greater than concentration of debts and iii) concentrations of debts and credits are similar. We also tested the effect of a variation in connectivity in conjunction with variation in concentration of links. The results suggest that more connected networks with high concentration of credits (featuring nodes that are large creditors of the system) present greater resilience to contagion when compared with the others networks analyzed. Evaluating some topological indices of systemic risk suggested by the literature we have verified the ability of these indices to explain the impact on the system caused by the failure of a node. There is a clear positive correlation between the topological indices and the magnitude of losses in the case of networks with high concentration of debts. This correlation is smaller for more resilient networks.
    Date: 2014–10
  16. By: Juliusz Jabłecki (Faculty of Economic Sciences, University of Warsaw; National Bank of Poland); Ryszard Kokoszczyński (Faculty of Economic Sciences, University of Warsaw; National Bank of Poland); Paweł Sakowski (Faculty of Economic Sciences, University of Warsaw); Robert Ślepaczuk (Faculty of Economic Sciences, University of Warsaw; Union Investment TFI S.A.); Piotr Wójcik (Faculty of Economic Sciences, University of Warsaw)
    Abstract: This paper investigates the changes in the investment portfolio performance after including VIX. We apply different models for optimal portfolio selection (Markowitz and Black-Litterman) assuming both the possibility of short sale and the lack of it. We also use various assets, data frequencies, and investment horizons to get a comprehensive picture of our results’ robustness. Investment strategies including VIX futures do not always deliver higher returns or higher Sharpe ratios for the period 2006-2013. Their performance is quite sensitive to changes in model parameters. However, including VIX significantly increases the returns in almost all cases during the recent financial crisis. This result clearly emphasizes potential gains of having such an asset in the portfolio in case of very high volatility in financial markets.
    Keywords: volatility, VIX futures, investment strategies, optimal portfolio selection, Markowitz model, Black-Litterman model
    JEL: G11 G14 G17
    Date: 2014
  17. By: Jose Apesteguia; Miguel A. Ballester
    Abstract: We analyze the use of discrete choice models for the estimation of risk aversion and show a fundamental flaw in the standard random utility model which is commonly used in the literature. Specifically, we find that given two gambles, the probability of selecting the riskier gamble may be larger for larger levels of risk aversion. We characterize when this occurs. By contrast, we show that the alternative random preference approach is free of such problems.
    Keywords: Discrete Choice; Structural Estimation; Risk Aversion; Random Utility Models; Random Preference Models.
    JEL: C25 D81
    Date: 2014–09
  18. By: Andries M.; Cassin G.; Bahhaouy A.; Philippe F.; Foratier Y.; Lopez Vernaza A.; Rigodanzo F.
    Abstract: Information systems are of strategic importance in both the banking and insurance sectors. The development of cloud computing is a recent advance that has become a subject of attention. Cloud computing is defined as a "method of processing a client's data, which are exploited via the Internet in the form of services provided by a service provider. Cloud computing is a special form of information technology (IT) outsourcing, in which end users are not informed of the location or internal structure of the cloud." This topic is particularly current for a number of regulatory bodies. In France, the Agence Nationale de Sécurité des Systèmes d’Information (ANSSI – French Network and Information Security Agency) is working on regulation via a certification mechanism. In 2012 the Commission Nationale de l’Informatique et des Libertés (CNIL – French Data Protection Authority) issued recommendations for companies considering subscribing to cloud computing services. Abroad, many supervisory authorities have issued statements (the United States of America, Singapore, the Netherlands), or imposed a system of prior authorisation (Spain) for the use of this technology. In this context, the Secrétariat général de l’Autorité de contrôle prudentiel (SGACP – General Secretariat of the Prudential Supervisory Authority) conducted a short survey to engage in a dialogue with companies in the banking and insurance sectors on the scope, use and risks of cloud computing. A total of 14 companies from the insurance sector and 12 from the banking sector responded to a questionnaire at the beginning of this year, providing a representative view on these topics. The first idea that emerged from this dialogue was a need to clarify the concept of cloud computing by offering a multi-criteria definition, inspired by that given by the American National Institute of Standards and Technology (NIST). The SGACP therefore proposes to describe these services as follows: cloud computing consists in using remote servers to store and process data traditionally located on local servers or on the user's terminal; it enables on-demand and self-service network access to virtualised and pooled computing resources typically charged for on a pay-per-use model; three types of services are offered (IaaS – Infrastructure as a Service, PaaS – Platform as a Service, SaaS – Software as a Service), deployed according to four models (internal private cloud, external private cloud or community cloud, public cloud, hybrid cloud). The credit institutions and insurance undertakings (companies) responding to the questionnaire confirmed that cloud computing poses greater risks compared to conventional IT outsourcing. The numerous risks identified include data privacy, unavailability of data and data processing, loss of integrity (especially the risk of non-reversibility or lock-in) and finally the area of evidence and control. They agree on the need for a stronger legal environment, the need for certain technical security measures, the need to audit the service provider, the need for the provider to commit to continuity of service and, finally, the need to obtain a guarantee from the service provider on the reversibility of the service. However, opinions differ on the importance of the economic aspects surrounding cloud computing, with many companies claiming that security considerations should prevail in analysing its value. Moreover, it is noted that an overwhelming majority of companies use cloud computing in management areas considered outside the "core business", even if use in more sensitive areas is also beginning to emerge. It also appears that there are differences in the procedures for the adoption of cloud computing between the insurance and banking sectors. As a result of this initial analysis, which shall be refined as changes in the use and the risks of cloud computing are observed, the Autorité de contrôle prudentiel (ACP – Prudential Supervisory Authority) is encouraging the companies it supervises to take suitable risk management measures in respect of the following aspects: - Legal: by enforcing a mandatory contractual framework for cloud computing services; - Technical: by encrypting data during transport and storage (in the absence of anonymisation); - Supervision of the service provider: by ensuring audit capability and the right for the ACP to conduct audits; - Continuity of the service: by ensuring that the expectations of the client company can be formalised in service contracts; - Reversibility of the service: by defining the conditions of reversibility when subscribing to the service; - Integration and architecture of information systems: by adapting the organisation and governance of information systems to the use of cloud computing. These good practices form part of the broader framework defined for the supervision of outsourced services, including conventional outsourcing. The expectations of the ACP in terms of governance of decisions, risk analysis, contractual elements, monitoring and the internal control of cloud computing services are therefore similar to those currently in force in prudential supervision.
    Keywords: .
    Date: 2013
  19. By: Krzysztof Urbanowicz
    Abstract: We briefly review the approach to optimization of portfolios according to the theory of Markowitz and propose a further modification that can improve the outcome of the optimization process. The modification takes account of the entropic contribution from the time series used to compute the parameters in the Markowitz method.
    Date: 2014–08

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