
on Risk Management 
Issue of 2014‒11‒22
eighteen papers chosen by 
By:  Albert J. Menkveld (VU University Amsterdam, the Netherlands) 
Abstract:  Counterparty default risk might hamper trade and trigger a financial crisis. The introduction of a central clearing counterparty (CCP) benefits trading but pushes systemic risk into CCP default. Standard risk management strategies at CCPs currently overlook a risk associated with crowded trades. This paper identifies it, measures it, and proposes a margin methodology that accounts for it. The application to actual CCP data illustrates that this hidden risk can become large, in particular at times of high CCP risk. 
Keywords:  Financial economics 
JEL:  G00 
Date:  2014–06–02 
URL:  http://d.repec.org/n?u=RePEc:dgr:uvatin:20140065&r=rmg 
By:  Yang, Bill Huajian 
Abstract:  Systematic risk has been a focus for stress testing and risk capital assessment. Under the Vasicek asymptotic single risk factor model framework, entity default risk for a risk homogeneous portfolio divides into two parts: systematic and entity specific. While entity specific risk can be modelled by a probit or logistic model using a relatively short period of portfolio historical data, modeling of systematic risk is more challenging. In practice, most default risk models do not fully or dynamically capture systematic risk. In this paper, we propose an approach to modeling systematic and entity specific risks by parts and then aggregating together analytically. Systematic risk is quantified and modelled by a multifactor Vasicek model with a latent residual, a factor accounting for default contagion and feedback effects. The asymptotic maximum likelihood approach for parameter estimation for this model is equivalent to least squares linear regression. Conditional entity PDs for scenario tests and throughthecycle entity PD all have analytical solutions. For validation, we model the pointintime entity PD for a commercial portfolio, and stress the portfolio default risk by shocking the systematic risk factors. Rating migration and portfolio loss are assessed. 
Keywords:  pointintime PD, throughthecycle PD, Vasicek model, systematic risk, entity specific risk, stress testing, rating migration, scenario loss 
JEL:  B4 C1 C5 E6 G18 G3 
Date:  2014–03–18 
URL:  http://d.repec.org/n?u=RePEc:pra:mprapa:59025&r=rmg 
By:  Ojo, Marianne 
Abstract:  The Basel III Leverage Ratio, as originally agreed upon in December 2010, has recently undergone revisions and updates – both in relation to those proposed by the Basel Committee on Banking Supervision – as well as proposals introduced in the United States. Whilst recent proposals have been introduced by the Basel Committee to improve, particularly, the denominator component of the Leverage Ratio, new requirements have been introduced in the U.S to upgrade and increase these ratios, and it is those updates which relate to the Basel III Supplementary Leverage Ratio that have primarily generated a lot of interests. This is attributed not only to concerns that many subsidiaries of US Bank Holding Companies (BHCs) will find it cumbersome to meet such requirements, but also to potential or possible increases in regulatory capital arbitrage: a phenomenon which plagued the era of the original 1988 Basel Capital Accord and which also partially provided impetus for the introduction of Basel II. This paper is aimed at providing an analysis of the recent updates which have taken place in respect of the Basel III Leverage Ratio and the Basel III Supplementary Leverage Ratio – both in respect of recent amendments introduced by the Basel Committee and proposals introduced in the United States. As well as highlighting and addressing gaps which exist in the literature relating to liquidity risks, corporate governance and information asymmetries, by way of reference to predominant based dispersed ownership systems and structures, as well as concentrated ownership systems and structures, this paper will also consider the consequences – as well as the impact  which the U.S Leverage ratios could have on Basel III. There are ongoing debates in relation to revision by the Basel Committee, as well as the most recent U.S proposals to update Basel III Leverage ratios and whilst these revisions have been welcomed to a large extent, in view of the need to address Tier One capital requirements and exposure criteria, there is every likelihood,indication, as well as tendency that many global systemically important banks (GSIBS), and particularly their subsidiaries, will resort to capital arbitrage. What is likely to be the impact of the recent proposals in the U.S.? The recent U.S proposals are certainly very encouraging and should also serve as impetus for other jurisdictions to adopt a proactive approach – particularly where existing ratios or standards appear to be inadequate. This paper also adopts the approach of evaluating the causes and consequences of the most recent updates by the Basel Committee, as well as those revisions which have taken place in the U.S, by attempting to balance the merits of the respective legislative updates and proposals. The value of adopting leverage ratios as a supplementary regulatory tool will also be illustrated by way of reference to the impact of the recent legislative changes on risk taking activities, as well as the need to also supplement capital adequacy requirements with the Basel Leverage ratios and the Basel liquidity standards. 
Keywords:  credit risk; liquidity risks; global systemically important banks (GSIBs); leverage ratios; harmonization; accounting rules; capital arbitrage; disclosure; stress testing techniques; U.S Basel III Final Rule 
JEL:  D8 E3 G3 G32 K2 
Date:  2014–08 
URL:  http://d.repec.org/n?u=RePEc:pra:mprapa:59598&r=rmg 
By:  Yoshiharu Maeno; Kenji Nishiguchi; Satoshi Morinaga; Hirokazu Matsushima 
Abstract:  It had been believed in the conventional practice that the risk of a bank going bankrupt is lessened in a straightforward manner by transferring the risk of loan defaults. But the failure of American International Group in 2008 posed a more complex aspect of financial contagion. This study presents an extension of the asset network systemic risk model (ANWSER) to investigate whether credit default swaps mitigate or intensify the severity of financial contagion. A protection buyer bank transfers the risk of every possible debtor bank default to protection seller banks. The empirical distribution of the number of bank bankruptcies is obtained with the extended model. Systemic capital buffer ratio is calculated from the distribution. The ratio quantifies the effective loss absorbency capability of the entire financial system to force back financial contagion. The key finding is that the leverage ratio is a good estimate of a systemic capital buffer ratio as the backstop of a financial system. The risk transfer from small and medium banks to big banks in an interbank network does not mitigate the severity of financial contagion. 
Date:  2014–09 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1411.1356&r=rmg 
By:  C, Loran (UiS); Eckbo, Espen (Darthmouth College); Lu, ChingChih (National Chengchi University) 
Abstract:  We analyze whether executive compensation reflects firm default risk, measured by distance to default of Merton (1974). Using a large panel of firms, we explore several empirical frameworks. In least squares, fixed effects and quantile regression settings, default risk and volatility possess significant explanatory power for compensation. The signs of the estimated coefficients are consistent with higher compensation for higher riskbearingmanagers of firms with higher default risk are paid more. In the benchmark models, estimates for default risk are quite small, indicating effects on average compensation of around $9,000. The corresponding figure for the upper 5percentile of CEOs is $50,000. Volatility has much larger average effects, in excess of $25 million, with upper 5percent effects above $150 million. In a partial identification framework, compensation is systematically associated with default risk. Moving to a higher default risk firm raises compensation by at least $.96%, corresponding to around $70,000 for average CEOs, and above $400,000 for the top 5percentile. The largest effect applies for moving into the highest default risk firms. For such firms, the treatment effect exceeds $180,000 for average CEOs, and for the top 5percent, the effect is well above $1 million. Conditional means exhibit monotonicity, suggesting that compensation is amenable to a treatment response approach. Surprisingly, when we utilize an instrumental variables approach, an increase in default risk reduces total compensation. Thus our results uncover a complex but powerful link between firm risk and CEO compensation, which may make it difficult to regulate compensation by means such as `SayonPay'. 
Keywords:  Default; Executive Compensation; Treatment Response; Partial Identification; Volatility 
JEL:  A10 
Date:  2014–09–11 
URL:  http://d.repec.org/n?u=RePEc:hhs:stavef:2014_011&r=rmg 
By:  Omer, Gamal Salih; Masih, Mansur 
Abstract:  Volatility is a measure of variability in the price of an asset and is associated with unpredictability and uncertainty about the price. Even it is a synonym for risk; higher volatility means higher risk in the respective context. With regard to stock market, the extent of variation in stock prices is referred to stock market volatility. A spiky and rapid movement in the stock prices may throw out riskaverse investors from the market. Hence a desired level of volatility is demanded by the markets and its investors. The traditional methods of volatility and correlation analysis did not consider the effect of conditional (or timevarying) volatility and correlation. Hence a major issue facing the investors in the contemporary financial world is how to minimize risk while investing in a portfolio of assets. An understanding of how volatilities of and correlations between asset returns change over time including their directions (positive or negative) and size (stronger or weaker) is of crucial importance for both the domestic and international investors with a view to diversifying their portfolios for hedging against unforeseen risks as well as for dynamic option pricing. Therefore, appropriate modelling of volatility is of importance due to several reasons such as it becomes a key input to many investment decisions and portfolio creations, the pricing of derivative securities and financial risk management. Thus, in this paper, we aim to estimate and forecast conditional volatility of and correlations between daily returns of the seven selected Dow Jones Islamic and conventional price indexes spanning from 01/1/2003 to 31/3/2013. The sample period from January 30, 2003 to December, 13, 2010 amounting to 2053 daily observations are used for estimation and the remaining sample period is used for evaluation, through the application of the recentlydeveloped Dynamic Multivariate GARCH approach to investigate empirical questions of the timevarying volatility parameters of these selected Dow Jones stock indices and time varying correlation among them. The contribution of this work is an improvement on others‘ works particularly in terms of timevarying volatility and correlation of assets incorporating Islamic assets. We find that all volatility parameters are highly significant, with the estimates very close to unity implying a gradual 2 volatility decay. The tdistribution appears to be more appropriate in capturing the fattailed nature of the distribution of stock returns and the conditional correlations of returns of all Dow Jones Islamic Markets, Dow Jones Islamic UK, and Dow Jones Islamic US Indices with other indices are not found constant but changing. The policy implications of this finding are that the shariah investors should monitor these correlations and mange their investment portfolios accordingly. In addition to this, the different financial markets offer different opportunities for portfolio diversification. 
Keywords:  conditional volatility and correlations of Islamic assets, forecast, MGARCHDCC 
JEL:  C22 C58 G11 G15 
Date:  2014–08–26 
URL:  http://d.repec.org/n?u=RePEc:pra:mprapa:58862&r=rmg 
By:  Andr� Lucas (VU University Amsterdam); Xin Zhang (Sveriges Riksbank, Sweden) 
Abstract:  We present a simple new methodology to allow for time variation in volatilities using a recursive updating scheme similar to the familiar RiskMetrics approach. We update parameters using the score of the forecasting distribution rather than squared lagged observations. This allows the parameter dynamics to adapt automatically to any nonnormal data features and robustifies the subsequent volatility estimates. Our new approach nests several extensions to the exponentially weighted moving average (EWMA) scheme as proposed earlier. Our approach also easily handles extensions to dynamic higherorder moments or other choices of the preferred forecasting distribution. We apply our method to ValueatRisk forecasting with Student's t distributions and a time varying degrees of freedom parameter and show that the new method is competitive to or better than earlier methods for volatility forecasting of individual stock returns and exchange rates. 
Keywords:  dynamic volatilities, time varying higher order moments, integrated generalized autoregressive score models, Exponential Weighted Moving Average (EWMA), ValueatRisk (VaR) 
JEL:  C51 C52 C53 G15 
Date:  2014–07–22 
URL:  http://d.repec.org/n?u=RePEc:dgr:uvatin:20140092&r=rmg 
By:  David E. Allen (University of Sydney, and University of South Australia, Australia); Michael McAleer (National Tsing Hua University, Taiwan, Erasmus University Rotterdam, the Netherlands, and Complutense University of Madrid, Spain); Robert J. Powell (Edith Cowan University, Australia); Abhay K. Singh (Edith Cowan University, Australia) 
Abstract:  This paper features an analysis of the effectiveness of a range of portfolio diversification strategies as applied to a set of daily arithmetically compounded returns on a set of ten market indices representing the major European markets for a nine year period from the beginning of 2005 to the end of 2013. The sample period, which incorporates the periods of both the Global Financial Crisis (GFC) and subsequent European Debt Crisis (EDC), is challenging one for the application of portfolio investment strategies. The analysis is undertaken via the examination of multiple investment strategies and a variety of holdout periods and backtests. We commence by using four two year estimation periods and subsequent one year investment hold out period, to analyse a naive 1/N diversification strategy, and to contrast its effectiveness with Markowitz mean variance analysis with positive weights. Markowitz optimisation is then compared with various downside investment opimisation strategies. We begin by comparing Markowitz with CVaR, and then proceed to evaluate the relative effectiveness of Markowitz with various drawdown strategies, utilising a series of backtests. Our results suggest that none of the more sophisticated optimisation strategies appear to dominate naive diversification. 
Keywords:  Portfolio Diversification, Markowitz Analaysis, Downside Risk, CVaR, Drawdown 
JEL:  G11 C61 
Date:  2014–10–16 
URL:  http://d.repec.org/n?u=RePEc:dgr:uvatin:20140134&r=rmg 
By:  John Cotter (UCD School of Business, University College Dublin and Anderson School of Management, University of California); Enrique Salvador (Smurfit School of Business,University of California) 
Abstract:  This study develops a multifactor framework where not only market risk is considered but also potential changes in the investment opportunity set. Although previous studies find no clear evidence about a positive and significant relation between return and risk, favourable evidence can be obtained if a nonlinear relation is pursued. The positive and significant riskreturn tradeoff is essentially observed during low volatility periods. However, this relationship is not obtained during periods of high volatility. Also, different patterns for the risk premium dynamics in low and high volatility periods are obtained both in prices of risk and market risk dynamics. 
Keywords:  Nonlinear riskreturn tradeoff, Procyclical risk aversion, RegimeSwitching GARCH, multifactor model, Risk premium 
JEL:  G10 G12 G15 
Date:  2014–11–06 
URL:  http://d.repec.org/n?u=RePEc:ucd:wpaper:201414&r=rmg 
By:  Yuri A. Katz 
Abstract:  We present the qGaussian generalization of the Merton framework, which takes into account slow fluctuations of the volatility of the firms market value of financial assets. The minimal version of the model depends on the Tsallis entropic parameter q and the generalized distance to default. The empirical foundation and implications of the model are illustrated by the study of 645 North American industrial firms during the financial crisis, 2006  2012. All defaulters in the sample have exceptionally large, corresponding to unusually fattailed unconditional distributions of logassetreturns. Using Receiver Operating Characteristic curves, we demonstrate the high forecasting power of the model in prediction of 1year defaults. Our study suggests that the level of complexity of the realized time series, quantified by q, should be taken into account to improve valuations of default risk. 
Date:  2014–10 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1410.6841&r=rmg 
By:  Bell, Peter Newton 
Abstract:  This paper explores how a put option changes the probability distribution of portfolio value. The paper extends the model introduced in Bell (2014) by allowing both the quantity and strike price to vary. I use the 5% quantile from the portfolio distribution to measure riskiness and compare different put options. I report a socalled ‘quantile surface’ that shows the quantile across different combinations of quantity and strike price. I find that it is possible to maximize the quantile by purchasing a put with quantity equal to one and strike deep in the money; however, the distribution with such a put option collapses to a single point because the option hedges all variation in stock price. This result is analogous to fullinsurance in insurance economics, but has practical limitations. The quantile surface also shows that certain put options will decrease the quantile, which is equivalent to increasing the riskiness of the portfolio, and leads me to ask: what return will an investor receive in return for bearing that extra risk? I find that one such put option will cause the distribution to have an asymmetric shape with positive skewness, which is interesting to some speculators. 
Keywords:  Portfolio, put option, probability distribution, quantile, optimization, risk management, speculation 
JEL:  C00 C69 D81 G00 G11 
Date:  2014–09–09 
URL:  http://d.repec.org/n?u=RePEc:pra:mprapa:58428&r=rmg 
By:  Masako Ikefuji (University of Southern Denmark, Denmark); Roger Laeven (University of Amsterdam, the Netherlands); Jan Magnus (VU University Amsterdam, the Netherlands); Chris Muris (Simon Fraser University, Canada) 
Abstract:  An expected utility based costbenefit analysis is in general fragile to its distributional assumptions. We derive necessary and sufficient conditions on the utility function of the expected utility model to avoid this. The conditions ensure that expected (marginal) utility remains finite also under heavytailed distributional assumptions. Our results are contextfree and are relevant to many fields encountering catastrophic risk analysis, such as, perhaps most noticeably, insurance and risk management. 
Keywords:  Expected utility, Catastrophe, Costbenefit analysis, Risk management, Power utility, Exponential utility, Heavy tails 
JEL:  D61 D81 G10 G20 
Date:  2014–10–14 
URL:  http://d.repec.org/n?u=RePEc:dgr:uvatin:20140133&r=rmg 
By:  Francis, Bill B. (Lally School of Management, Rensselaer Polytechnic Institute); Hasan, Iftekhar (Fordham University and Bank of Finland); Li , Lingxiang (State University of New YorkOld Westbury) 
Abstract:  We study the impact of firms’ abnormal business operations on their future crash risk in stock prices. Computed based on real earnings management (REM) models, firms' deviation in real operations from industry norms (DRO) is shown to be positively associated with their future crash risk. This association is incremental to that between discretionary accruals (DA) and crash risk found by prior studies. Moreover, after SarbanesOxley Act (SOX) of 2002, DRO's predictive power for crash risk strengthens substantially, while DA's predictive power essentially dissipates. These results are consistent with the prior finding that managers shift from accrual earnings management (AEM) to REM after SOX. We further develop a suspectfirm approach to capture firms' use of DRO for REM purposes. This analysis shows that REMfirms experience a significant increase in crash risk in the following year. These findings suggest that the impact of DRO on crash risk is at least partially through REM. 
Keywords:  crash risk; deviation in real operations; earnings management; real earnings management; SarbanesOxley 
JEL:  D89 G19 M10 M41 
Date:  2014–07–09 
URL:  http://d.repec.org/n?u=RePEc:hhs:bofrdp:2014_019&r=rmg 
By:  Lubberink, Martien 
Abstract:  To calculate regulatory capital ratios, banks have to apply adjustments to book equity. These regulatory adjustments vary with a bank’s solvency position. Lowsolvency banks report values of Tier 1 capital that exceed book equity. They use regulatory adjustments to inflate regulatory solvency ratios such as the Tier 1 leverage ratio and the Tier 1 riskbased capital ratio. In contrast, highly solvent banks report Tier 1 capital that is lower than book equity. These banks adjust their solvency ratios downward for prudential reasons, despite their resilient solvency levels. These results weaken the case for regulatory adjustments. The decreasing relationship between regulatory adjustments and bank solvency reflects the cost of deleveraging, a cost that demonstrates the resistance of banks to substituting equity for debt. 
Keywords:  Keywords: Banking, Regulatory Capital, Solvency, Accounting. 
JEL:  G21 
Date:  2014–03–30 
URL:  http://d.repec.org/n?u=RePEc:pra:mprapa:55290&r=rmg 
By:  Swamy, Vighneswara 
Abstract:  This study models the impact of new capital regulations proposed under Basel III on bank profitability by constructing a stylized representative bank’s financial statements. We show that the higher cost associated with a onepercentage increase in the capital ratio can be recovered by increasing lending spreads. The results indicate that in the case of scheduled commercial banks, onepercentage point increase in capital ratio can be recovered by increasing the bank lending spread by 31 basis points and would go upto an extent of 100 basis points for sixpercentage point increase assuming that the risk weighted assets are unchanged. We also provide the estimations for the scenarios of changes in risk weighted assets, changes in return on equity (ROE) and the cost of debt. 
Keywords:  Banks, Regulation, Basel III, Capital, Interest Income 
JEL:  E44 E51 E61 G21 G28 
Date:  2014 
URL:  http://d.repec.org/n?u=RePEc:pra:mprapa:58323&r=rmg 
By:  Søren Johansen (University of Copenhagen and CREATES); Lukasz Gatarek (Econometric Institute and Tinbergen Institute) 
Abstract:  We derive the optimal hedging ratios for a portfolio of assets driven by a Cointegrated Vector Autoregressive model (CVAR) with general cointegration rank. Our hedge is optimal in the sense of minimum variance portfolio. We consider a model that allows for the hedges to be cointegrated with the hedged asset and among themselves. We find that the minimum variance hedge for assets driven by the CVAR, depends strongly on the portfolio holding period. The hedge is defined as a function of correlation and cointegration parameters. For short holding periods the correlation impact is predominant. For long horizons, the hedge ratio should overweight the cointegration parameters rather then shortrun correlation information. In the infinite horizon, the hedge ratios shall be equal to the cointegrating vector. The hedge ratios for any intermediate portfolio holding period should be based on the weighted average of correlation and cointegration parameters. The results are general and can be applied for any portfolio of assets that can be modeled by the CVAR of any rank and order. 
Keywords:  hedging, cointegration, minimum variance portfolio 
JEL:  C22 C58 G11 
Date:  2014–09–18 
URL:  http://d.repec.org/n?u=RePEc:aah:create:201440&r=rmg 
By:  Lubberink, Martien 
Abstract:  In the leadup to the implementation of Basel III, European banks bought back debt securities that traded at a discount. Banks engaged in these Liability Management Exercises (LMEs) to realize a fair value gain that the accounting and prudential rules exclude from regulatory capital calculations, this to safeguard the safety and soundness of the banking system. For a sample of 720 European LMEs conducted from April 2009 to December 2013, I show that banks lost about 9.3 billion euros in premiums to compensate investors for parting from their debt securities. This amount would have been recognized as Core Tier 1 regulatory capital, if regulation would accept the recognition of fair value gains on debt. The premiums paid are particularly high for the most loss absorbing capital securities. More importantly, the premiums increase with leverage and in times of stress, right when conserving cash is paramount to preserve the safety and soundness of the banking system. These results weaken the case of the exclusion from regulatory capital of unrealized gains that originate from a weakened own credit standing. 
Keywords:  Banking, repurchases, subordinated debt. 
JEL:  E58 G21 G28 G32 G35 M41 
Date:  2014–10–20 
URL:  http://d.repec.org/n?u=RePEc:pra:mprapa:59475&r=rmg 
By:  Naseri, Marjan; Masih, Mansur 
Abstract:  This paper attempts to analyse the extent of financial integration of two developed (the U.S. and Japan) and two emerging Islamic stock markets (China and India) with the Malaysian Islamic stock market in order for the Malaysian financial traders to make decision about their portfolio diversification, risk management and asset allocation. Despite the growing interest in Islamic finance, there are few empirical studies investigating integration of Islamic stock markets. As a result there is a certain gap in the literature pertaining to this area of research. By applying recent related techniques, this paper examines the correlations among these Islamic stock markets in a timevariant manner to indicate the degree of financial integration among them. It is found that Strong financial integration exists between the Chinese and Malaysian Islamic stock markets. Furthermore, the study suggests that in the long run, investors in Malaysia could gain by diversifying their portfolios in Japan and in the short run the US market is a better option to consider. Overall, the developed Islamic stock markets are better for the Malaysian financial traders rather than the emerging markets. 
Keywords:  International Portfolio Diversification, Dynamic Conditional Correlation (DCC), Multivariate GARCH, Islamic Stock Indices, Financial Integration, CWT, MODWT, Wavelet Coherence 
JEL:  C22 C58 G11 G15 
Date:  2014–08–22 
URL:  http://d.repec.org/n?u=RePEc:pra:mprapa:58799&r=rmg 