nep-rmg New Economics Papers
on Risk Management
Issue of 2014‒12‒08
sixteen papers chosen by
Stan Miles
Thompson Rivers University

  1. Risk Appetite in Practice: Vulgaris Mathematica By Bertrand K. Hassani
  2. The Bank Capital Regulation (BCR) Model By Hyejin Cho
  3. The limits of model-based regulation By Behn, Markus Wilhelm; Haselmann, Rainer; Vig, Vikrant
  4. Does a leverage ratio requirement increase bank stability? By Kiema, Ilkka; Jokivuolle, Esa
  5. Optimal Hedging for Fund & Insurance Managers with Partially Observable Investment Flows By Masaaki Fujii; Akihiko Takahashi
  6. Fiscal Sustainability in the Presence of Systemic Banks: the Case of EU countries By Agnès Bénassy-Quéré; Guillaume Roussellet
  7. Bayesian default probability models By Petra Andrlíková
  8. Risk-adjusted option-implied moments By Brinkmann, Felix; Korn, Olaf
  9. Parametric Bootstrap Tests for Futures Price and Implied Volatility Biases With Application to Rating Dairy Margin Insurance By Bozic, Marin; Newton, John; Thraen, Cameron S.; Gould, Brian W.
  10. Global Variance Risk Premium and Forex Return Predictability By Aloosh, Arash
  11. Predicting Financial Stress Events: A Signal Extraction Approach By Ian Christensen; Fuchun Li
  12. Taking Uncertainty Seriously: Simplicity versus Complexity in Financial Regulation By Aikman, David; Galesic, Mirta; Gigerenzer, Gerd; Kapadia, Sujit; Katsikopolous, Konstantinos; Kothiyal, Amit; Murphy, Emma; Neumann, Tobias
  13. Illiquidity transmission from spot to futures markets By Korn, Olaf; Krischak, Paolo; Theissen, Erik
  14. Dynamic Defaultable Term Structure Modelling beyond the Intensity Paradigm By Frank Gehmlich; Thorsten Schmidt
  15. Weather Risk and Cropping Intensity: A Non-Stationary and Dynamic Panel Modeling Approach By Khanal, Aditya R.; Mishra, Ashok K.; Bhattarai, Madhusan
  16. Risk or Sentiment: Value and Size Premium under Terrorism By Ahmad, Tanveer; Shahzad, Syed Jawad Hussain; Rehman, Mobeen ur

  1. By: Bertrand K. Hassani (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Paris I - Panthéon-Sorbonne)
    Abstract: The ultimate goal of risk management is the generation of efficient incomes. The objective is to generate the maximum return for a unit of risk taken or to minimise the risk taken to generate the return expected i.e. it is the optimisation of a financial institution strategy. Therefore, by measuring its exposure against its appetite, a financial institution is assessing its couple risk-return. But this taskk may be difficult as banks face various types of risks, for instance, Operational, Market, Credit, Liquidity, etx. and these cannot be evaluated on a stand alone basis, interaction and contagion effects should be taken into account. In this paper, methodologies to evaluate banks' exposures are presented along their management implications, as the purpose of the risk appetite evaluation process is the transformation of risk metrics into effective management decisions.
    Keywords: Risk management; risk measures; risk appetite; interdependencies
    Date: 2014–04
  2. By: Hyejin Cho (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Paris I - Panthéon-Sorbonne)
    Abstract: The motivation of this article is to induce the bank capital management solution for banks and regulation bodies on commercial banks. The goal of the paper is intended to mitigate the risk of a banking area and also provide the right incentive for banks to support the real economy.
    Keywords: Demand Deposit, On-balance-sheet risks and off-balance-sheet risks, Portfolio composition, Minimum equity capital regulation.
    Date: 2014–09–22
  3. By: Behn, Markus Wilhelm; Haselmann, Rainer; Vig, Vikrant
    Abstract: In this paper, we investigate how the introduction of complex, model-based capital regulation affected credit risk of financial institutions. Model-based regulation was meant to enhance the stability of the financial sector by making capital charges more sensitive to risk. Exploiting the staggered introduction of the model-based approach in Germany and the richness of our loan-level data set, we show that (1) internal risk estimates employed for regulatory purposes systematically underpredict actual default rates by 0.5 to 1 percentage points; (2) both default rates and loss rates are higher for loans that were originated under the model-based approach, while corresponding risk-weights are significantly lower; and (3) interest rates are higher for loans originated under the model-based approach, suggesting that banks were aware of the higher risk associated with these loans and priced them accordingly. Further, we document that large banks benefited from the reform as they experienced a reduction in capital charges and consequently expanded their lending at the expense of smaller banks that did not introduce the model-based approach. Counter to the stated objectives, the introduction of complex regulation adversely affected the credit risk of financial institutions. Overall, our results highlight the pitfalls of complex regulation and suggest that simpler rules may increase the efficacy of financial regulation.
    Keywords: capital regulation,internal ratings,Basel regulation
    JEL: G01 G21 G28
    Date: 2014
  4. By: Kiema, Ilkka; Jokivuolle, Esa
    Abstract: Basel III has introduced a non-risk-weighted leverage ratio requirement (LRR) which complements the internal ratings based (IRB) capital requirements. It provides a backstop against model risk which arises if some loans get incorrectly rated and become toxic. We study the effects of the LRR on lending strategies and its implications for banks’ stability. We show that the LRR might induce banks with low-risk lending strategies to diversify their portfolios into high-risk loans until the LRR is no longer the binding capital constraint on them. If the LRR is lower than the average bank’s IRB requirement, the aggregate capital costs of banks do not increase. However, because the diversification makes banks’ portfolios more alike the banking sector as a whole may become more exposed to model risk in each loan category. This may undermine banking sec- tor stability. On balance, our calibrated model motivates a significantly higher LRR than the current one. JEL Classification: D41, D82, G14, G21, G28
    Keywords: bank regulation, Basel III, capital requirements, credit risk, leverage ratio
    Date: 2014–05
  5. By: Masaaki Fujii (The University of Tokyo); Akihiko Takahashi (The University of Tokyo)
    Abstract: All the financial practitioners are working in incomplete markets full of unhedgeable risk-factors. Making the situation worse, they are only equipped with the imperfect information on the relevant processes. In addition to the market risk, fund and insurance managers have to be prepared for sudden and possibly contagious changes in the investment flows from their clients so that they can avoid the over- as well as under-hedging. In this work, the prices of securities, the occurrences of insured events and (possibly a network of) the investment flows are used to infer their drifts and intensities by a stochastic filtering technique. We utilize the inferred information to provide the optimal hedging strategy based on the mean-variance (or quadratic) risk criterion. A BSDE approach allows a systematic derivation of the optimal strategy, which is shown to be implementable by a set of simple ODEs and the standard Monte Carlo simulation. The presented framework may also be useful for manufactures and energy firms to install an efficient overlay of dynamic hedging by financial derivatives to minimize the costs.
    Date: 2014–07
  6. By: Agnès Bénassy-Quéré (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Paris I - Panthéon-Sorbonne, EEP-PSE - Ecole d'Économie de Paris - Paris School of Economics - Ecole d'Économie de Paris, CEPII - Centre d'Etudes Prospectives et d'Informations Internationales - Centre d'analyse stratégique); Guillaume Roussellet (ENSAE - École Nationale de la Statistique et de l'Administration Économique - ENSAE ParisTech, Centre de recherche de la Banque de France - Banque de France, CEREMADE - CEntre de REcherches en MAthématiques de la DEcision - CNRS : UMR7534 - Université Paris IX - Paris Dauphine)
    Abstract: We provide a first attempt to include off-balance sheet, implicit insurance to SIFIs into a consistent assessment of fiscal sustainability, for 27 countries of the European Union. We first calculate tax gaps à la Blanchard (1990) and Blanchard et al. (1990). We then introduce two alternative measures of implicit off-balance sheet liabilities related to the risk of a systemic bank crisis. The first one relies on microeconomic data at the bank level. The second one is based on econometric estimations of the probability and the cost of a systemic banking crisis. The former approach provides an upper evaluation of the fiscal cost of systemic banking crises, whereas the latter one provides a lower one. Hence we believe that the combined use of these two methodologies helps to gauge the range of fiscal risk.
    Keywords: fiscal sustainability ; tax gap ; systemic banking risk ; off-balance sheet liabilities
    Date: 2014
  7. By: Petra Andrlíková (Institute of Economic Studies, Faculty of Social Sciences, Charles University in Prague, Smetanovo nábreží 6, 111 01 Prague 1, Czech Republic)
    Abstract: This paper proposes a methodology for default probability estimation for low default portfolios, where the statistical inference may become troublesome. The author suggests using logistic regression models with the Bayesian estimation of parameters. The piecewise logistic regression model and Box-Cox transformation of credit risk score is used to derive the estimates of probability of default, which extends the work by Neagu et al. (2009). The paper shows that the Bayesian models are more accurate in statistical terms, which is evaluated based on Hosmer-Lemeshow goodness of fit test, Hosmer et al. (2013).
    Keywords: default probability, bayesian analysis, logistic regression, goodness-of-fit
    JEL: C11 C51 C52 G10
    Date: 2014–04
  8. By: Brinkmann, Felix; Korn, Olaf
    Abstract: Option-implied moments, like implied volatility, contain useful information about an underlying asset's return distribution, but are derived under the risk-neutral probability measure. This paper shows how to convert risk-neutral moments into the corresponding physical ones. The main theoretical result expresses moments under the physical probability measure in terms of observed option prices and the preferences of a representative investor. Based on this result, we investigate several empirical questions. We show that a model of a representative investor with CRRA utility can explain the variance risk premium for the S&P500 index but fails to capture variance and skewness risk premiums simultaneously. Moreover, we present methods to estimate forward-looking market risk premiums and investors' disappointment aversion implied in market prices.
    Keywords: option-implied moments,risk adjustment,variance risk premium,market risk premium,disappointment aversion
    JEL: G13 G17 C51 C53
    Date: 2014
  9. By: Bozic, Marin; Newton, John; Thraen, Cameron S.; Gould, Brian W.
    Abstract: We develop a new parametric bootstrap-based statistical test for presence of futures price and options-based implied volatility biases. The new test is applicable to data with overlapping prediction horizons. Information on anticipated volatility embedded in options prices is explicitly used when testing for futures price biases. Our method is well adapted to analysis of fast changing commodity markets as it does not rely on asymptotic theory and does not require a time series spanning several decades. We apply the new test to investigate if futures and options biases can explain very low loss ratios exhibited by USDA’s Livestock Gross Margin for Dairy Cattle insurance program.
    Keywords: parametric bootstrap, futures price bias, volatility bias, revenue insurance, LGMDairy, Agricultural and Food Policy, Research Methods/ Statistical Methods, Risk and Uncertainty,
    Date: 2014
  10. By: Aloosh, Arash
    Abstract: In a long-run risk model with stochastic volatility and frictionless markets, I express expected forex returns as a function of consumption growth variances and stock variance risk premiums (VRPs)—the difference between the risk-neutral and statistical expectations of market return variation. This provides a motivation for using the forward-looking information available in stock market volatility indices to predict forex returns. Empirically, I find that stock VRPs predict forex returns at a one-month horizon, both in-sample and out-of-sample. Moreover, compared to two major currency carry predictors, global VRP has more predictive power for currency carry trade returns, bilateral forex returns, and excess equity return differentials.
    Keywords: Global Variance Risk Premium; Excess Foreign Exchange (Forex) Return; Frictionless Markets; Predictability.
    JEL: F31 F37 G15
    Date: 2014–11–19
  11. By: Ian Christensen; Fuchun Li
    Abstract: The objective of this paper is to propose an early warning system that can predict the likelihood of the occurrence of financial stress events within a given period of time. To achieve this goal, the signal extraction approach proposed by Kaminsky, Lizondo and Reinhart (1998) is used to monitor the evolution of a number of economic indicators that tend to exhibit an unusual behaviour in the periods preceding a financial stress event. Based on the individual indicators, we propose three different composite indicators, the summed composite indicator, the extreme composite indicator and the weighted composite indicator. In-sample forecasting results indicate that the three composite indicators are useful tools for predicting financial stress events. The out-of-sample forecasting results suggest that for most countries, including Canada, the weighted composite indicator performs better than the two others across all criteria considered.
    Keywords: Econometric and statistical methods, Financial stability
    JEL: C14 C4 E37 E47 F36 F37 G01 G17
    Date: 2014
  12. By: Aikman, David; Galesic, Mirta; Gigerenzer, Gerd; Kapadia, Sujit; Katsikopolous, Konstantinos; Kothiyal, Amit; Murphy, Emma; Neumann, Tobias
    Abstract: Distinguishing between risk and uncertainty, this paper draws on the psychological literature on heuristics to consider whether and when simpler approaches may out-perform more complex methods for modelling and regulating the financial system. We find that: (i) simple methods can sometimes dominate more complex modelling approaches for calculating banks’ capital requirements, especially if limited data are available for estimating models or the underlying risks are characterised by fat-tailed distributions; (ii) simple indicators often outperformed more complex metrics in predicting individual bank failure during the global financial crisis; (iii) when combining information from different indicators to predict bank failure, “fast-and-frugal” decision trees can perform comparably to standard, but more information-intensive, regression techniques, while being simpler and easier to communicate.
    Keywords: Bank regulation; financial regulation; uncertainty; simplicity; heuristics; Basel 2; risk modelling
    JEL: A12 G28
    Date: 2014–05–02
  13. By: Korn, Olaf; Krischak, Paolo; Theissen, Erik
    Abstract: We develop a model of the illiquidity transmission from spot to futures markets that formalizes the derivative hedge theory proposed by Cho and Engle (1999). The model shows that spot market illiquidity does not translate one-to-one to the futures market, but rather interacts with price risk, liquidity risk, and the risk aversion of the market maker. The predictions of the model are tested empirically with data from the stock market and the market for single-stock futures. The results support our model. In particular, they show that the derivative hedge theory is important for the explanation of the liquidity link between spot and futures markets. Our results provide no evidence in favor of the substitution hypothesis.
    Keywords: illiquidity,liquidity risk,futures markets
    JEL: G10 G13
    Date: 2014
  14. By: Frank Gehmlich; Thorsten Schmidt
    Abstract: The two main approaches in credit risk are the structural approach pioneered in Merton (1974) and the reduced-form framework proposed in Jarrow & Turnbull (1995) and in Artzner & Delbaen (1995). The goal of this article is to provide a unified view on both approaches. This is achieved by studying reduced-form approaches under weak assumptions. In particular we do not assume the global existence of a default intensity and allow default at fixed or predictable times with positive probability, such as coupon payment dates. In this generalized framework we study dynamic term structures prone to default risk following the forward-rate approach proposed in Heath-Jarrow-Morton (1992). It turns out, that previously considered models lead to arbitrage possibilities when default may happen at a predictable time with positive probability. A suitable generalization of the forward-rate approach contains an additional stochastic integral with atoms at predictable times and necessary and sufficient conditions for a suitable no-arbitrage condition (NAFL) are given. In the view of efficient implementations we develop a new class of affine models which do not satisfy the standard assumption of stochastic continuity. The chosen approach is intimately related to the theory of enlargement of filtrations, to which we provide a small example by means of filtering theory where the Azema supermartingale contains upward and downward jumps, both at predictable and totally inaccessible stopping times.
    Date: 2014–11
  15. By: Khanal, Aditya R.; Mishra, Ashok K.; Bhattarai, Madhusan
    Abstract: Climatic conditions and weather play an important role in production agriculture. Using district level panels for 42 years from India and dynamic panel estimation procedure we estimate the impact of weather risk on cropping intensity. Our non-stationary and dynamic panel model results suggest that the impact of weather risk on cropping intensity, in rural India, is negative on short run, while it is positive on long run. Additionally, we found a negative effect of education on cropping intensity. Finally, in the long run, our results indicate positive effects of high yielding variety production and share of irrigated land on cropping intensity.
    Keywords: weather risk, panel, non-stationary, adaptation, land use, cropping intensity, rainfall variability, Land Economics/Use, Production Economics, Research Methods/ Statistical Methods, Resource /Energy Economics and Policy, Risk and Uncertainty,
    Date: 2014–05–28
  16. By: Ahmad, Tanveer; Shahzad, Syed Jawad Hussain; Rehman, Mobeen ur
    Abstract: This study aims to identify the effect of terrorism on size and value premium using value weighted monthly returns for non-financial firms from January 2001 to December 2010. In addition to Independent size and BE/ME sorted portfolios, two dimensional portfolio formation methodology of Dimson, Nagel, and Quigley (2003) is also used. The results reveal that market, size, value premium and terrorism have a significant positive impact on stock returns. The study further suggests that value and size premiums are dependent on the level of psychosocial impact caused by terrorist incidents. Findings suggest that the small stocks generate higher returns than large stocks and the size premium occurs mainly during the months of higher terrorism activities. In contrast, value premium is more profound during the months of low (high) terrorist activities for portfolios sorted on one (two) dimension. This indicates that both size and BE/ME premiums are effected by investors sentiment.
    Keywords: Value premium, size premium, terrorism, Pakistan.
    JEL: G02 G12
    Date: 2014–11–15

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