nep-rmg New Economics Papers
on Risk Management
Issue of 2014‒12‒19
fifteen papers chosen by
Stan Miles
Thompson Rivers University

  1. Modeling Dependence Structure and Forecasting Portfolio Value-at-Risk with Dynamic Copulas By Mario Cerrato; John Crosby; Minjoo Kim; Yang Zhao
  2. Fire-Sale Spillovers and Systemic Risk By Thomas Eisenbach; Fernando Duarte
  3. Interest Rate Swap Credit Valuation Adjustment By Jakub Èerný; Jiøí Witzany
  4. A Quadratic Optimization Framework for Credit Portfolio By Boguk Kim
  5. Modeling and Forecasting Volatility – How Reliable are modern day approaches? By Mehta, Anirudh; Kanishka, Kunal
  6. Jointly optimal regulation of bank capital and maturity structure By Ansgar Walther
  7. Quantifying Liquidity and Default Risks of Corporate Bonds over the Business Cycle By Hui Chen; Rui Cui; Zhiguo He; Konstantin Milbradt
  8. Do correlated defaults matter for CDS premia? An empirical analysis By Koziol, Christian; Koziol, Philipp; Schön, Thomas
  9. Up- and Downside Variance Risk Premia in Global Equity Markets By Matthias Held; Marcel Omachel
  10. Industry Premiums and Systematic Risk under Terror: Empirical Evidence from Pakistan By Ahmad, Tanveer; Shahzad, Syed Jawad Hussain; Rehman, Mobeen ur
  11. "Price Impacts of Imperfect Collateralization" By Kenichiro Shiraya; Akihiko Takahashi
  12. Do We Really Value Identified Lives More Highly Than Statistical Lives? By Louise B Russell
  13. Capital Structure and Financial Flexibility: Expectations of Future Shocks By Costas Lambrinoudakis; Michael Neumann; George Skiadopoulos
  14. Family matters: Concurrent capital buffers in a banking group By Michal Skorepa
  15. A Model of the Topology of the Bank-Firm Credit Network and Its Role as Channel of Contagion By Lux, Thomas

  1. By: Mario Cerrato; John Crosby; Minjoo Kim; Yang Zhao
    Abstract: We study the asymmetric and dynamic dependence between financial assets and demonstrate, from the perspective of risk management, the economic significance of dynamic copula models. First, we construct stock and currency portfolios sorted on different characteristics (ex ante beta, coskewness, cokurtosis and order flows), and find substantial evidence of dynamic evolution between the high beta (respectively, coskewness, cokurtosis and order flow) portfolios and the low beta (coskewness, cokur- tosis and order flow) portfolios. Second, using three different dependence measures, we show the presence of asymmetric dependence between these characteristic-sorted portfolios. Third, we use a dynamic copula framework based on Creal et al. (2013) and Patton (2012) to forecast the portfolio Value-at-Risk of long-short (high minus low) equity and FX portfolios. We use several widely used univariate and multivariate VaR models for the purpose of comparison. Backtesting our methodology, we find that the asymmetric dynamic copula models provide more accurate forecasts, in general, and, in particular, perform much better during the recent financial crises, indicating the economic significance of incorporating dynamic and asymmetric dependence in risk management.
    Keywords: asymmetric dependence, dynamic copulas, tail risk, Value-at-Risk forecasting.
    JEL: C32 C53 G17 G32
    Date: 2014–10
  2. By: Thomas Eisenbach (Federal Reserve Bank of New York); Fernando Duarte (Federal Reserve Bank of New York)
    Abstract: We construct a new systemic risk measure that quantifies vulnerability to fire-sale spillovers using detailed regulatory balance sheet data for U.S. commercial banks and repo market data for broker-dealers. Even for moderate shocks in normal times, fire-sale externalities can be substantial. For commercial banks, a 1 percent exogenous shock to assets in 2013-Q1 produces fire sale externalities equal to 21 percent of system capital. For broker-dealers, a 1 percent shock to assets in August 2013 generates spillover losses equivalent to almost 60 percent of system capital. Externalities during the last financial crisis are between two and three times larger. Our systemic risk measure reaches a peak in the fall of 2007 but shows a notable increase starting in 2004, ahead of many other systemic risk indicators. Although the largest banks and broker-dealers produce – and are victims of – most of the externalities, leverage and linkages of financial institutions also play important roles.
    Date: 2014
  3. By: Jakub Èerný (Charles University in Prague, Faculty of Mathematics and Physics Department of Probability and Mathematical Statistics, Sokolovska 83, 186 75, Prague, Czech Republic); Jiøí Witzany (University of Economics, Faculty of Finance and Accounting, Department of Banking and Insurance, W. Churchill Sq. 4, 130 67, Prague, Czech Republic)
    Abstract: The credit valuation adjustment (CVA) of OTC derivatives is an important part of the Basel III credit risk capital requirements and current accounting rules. Its calculation is not an easy task - not only it is necessary to model the future value of the derivative, but also the probability of default of a counterparty. Another complication arises in the calculation when the exposure to a counterparty is adversely correlated with the credit quality of that counterparty, i.e. when it is needed to incorporate the wrong-way risk. A semi-analytical CVA formula simplifying the interest rate swap (IRS) valuation with the counterparty credit risk including the wrong-way risk is derived and analyzed in the paper. The formula is based on the fact that the CVA of an IRS can be expressed using swaption prices. The link between the interest rates and the default time is represented by a Gaussian copula with constant correlation coefficient. Finally, the results of the semi-analytical approach are compared with the results of a complex simulation study.
    Keywords: Counterparty Credit Risk, Credit Valuation Adjustment, Wrong-way Risk, Risky Swaption Price, Semi-analytical Formula, Interest Rate Swap Pricecointegration test
    JEL: C63 G12 G13 G32
    Date: 2014–05
  4. By: Boguk Kim
    Abstract: A novel quadratic optimization framework for credit portfolio is introduced when the portfolio risk is measured by Conditional Value-at-Risk (CVaR). This method is formulated in terms of the Lagrange multiplier method subjected under an artificial quadratic error term, which is comparable to the amount or cost of total portfolio adjustment, as the necessary constraint. The route toward the optimal portfolio state can be searched from the initial portfolio state via a continuation process through the maximally three-parameter space described by the total portfolio budget, the increment of the total return or the tolerance of the additional risk, and the total portfolio adjustment cost.
    Date: 2014–11
  5. By: Mehta, Anirudh; Kanishka, Kunal
    Abstract: This study explores the volatility models and evaluates the quality of one-step ahead forecasts of volatility constructed by (1) GARCH, (2) TGARCH, (3) Risk metrics and (4) Historical volatility. Volatility forecasts suggest that TGARCH performs relatively best in term of MSPE, followed by GARCH, Risk metrics and historical volatility. In terms of VaR, we test for correct unconditional coverage and index- Dependence of violations using Likelihood Ratio tests. The tests suggest that VaR forecasts at 90 % and 95% have desirable properties. Regarding 99% VaR forecasts, We find significant evidence that suggests none of the models can reliably predict at this confidence level.
    Keywords: Asset pricing, Volatility Forecasting, GARCH, T-GARCH, Risk metrics, LR ratio, VaR
    JEL: C10 C12 C15 C19 C51 C53 C58
    Date: 2014–11–08
  6. By: Ansgar Walther
    Abstract: Banks create excessive systemic risk through leverage and maturity mismatch, as financial constraints introduce welfare-reducing pecuniary externalities.  Macroprudential regulators can achieve efficiency with simple linear constraints on banks' balance sheets, which require less information than Pigouvian taxes.  These can be implemented using the Liquidity Coverage and Net Stable Funding ratios of Basel III.  When bank failures are socially costly, microprudential regulation of leverage is also required.  Optimally, macroprudential policy reacts to changes in systematic risk and credit conditions over the business cycle, while microprudential policy reacts to both systematic and idiosyncratic risk.
    Keywords: Systemic risk, leverage, maturity mismatch, macroprudential regulation, liquidiity, capital requirements, fire sales
    JEL: G18 G21 G28 E44
    Date: 2014–09–25
  7. By: Hui Chen; Rui Cui; Zhiguo He; Konstantin Milbradt
    Abstract: We develop a structural credit risk model to examine how the interactions of liquidity and default risk affect corporate bond pricing. By explicitly modeling debt rollover and by endogenizing the holding costs via collateralized financing, our model generates rich links between liquidity risk and default risk. The introduction of macroeconomic risks helps the model capture realistic time variation in default risk premia and the default-liquidity spiral over the business cycle. Across different credit ratings, our calibrated model can simultaneously match the average default probabilities, credit spreads, and bond liquidity measures including Bond-CDS spreads and bid-ask spreads in the data. Through a structural decomposition, we show that the interactions between liquidity and default risk account for 25∼40% of the observed credit spreads and up to 55% of the credit spread changes over the business cycle. As an application, we use this framework to quantitatively evaluate the effects of liquidity-provision policies for the corporate bond market.
    JEL: G00 G1 G12 G20
    Date: 2014–10
  8. By: Koziol, Christian; Koziol, Philipp; Schön, Thomas
    Abstract: Correlated defaults and systemic risk are clearly priced in credit portfolio securities such as CDOs or index CDSs. In this paper we study an extensive CDX data set for evidence whether correlated defaults are also present in the underlying CDS market. We develop a cash flow based top-down approach for modeling CDSs from which we can derive the following major contributions: (I) Correlated defaults did not matter for CDS prices prior to the financial crisis in 2008. During and after the crisis, however, their importance has increased strongly. (II) In line with a plausible default order, we observe that correlated defaults primarily impact the CDS prices of firms with an overall low CDS level. (III) Idiosyncratic risk factors for each single CDS play a major (minor) role when the CDS premia are high (low).
    Keywords: Correlated Defaults,Systemic Risk,Idiosyncratic Risk,Collateralized Debt Obligations,Credit Default Swaps,Credit Derivatives
    JEL: G14 G21
    Date: 2014
  9. By: Matthias Held (Faculty of Finance, WHU - Otto Beisheim School of Management); Marcel Omachel (Faculty of Finance, WHU - Otto Beisheim School of Management)
    Abstract: This paper studies the variance risk premium from a new perspective by disaggregating the total premium into upper and lower semivariance premia. To this end, we provide novel tools for computing conditional expectations using traded options as well as moment generating functions. Across a dataset of global stock market indices, we find that the variance premium is almost exclusively driven by downside risk. Our results are robust with respect to the sample period. These findings substantiate the hypothesis found in the literature that the variance premium is largely driven by the left tail of the index return distribution.
    Keywords: variance risk premium, semivariance, derivatives
    JEL: G12
    Date: 2014–09
  10. By: Ahmad, Tanveer; Shahzad, Syed Jawad Hussain; Rehman, Mobeen ur
    Abstract: This study aims to investigate the impact of terrorism on Pakistani industry excess returns and systematic risk. Value weighted monthly returns for non-financial firms listed at Karachi Stock Exchange, from January 2001 to December 2010, are used for this study. A multiplicative term to study the change in systematic risk and a dummy variable to examine the industry wise impact on excess returns was introduced in the standard CAPM framework. Terrorism as a phenomenon, not an event in Pakistan, has a significant negative impact on the excess returns of twelve out of twenty seven industries. The evidence suggests a mixed effect of terrorism on the systematic risk of some industries. Transportation, Tobacco and Automobiles industries appear to be most affected sectors of the economy.
    Keywords: Terrorism; Equity market; Systematic risk; Pakistan.
    JEL: G1 G11 H56
    Date: 2014–12–20
  11. By: Kenichiro Shiraya (Faculty of Economics, The University of Tokyo); Akihiko Takahashi (Faculty of Economics, The University of Tokyo)
    Abstract: This paper studies impacts of imperfect collateralization on derivatives values. Firstly, we present a general framework for the analysis in a multi-dimensional dif fusion setting, and then calclate pre-default values of forwards and options for the numerical experiments. In particular, we investigate no collateral posting and time-lagged collateral posting cases under a stochastic volatility model for the underlying asset prices and stochastic interest and hazard rate models for the risk-free rate and default intensities. We also derive an approximation for the density function of the CVA (Credit Value Adjustment) in the valuation of forward contract with bilateral counter party risk. Moreover, we allow a stochastic collateral asset value to depend not only on the underlying contract values, but also on other asset prices such as a currency different from the payment currency of the underlying contract. Finally, we also examine the effect of correlations on basket option values with stochastic volatility and stochastic hazard rate models.
    Date: 2014–11
  12. By: Louise B Russell (Department of Economics and Institute for Health)
    Abstract: Value of Statistical Life (VSL) studies suggest that people’s willingness to pay for statistical lives is consistent with their willingness to pay for identified lives. The idea that the valuations are different may be no more than an artifact of the economic method for valuing statistical lives, the human capital approach, that was dominant at the time the distinction was proposed.
    Keywords: Value of Statistical Life, Identified Lives
    JEL: D6 I1 H4
    Date: 2014–09–30
  13. By: Costas Lambrinoudakis (University of Piraeus); Michael Neumann (Queen Mary University of London); George Skiadopoulos (Queen Mary University of London University of Piraeus)
    Abstract: We test one of the main predictions of the financial flexibility paradigm that expectations about future firm-specific shocks affect the firm's leverage. We extract the expectations of small and large future shocks from the market prices of equity options. We find that expectations for future shocks decrease leverage and are statistically significant even when we control for traditional determinants. Moreover, they have a first-order effect to capital structure decisions affecting more the small and financially constrained firms. Our findings confirm the De Angelo et al. (2011) model predictions and evidence drawn from surveys that managers seek for financial flexibility.
    Keywords: Capital structure, Financial flexibility, Options, Risk-neutral volatility, Risk-neutral kurtosis
    JEL: G13 G30 G32
    Date: 2014–10
  14. By: Michal Skorepa (Czech National Bank)
    Abstract: We simulate how the probability of failure of a subsidiary and the group changes after a capital buffer is imposed on the group as a whole and/or the subsidiary. The simulation takes into account the relative sizes of the parent and the subsidiary, the parent’s share in the subsidiary, the similarity between the business models of the parent and the subsidiary, and the preparedness of the parent to support the subsidiary if the latter is in danger of failing.
    Keywords: capital, buffers, Basel III, probability of bank failure, banking group, parent, subsidiary, regulatory consolidation
    JEL: F23 G21 G28
    Date: 2014–07
  15. By: Lux, Thomas
    Abstract: This paper proposes a stochastic model of a bipartite credit network between banks and the non-bank corporate sector that encapsulates basic stylized facts found in comprehensive data sets for bank-firm loans for a number of countries. When performing computational experiments with this model, we find that it shows a pronounced non-linear behavior under shocks: The default of a single unit will mostly have practically no knock-on effects, but might lead to an almost full-scale collapse of the entire system in a certain number of cases. The dependency of the overall outcome on firm characteristics like size or number of loans seems fuzzy. Distinguishing between contagion due to interbank credit and due to joint exposures to counterparty risk via loans to firms, the later channel appears more important for contagious spread of defaults.
    Keywords: credit network,contagion,interbank network
    JEL: D85 G21 D83
    Date: 2014

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