nep-rmg New Economics Papers
on Risk Management
Issue of 2014‒12‒24
twelve papers chosen by

  1. Stess-testing the system: Financial shock contagion in the realm of uncertainty By Stefano Gurciullo
  2. The impact of Basel III on financial (in)stability: An agent-based credit network approach By Krug, Sebastian; Lengnick, Matthias; Wohltmann, Hans-Werner
  3. Max-factor individual risk models with application to credit portfolios By Michel Denuit; Anna Kiriliouk; Johan Segers
  4. Corporate Governance and Bank Insolvency Risk : International Evidence By Anginer, D.; Demirguc-Kunt, Asli; Huizinga, H.P.; Ma, K.
  5. The economic consequences of including fair value adjustments to shareholders’ equity in regulatory capital calculations By Justin Chircop; Zoltán Novotny-Farkas
  6. Tail Risk Premia and Return Predictability By Tim Bollerslev; Viktor Todorov; Lai Xu
  7. Reflected Backward SDE approach to the price-hedge of defaultable claims with contingent switching CSA By Giovanni Mottola
  8. Predicting the VIX and the Volatility Risk Premium: What's Credit and Commodity Volatility Risk Got To Do With It? By Andreou, Elena; Ghysels, Eric
  9. Why Rating Agencies Disagree on Sovereign Ratings By Bernd Bartels
  10. Hometown Investment Trust Funds: An Analysis of Credit Risk By Yoshino, Naoyuki; Taghizadeh-Hesary, Farhad
  11. Risk, Return and Volatility Feedback: A Bayesian Nonparametric Analysis By Mark J. Jensen; John M. Maheu
  12. Monte Carlo Calculation of Exposure Profiles and Greeks for Bermudan and Barrier Options under the Heston Hull-White Model By Q. Feng; C. W. Oosterlee

  1. By: Stefano Gurciullo
    Abstract: This work proposes an augmented variant of DebtRank with uncertainty intervals as a method to investigate and assess systemic risk in financial networks, in a context of incomplete data. The algorithm is tested against a default contagion algorithm on three ensembles of networks with increasing density, estimated from real-world banking data related to the largest 227 EU15 financial institutions indexed in a stock market. Results suggest that DebtRank is capable of capturing increasing rates of systemic risk in a more sensitive and continuous way, thereby acting as an early-warning signal. The paper proposes three policy instruments based on this approach: the monitoring of systemic risk over time by applying the augmented DebtRank on time snapshots of interbank networks, a stress-testing framework able to test the systemic importance of financial institutions on different shock scenarios, and the evaluation of distribution of systemic losses in currency value.
    Date: 2014–12
  2. By: Krug, Sebastian; Lengnick, Matthias; Wohltmann, Hans-Werner
    Abstract: The Basel III accord reacts to the events of the recent financial crisis with a combination of revised micro- and new macroprudential regulatory instruments to address various dimensions of systemic risk. This approach of cumulating requirements bears the risk of individual measures negating or even conflicting with each other which might lessen their desired effects on financial stability. We provide an analysis of the impact of Basel III's main components on financial stability in a stock-flow consistent (SFC) agent-based computational economic (ACE) model. We find that the positive joint impact of the microprudential instruments is considerably larger than the sum of the individual contributions to stability, i.e. the standalone impacts are non-additive. However, except for the buffers, the macroprudential overlay's impact is either marginal or even destabilizing. Despite its simplicity, the leverage ratio performs poorly especially when associated drawbacks are explicitly taken into account. Surcharges on SIBs seem to rather contribute to financial regulations complexity than to the resilience of the system.
    Keywords: Banking Supervision,Basel III,Liquidity Coverage Ratio,Macroprudential Regulation,Financial Instability,Agent-based Computational Economics
    JEL: G01 G28 E40 C63
    Date: 2014
  3. By: Michel Denuit; Anna Kiriliouk; Johan Segers
    Abstract: Individual risk models need to capture possible correlations as failing to do so typically results in an underestimation of extreme quantiles of the aggregate loss. Such dependence modelling is particularly important for managing credit risk, for instance, where joint defaults are a major cause of concern. Often, the dependence between the individual loss occurrence indicators is driven by a small number of unobservable factors. Conditional loss probabilities are then expressed as monotone functions of linear combinations of these hidden factors. However, combining the factors in a linear way allows for some compensation between them. Such diversification effects are not always desirable and this is why the present work proposes a new model replacing linear combinations with maxima. These max-factor models give more insight into which of the factors is dominant.
    Date: 2014–12
  4. By: Anginer, D.; Demirguc-Kunt, Asli; Huizinga, H.P. (Tilburg University, Center For Economic Research); Ma, K. (Tilburg University, Center For Economic Research)
    Abstract: This paper finds that shareholder-friendly corporate governance is positively associated with bank insolvency risk, as proxied by the Z-score and the Merton’s distance to default measure, for an international sample of banks over the 2004-2008 period. Banks are special in that ‘good’ corporate governance increases bank insolvency risk relatively more for banks that are large and located in countries with sound public finances, as banks aim to exploit the financial safety net. ‘Good’ corporate governance is specifically associated with higher asset volatility, more non-performing loans, and a lower tangible capital ratio. Furthermore, ‘good’ corporate governance is associated with more bank risk taking at times of rapid economic expansion. Consistent with increased risk-taking, ‘good’ corporate governance is associated with a higher valuation of the implicit insurance provided by the financial safety net, especially in the case of large banks. These results underline the importance of the financial safety net and too-big-to-fail policies in encouraging excessive risk-taking by banks
    Keywords: Corporate governance; Bank insolvency; Capitalization; Non-performing loans
    JEL: G21 M21
    Date: 2014
  5. By: Justin Chircop (Lancaster University Management School, Lancaster University, UK); Zoltán Novotny-Farkas (Lancaster University Management School, Lancaster University, UK)
    Abstract: We investigate the economic consequences of the implementation of a particular aspect of Basel III in the U.S. Specifically, the Basel III proposal and the corresponding U.S. rule (hereafter referred to as the removal of the AOCI filter) to make the inclusion of unrealized fair value gains and losses of available-for-sale (AFS) securities in regulatory capital mandatory for all banks was highly controversial. The regulators’ view that such an inclusion would result in greater bank regulatory discipline was met with the concern that the regulatory costs of such regulatory tightening would exceed any possible benefits. Specifically, opponents of this rule argue that the inclusion of unrealized gains and losses would result in unrealistic volatility in regulatory capital and would force banks to make costly changes to their investment and risk management behavior. Using a comprehensive sample of U.S. banks we provide three pieces of evidence: First, we find that inclusion of unrealized fair value gains and losses on AFS securities for the period 2009 to 2013 would have resulted in increased volatility of regulatory capital. Second, bank share prices reacted negatively (positively) to pronouncements that increased (decreased) the likelihood that this rule would be implemented and these market reactions are strongly positively related to the relative amount of unrealized gains and losses. Third, we find evidence that banks affected by the AOCI filter removal (i.e., advanced approaches banks) changed their investment portfolio management. Specifically, affected banks reduce the maturity of their investment portfolio and decrease the proportion of AFS securities more significantly than unaffected benchmark banks. Interestingly, our results also suggest that affected banks reduce the size of their illiquid investment securities held in the AFS category more than unaffected banks. Given that we observe these changes before the actual implementation date of the new rule, we believe our results speak to the ex ante effects of fair value accounting on banks' risk taking behavior.
    Keywords: Banks, Fair Value Accounting, Prudential regulation, Regulatory Capital
    JEL: G21 M41
    Date: 2014–11
  6. By: Tim Bollerslev (Duke University, NBER and CREATES); Viktor Todorov (Northwestern University and CREATES); Lai Xu (Duke University)
    Abstract: The variance risk premium, defined as the difference between actual and risk-neutralized expectations of the forward aggregate market variation, helps predict future market returns. Relying on new essentially model-free estimation procedure, we show that much of this predictability may be attributed to time variation in the shape of the tails and compensation demanded by investors for bearing jump tail risk. Our results are consistent with the idea that the temporal variation in the separate diffusive and jump risk components of the variance risk premium may be associated with notions of time-varying economic uncertainty and changes in risk aversion, or market fears, respectively.
    Keywords: Variance risk premium, time-varying jump tails, market sentiment and fears, return predictability.
    JEL: C13 C14 G10 G12
    Date: 2014–09–29
  7. By: Giovanni Mottola
    Abstract: In this work we study the price-hedge issue for general defaultable contracts characterized by the presence of a contingent CSA of switching type. This is a contingent risk mitigation mechanism that allow the counterparties of a defaultable contract to switch from zero to full/perfect collateralization and switch back whenever until maturity T paying some instantaneous switching costs, taking in account in the picture CVA, collateralization and the funding problem. We have been lead to the study of this theoretical pricing/hedging problem, by the economic significance of this type of mechanism which allows a better management of all the defaultable contract risks respect to the standard mitigation mechanisms. In particular, our approach through hedging strategy decomposition of the claim and its solution representation through system of nonlinear reflected BSDE (theorem 3.2.4) are the main contribution of the work.
    Date: 2014–12
  8. By: Andreou, Elena; Ghysels, Eric
    Abstract: This paper presents an innovative approach to extracting factors which are shown to predict the VIX, the S&P 500 Realized Volatility and the Variance Risk Premium. The approach is innovative along two different dimensions, namely: (1) we extract factors from panels of filtered volatilities - in particular large panels of univariate financial asset ARCH-type models and (2) we price equity volatility risk using factors which go beyond the equity class. These are volatility factors extracted from panels of volatilities of short-term funding and long-run corporate spreads as well as volatilities of energy and metals commodities returns and sport/future spreads.
    Keywords: ARCH filters; Factor asset pricing models
    JEL: C2 C5 G1
    Date: 2014–11
  9. By: Bernd Bartels (Department of Economics, Johannes Gutenberg-Universitaet Mainz, Germany)
    Abstract: We empirically analyze why rating agencies disagree on countries' default risk. Specically, we explore the sovereign ratings of four agencies and their interaction. Our results indicate that the frequency of split ratings and their lopsidedness is not related to their home region. We nevertheless nd that rating agencies treat world regions differently. The Big Three rating agencies tend to follow each other predominantly in times of crises. The smaller European agency seems to b e more independent but also more volatile in its rating behaviour.
    Keywords: Sovereign Risk, European Rating Agency, Rating Agencies
    JEL: E62 F34
    Date: 2014–12–02
  10. By: Yoshino, Naoyuki (Asian Development Bank Institute); Taghizadeh-Hesary, Farhad (Asian Development Bank Institute)
    Abstract: In Asia, small and medium-sized enterprises (SMEs) account for a major share of employment and dominate the economy. Asian economies are often characterized as having bank-dominated financial systems and underdeveloped capital markets, in particular venture capital markets. Hence, looking for new methods of financing for SMEs is crucial. Hometown investment trust funds (HIT) are a new form of financial intermediation that has now been adopted as a national strategy in Japan. In this paper, we explain the importance of SMEs in Asia and describe about HITs. We then provide a scheme for the credit rating of SMEs by employing two statistical analysis techniques, principal components analysis and cluster analysis, and applying various financial variables to 1,363 SMEs in Asia. Adoption of this comprehensive and efficient method would enable banks to group SME customers based on financial health, adjust interest rates on loans, and set lending ceilings for each group. Moreover, this method is applicable to HITs around the world.
    Keywords: smes; credit risk; hometown investment trust funds; venture capital markets; asian capital markets
    JEL: G21 G24 G28
    Date: 2014–12–03
  11. By: Mark J. Jensen (Federal Reserve Bank of Atlanta, USA); John M. Maheu (DeGroote School of Business, McMaster University, Canada; University of Toronto, Canada; The Rimini Centre for Economic Analysis, Italy)
    Abstract: The relationship between risk and return is one of the most studied topics in finance. The majority of the literature is based on a linear, parametric relationship between expected returns and conditional volatility. This paper models the contemporaneous relationship between market excess returns and contemporaneous log-realized variances nonparametrically with an infinite mixture representation of their joint distribution. The conditional distribution of excess returns given log-realized variance will also have a infinite mixture representation but with probabilities and arguments depending on the value of realized variance. Our nonparametric approach allows for deviation from Gaussianity by allowing for higher order non-zero moments and a smooth nonlinear relationship between the conditional mean of excess returns and contemporaneous log-realized variance. We find strong robust evidence of volatility feedback in monthly data. Once volatility feedback is accounted for, there is an unambiguous positive relationship between expected excess returns and expected log-realized variance. This relationship is nonlinear. Volatility feedback impacts the whole distribution and not just the conditional mean.
    Date: 2014–11
  12. By: Q. Feng; C. W. Oosterlee
    Abstract: Valuation of Credit Valuation Adjustment (CVA) has become an important field as its calculation is required in Basel III, issued in 2010, in the wake of the credit crisis. Exposure, which is defined as the potential future loss of a default event without any recovery, is one of the key elementsfor pricing CVA. This paper provides a backward dynamics framework for assessing exposure profiles of European, Bermudan and barrier options under the Heston and Heston Hull-White asset dynamics. We discuss the potential of an efficient and adaptive Monte Carlo approach, the Stochastic Grid Bundling Method}(SGBM), which employs the techniques of simulation, regression and bundling. Greeks of the exposure profiles can be calculated in the same backward iteration with little extra effort. Assuming independence between default event and exposure profiles, we give examples of calculating exposure, CVA and Greeks for Bermudan and barrier options.
    Date: 2014–12

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NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.