nep-rmg New Economics Papers
on Risk Management
Issue of 2015‒01‒09
twenty-one papers chosen by
Stan Miles
Thompson Rivers University

  1. How much of bank credit risk is sovereign risk? Evidence from the eurozone By Junye Li; Gabriele Zinna
  2. Tractable Counterparts of Distributionally Robust Constraints on Risk Measures By Postek, K.S.; den Hertog, D.; Melenberg, B.
  3. Active Risk Management and Banking Stability By Silva Buston, C.F.
  4. European Market Portfolio Diversification Strategies across the GFC By David E. Allen; Michael McAleer; Robert J. Powell; Abhay K. Singh
  5. The Two Faces of Interbank Correlation By Schaeck, K.; Silva Buston, C.F.; Wagner, W.B.
  6. Hedge Fund Portfolio Diversification Strategies Across the GFC By David E. Allen; Michael McAleer; Shelton Peiris; Abhay K. Singh
  7. Aggregation operators for the measurement of systemic risk By Jozsef Mezei; Peter Sarlin
  8. The Risk Premia Embedded in Index Options By Torben G. Andersen; Nicola Fusari; Viktor Todorov
  9. Detection and quantification of causal dependencies in multivariate time series: a novel information theoretic approach to understanding systemic risk. By Peter Martey Addo; Philippe De Peretti
  10. Banking Competition and Stability: The Role of Leverage By Freixas, Xavier; Ma, Kebin
  11. Crisis performance of European banks – does management ownership matter? By Westman, Hanna
  13. Understanding Risk in an Evolving World : A Policy Note By Global Facility for Disaster Reduction and Recovery
  14. A detailed analysis of fulfilling and delinquency of payments on loan By Voloshyn, Ihor
  15. An inquiry into the stability of Islamic Financial Services Institutions in terms of volatility, risk and correlations: A case study of Malaysia employing M-GARCH t-DCC and MODWT Wavelet approaches By Kamaruzdin, Thaqif; Masih, Mansur
  16. A comparative analysis of the UK and Italian small businesses using Generalised Extreme Value models By Galina Andreeva; Raffaella Calabrese; Silvia Angela Osmetti
  17. Asymptotically Distribution-Free Goodness-of-Fit Testing for Tail Copulas By Can, S.U.; Einmahl, J.H.J.; Khmaladze, E.V.; Laeven, R.J.A.
  18. Asset pricing with horizon-dependent risk aversion By Andries, Marianne; Eisenbach, Thomas M.; Schmalz, Martin C.
  19. Components of intraday volatility and their prediction at different sampling frequencies with application to DAX and BUND futures By Herrmann, Klaus; Teis, Stefan; Yu, Weijun
  20. Problem loans management system in bank By Kryklii, Olena; Krukhal, Olena
  21. Roughing up Beta: Continuous vs. Discontinuous Betas, and the Cross-Section of Expected Stock Returns By Tim Bollerslev; Sophia Zhengzi Li; Viktor Todorov

  1. By: Junye Li (ESSEC Business School); Gabriele Zinna (Bank of Italy)
    Abstract: We develop a multivariate credit risk model for the term structures of sovereign and bank credit default swaps. First, we separate the probability of joint defaults of large Eurozone sovereigns (systemic risk) from that of sovereign-specific defaults (country risk). Then, we quantify individual banks' exposures to each type of sovereign risk, as well as bank-specific credit risk. Banks� sovereign risk exposures vary with banks� size, their holdings of sovereign debt, and expected government support. On average, 45% of French and Spanish banks' credit risk consists in sovereign risk, compared with only 30% for Italian and 23% for German banks. Furthermore, short- to medium-term contracts are particularly informative on sovereign systemic risk.
    Keywords: Sovereign and Bank Credit Risk; Credit Default Swaps; Distress Risk Premia; Bayesian Estimation.
    JEL: F34 G12 G15
    Date: 2014–10
  2. By: Postek, K.S. (Tilburg University, Center For Economic Research); den Hertog, D. (Tilburg University, Center For Economic Research); Melenberg, B. (Tilburg University, Center For Economic Research)
    Abstract: In this paper we study distributionally robust constraints on risk measures (such as standard deviation less the mean, Conditional Value-at-Risk, Entropic Value-at-Risk) of decision-dependent random variables. The uncertainty sets for the discrete probability distributions are defined using statistical goodness-of-fit tests and probability metrics such as Pearson, likelihood ratio, Anderson-Darling tests, or Wasserstein distance. This type of constraints arises in problems in portfolio optimization, economics, machine learning, and engineering. We show that the derivation of a tractable robust counterpart can be split into two parts: one corresponding to the risk measure and the other to the uncertainty set. We also show how the counterpart can be constructed for risk measures that are nonlinear in the probabilities (for example, variance or the Conditional Value-at-Risk). We provide the computational tractability status for each of the uncertainty set-risk measure pairs that we could solve. Numerical examples including portfolio optimization and a multi-item newsvendor problem illustrate the proposed approach.
    Keywords: risk measure; robust counterpart; nonlinear inequality; robust optimization; support functions
    JEL: C1
    Date: 2014
  3. By: Silva Buston, C.F. (Tilburg University, Center For Economic Research)
    Abstract: Abstract: This paper analyzes the net impact of two opposing effects of active risk management at banks on their stability: higher risk-taking incentives and better isolation of credit supply from varying economic conditions. We present a model where banks actively manage their portfolio risk by buying and selling credit protection. We show that anticipation of future risk management opportunities allows banks to operate with riskier balance sheets. However, since they are better insulated from shocks than banks without active risk management, they are less prone to insolvency. Empirical evidence from US bank holding companies broadly supports the theoretical predictions. In particular, we fi nd that active risk management banks were less likely to become insolvent during the crisis of 2007-2009, even though their balance sheets displayed higher risktaking. These results provide an important message for bank regulation, which has mainly focused on balance-sheet risks when assessing fi nancial stability.
    Keywords: Financial innovation; credit derivatives; financial stability; financial crisis
    Date: 2013
  4. By: David E. Allen (School of Accounting, Finance and Economics Edith Cowan University, Australia.); Michael McAleer (Econometric Institute, Erasmus School of Economics, Erasmus University Rotterdam and Tinbergen Institute, The Netherlands, Department of Quantitative Economics, Complutense University of Madrid, and Institute of Economic Research, Kyoto University.); Robert J. Powell (School of Accounting, Finance and Economics, Edith Cowan University); Abhay K. Singh (School of Accounting, Finance and Economics, Edith Cowan University)
    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 hold-out periods and back-tests. 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 opimisation is then compared with various down-side investment opimisation strategies. We begin by comparing Markowitz with CVaR, and then proceed to evaluate the relative effectiveness of Markowitz with various draw-down strategies, utilising a series of backtests .Our results suggest that none of the more sophisticated opimisation strategies appear to dominate naive diversification.
    Keywords: Portfolio Diversification, Markowitz Analaysis, Downside Risk, CVaR, Draw-down.
    JEL: G11
    Date: 2014
  5. By: Schaeck, K.; Silva Buston, C.F. (Tilburg University, Center For Economic Research); Wagner, W.B. (Tilburg University, Center For Economic Research)
    Abstract: Abstract: We decompose the correlation of bank stock returns into a systemic risk component and a component arising from diversi cation activities. Estimation for U.S. Bank Holding Companies (BHCs) shows the diversification component to be large and positively related to BHC performance during the crisis of 2007-2009. This suggests that it is important to distinguish between the two sources of interbank correlations when quantifying systemic risk at banks. Our decomposition also permits us to estimate the marginal gains from diversfication, which turn out to be rapidly declining with bank size. Since large banks are additionally found to display high levels of the systemic risk component, they are hence predominantly exposed to the undesirable source of interbank correlation.
    Keywords: systemic risk; interbank correlation; diversification
    Date: 2013
  6. By: David E. Allen; Michael McAleer (University of Canterbury); Shelton Peiris; Abhay K. Singh
    Abstract: This paper features an analysis of the effectiveness of a range of portfolio diversification strategies as applied to a set of 17 years of monthly hedge fund index returns on a set of ten market indices representing 13 major hedge fund categories, as compiled by the EDHEC Risk Institute. The 17-year period runs from the beginning of 1997 to the end of August 2014. The sample period, which incorporates both the Global Financial Crisis (GFC) and subsequent European Debt Crisis (EDC), is a challenging one for the application of diversification and portfolio investment strategies. The analysis features an examination of the diversification benefits of hedge fund investments through successive crisis periods. The connectedness of the Hedge Fund Indices is explored via application of the Diebold and Yilmaz (2009, 2014) spillover index. We conduct a series of portfolio optimisation analyses: comparing Markowitz with naive diversification, and evaluate the relative effectiveness of Markowitz portfolio optimisation with various draw-down strategies, using a series of backtests. Our results suggest that Markowitz optimisation matches the characteristics of these hedge fund indices quite well.
    Keywords: Hedge Fund Diversification, Spillover Index, Markowitz Analysis, Downside Risk, CVaR, Draw-Down
    JEL: G11 C61
    Date: 2014–12–10
  7. By: Jozsef Mezei; Peter Sarlin
    Abstract: The policy objective of safeguarding financial stability has stimulated a wave of research on systemic risk analytics, yet it still faces challenges in measurability. This paper models systemic risk by tapping into expert knowledge of financial supervisors. The model builds on the decomposition of systemic risk into a number of interconnected segments, for which the level of vulnerability is measured. The system is represented in the form of a Fuzzy Cognitive Map (FCM) with nodes representing vulnerability in the corresponding segment. A main problem tackled in this paper is the aggregation of values in different interrelated nodes of the network to obtain an estimation of systemic risk. For this purpose, the Choquet integral is employed for aggregating expert evaluations of measures, as it allows for the integration of interrelations among factors in the aggregation process. The approach is illustrated through two applications in a European setting. First, we provide an estimation of systemic risk with a of pan-European set-up. Second, we estimate country-level risks, allowing for a more granular decomposition. This sets a starting point for the use of the rich, oftentimes tacit, knowledge in policy organizations.
    Date: 2014–12
  8. By: Torben G. Andersen (Northwestern University, NBER, and CREATES); Nicola Fusari (The Johns Hopkins University Carey Business School); Viktor Todorov (Northwestern University)
    Abstract: We study the dynamic relation between market risks and risk premia using time series of index option surfaces. We find that priced left tail risk cannot be spanned by market volatility (and its components) and introduce a new tail factor. This tail factor has no incremental predictive power for future volatility and jump risks, beyond current and past volatility, but is critical in predicting future market equity and variance risk premia. Our findings suggest a wide wedge between the dynamics of market risks and their compensation, with the latter typically displaying a far more persistent reaction following market crises.
    Keywords: Option Pricing, Risk Premia, Jumps, Stochastic Volatility, Return Predictability, Risk Aversion, Extreme Events
    JEL: C51 C52 G12
    Date: 2014–12–15
  9. By: Peter Martey Addo (Centre d'Economie de la Sorbonne); Philippe De Peretti (Centre d'Economie de la Sorbonne)
    Abstract: The recent financial crisis has lead to a need for regulators and policy makers to understand and track systemic linkages. We provide a new approach to understanding systemic risk tomography in finance and insurance sectors. The analysis is achieved by using a recently proposed method on quantifying causal coupling strength, which identifies the existence of causal dependencies between two components of a multivariate time series and assesses the strength of their association by defining a meaningful coupling strength using the momentary information transfer (MIT). The measure of association is general, causal and lag-specific, reflecting a well interpretable notion of coupling strength and is practically computable. A comprehensive analysis of the feasibility of this approach is provided via simulated data and then applied to the monthly returns of hedge funds, banks, broker/dealers, and insurance companies.
    Keywords: Systemic risk, financial crisis, Coupling strength, financial institutions
    JEL: G12 C40 C32 G29
    Date: 2014–10
  10. By: Freixas, Xavier; Ma, Kebin
    Abstract: This paper reexamines the classical issue of the possible trade-o s between banking competition and financial stability by highlighting different types of risk and the role of leverage. By means of a simple model we show that competition can affect portfolio risk, insolvency risk, liquidity risk, and systemic risk differently. The effect depends crucially on banks' liability structure, on whether banks are financed by insured retail deposits or by uninsured wholesale debts, and on whether the indebtness is exogenous or endogenous. In particular we suggest that, while in a classical originate-to-hold banking industry competition might increase financial stability, the opposite can be true for an originate-to-distribute banking industry of a larger fraction of market short-term funding. This leads us to revisit the existing empirical literature using a more precise classification of risk. Our theoretical model therefore helps to clarify a number of apparently contradictory empirical results and proposes new ways to analyze the impact of banking competition on financial stability.
    Keywords: banking competition; financial stability; leverage
    JEL: G21 G28
    Date: 2014–08
  11. By: Westman, Hanna (Bank of Finland Research)
    Abstract: Failure in bank corporate governance has been seen as a contributing factor to excessive risk-taking pre-crisis with devastating implications as risks realised during the financial crisis. Unfortunately, the empirical evidence on the impact of managerial incentives on bank crisis performance is scarce. Moreover, bank strategy has not previously been accounted for. Hence, this paper presents novel findings on drivers for risk-taking and crisis performance. Specifically, I find a positive impact of management ownership in small diversified banks and non-traditional banks, the monitoring of which is challenging due to their opacity. The impact is negative in traditional banks and large diversified banks, indicating that shareholders induce managers to take risk where the safety net creates incentives for risk-shifting to debt holders and taxpayers. These findings have implications for both academic research as well as policy making particularly in the domain of corporate governance.
    Keywords: banks' crisis performance; management ownership; traditional vs. nontraditional banking; diversification; safety net; bank opacity and complexity
    JEL: G01 G21 G28 G32 L25
    Date: 2014–11–26
  12. By: Elisabetta Gualandri; Mario Noera
    Abstract: Understanding the nature of systemic risk and identifying the channels of diffusion of the shocks are the necessary prerequisite to anticipate and manage successfully the insurgence of financial crises. In order to prevent financial distress and manage instability, the macroprudential regulator needs to track and measure systemic risks ex-ante. The aim of the paper is twofold: on one side, it reviews the theoretical frameworks which allow to assess the different dimensions of systemic risk and, on the other, it classifies accordingly and analyzes the methodologies available to assess in advance the occurrence of systemic distress. The paper classifies the different definitions of systemic risk and discusses their significance during the 2007-08 crisis. It presents the tools available to extract real time information on market perception of risk from market prices of securities and derivatives (i.e. CDS and equity options). The analysis is extended to the methods focused on the measurement of the financial fragility due to the networks linkages within the financial system. On the basis of the available empirical research, the paper also reviews the capacity of the different methods to spot in advance the insurgence of the crisis prior to 2007-08 and draws some preliminary conclusions on the completeness and consistency of the toolkit available to policy makers.
    Keywords: systemic risk, financial crisis, prudential regulation, financial institutions
    JEL: G01 G18 G G28
    Date: 2014–11
  13. By: Global Facility for Disaster Reduction and Recovery
    Keywords: Insurance and Risk Mitigation Banks and Banking Reform Environment - Natural Disasters Social Protections and Labor - Labor Policies Urban Development - Hazard Risk Management Finance and Financial Sector Development
    Date: 2014
  14. By: Voloshyn, Ihor
    Abstract: A new model for predicting the future expected cash flows from a loan is developed. It is based on a detailed analysis of the events of fulfilling, delinquency and default of each individual payment on the loan. The proposed model has significantly less uncertainty compared with the Markov chain model with the same detailing. The model is expected to have greater predictive power in comparison to the traditional models, and its usage will allow reducing the interest rate on the loan. The results of estimation of the probabilities of payments over time and the future expected cash flows from the loan with monthly equal principal repayment are given.
    Keywords: loan, payment, delinquency, default, cash flow, present value, interest rate, credit spread, credit risk, liquidity risk, Markov chain, soft collection
    JEL: G12 G21
    Date: 2014–12–03
  15. By: Kamaruzdin, Thaqif; Masih, Mansur
    Abstract: Islamic Finance as an industry in recent times has been celebrated for its stability and resilience. With the philosophy of risk sharing and strict rules governing its activities to be in line with Islamic Law (the Shariah), the industry is seen as an alternative to the conventional finance with its tainted image of profit maximizing at any cost causing the Global Financial Crisis of 2008 - 2009. Given this claim it would be interesting to investigate the stability of the Islamic Financial Services Institutions (IFSIs) in comparison to the conventional sector. The Malaysian IFSIs were chosen as a case study as the Malaysia‟s Islamic Finance industry developed in the world with strict Shariah screening. As such, the Malaysian IFSIs are investigated to gain insights into their performance in terms of volatility and correlations with the market and then compared to their competitors by employing an M-GARCH t-DCC and also MODWT Wavelet technique to further dissect this volatility into their contributions from the point of view of different time scales. The findings are that IFSIs are much more volatile than their competitors with seemingly independent spikes in volatility unique to themselves but are low in correlation to the market implying that IFSIs volatility may be independent of the market due to assets that require the risk taking in order to justify earnings. IFSIs may need to cooperate in developing risk management standards and practices to mitigate risk that are unique to themselves as well as review the contracts and assets that may expose the IFSIs to too much risk.
    Keywords: Islamic Finance, Islamic Financial Services Institutions, Volatility, Risk, Correlation, Diversification, M-GARCH t-DCC and MODWT Wavelet
    JEL: C22 C58 E44 G2
    Date: 2014–07–23
  16. By: Galina Andreeva; Raffaella Calabrese; Silvia Angela Osmetti
    Abstract: This paper presents a cross-country comparison of significant predictors of small business failure between Italy and the UK. Financial measures of profitability, leverage, coverage, liquidity, scale and non-financial information are explored, some commonalities and differences are highlighted. Several models are considered, starting with the logis- tic regression which is a standard approach in credit risk modelling. Some important improvements are investigated. Generalised Extreme Value (GEV) regression is applied to correct for the symmetric link function of the logistic regression. The assumption of non-linearity is relaxed through application of BGEVA, non-parametric additive model based on the GEV link function. Two methods of handling missing values are compared: multiple imputation and Weights of Evidence (WoE) transformation. The results suggest that the best predictive performance is obtained by BGEVA, thus implying the necessity of taking into account the relative volume of defaults and non-linear patterns when modelling SME performance. WoE for the majority of models considered show better prediction as compared to multiple imputation, suggesting that missing values could be informative and should not be assumed to be missing at random.
    Date: 2014–12
  17. By: Can, S.U. (Tilburg University, Center For Economic Research); Einmahl, J.H.J. (Tilburg University, Center For Economic Research); Khmaladze, E.V.; Laeven, R.J.A. (Tilburg University, Center For Economic Research)
    Abstract: Let (X1, Y1),…., (Xn, Yn) be an i.i.d. sample from a bivariate distribution function that lies in the max-domain of attraction of an extreme value distribution. The asymptotic joint distribution of the standardized component-wise maxima √n i=1 Xi and √n i=1 Yi is then characterized by the marginal extreme value indices and the tail copula R. We propose a procedure for constructing asymptotically distribution-free goodness-of-fit tests for the tail copula R. The procedure is based on a transformation of a suitable empirical process derived from a semi-parametric estimator of R. The transformed empirical process converges weakly to a standard Wiener process, paving the way for a multitude of asymptotically distribution-free goodness-of-fit tests. We also extend our results to the m-variate (m > 2) case. In a simulation study we show that the limit theorems provide good approximations for finite samples and that tests based on the transformed empirical process have high power.
    Keywords: Extreme value theory; tail dependence; goodness-of-fit testing; martingale transformation
    JEL: C12 C14
    Date: 2014
  18. By: Andries, Marianne; Eisenbach, Thomas M. (Federal Reserve Bank of New York); Schmalz, Martin C.
    Abstract: We study general equilibrium asset prices in a multi-period endowment economy when agents’ risk aversion is allowed to depend on the maturity of the risk. We find horizon-dependent risk aversion preferences generate a decreasing term structure of risk premia if and only if volatility is stochastic. Our model can thus justify the recent empirical results on the term structure of risk premia if the pricing of volatility risk is downward sloping (in absolute value) in the data and if downward-sloping term structures of returns on a given market are driven solely by exposures to volatility risk. We test these predictions by estimating the price of volatility risk using index options data and by showing that the value premium is related to the exposure to volatility risk.
    Keywords: risk aversion; term structure; volatility risk
    JEL: D03 D90 G02 G12
    Date: 2014–12–01
  19. By: Herrmann, Klaus; Teis, Stefan; Yu, Weijun
    Abstract: The adjusted measure of realized volatility suggested in [20] is applied to high- frequency orderbook and transaction data of DAX and BUND futures from EU- REX in order to identify the drivers of intraday volatility. Four components are identified to have predictive power: an auto-regressive pattern, a seasonal pattern, long-term memory and scheduled data releases. These components are analyzed in detail. Some evidence for two additional components, market microstrucuture events and unscheduled news, is given. Depending on the sampling frequency we estimate that between one and two thirds of the variation in realized volatility can be predicted by a simple linear model based on the components identified. It is shown how the predictive power of the different components depends on sampling frequencies.
    Keywords: volatility,realized variance,intraday seasonality,volatility prediction,high-frequency data,tick data,fractional integration,sampling frequency
    Date: 2014
  20. By: Kryklii, Olena; Krukhal, Olena
    Abstract: Advisability of a systematic approach to problem loans management in bank is justified. It was determined that problem loans management system in bank should be defined as its structural and functional integrity of an object, a subject, principles and a mechanism. The interaction of these elements allows minimizing losses which may arise from the relationships with borrowers. The article described the strategy of bank’s problem debts’ mitigation.
    Keywords: problem loans management, problem loans, the subjects of management, strategy of problem debts regulation.
    JEL: G21
    Date: 2014
  21. By: Tim Bollerslev (Duke University, NBER and CREATES); Sophia Zhengzi Li (Michigan State University); Viktor Todorov (Northwestern University and CREATES)
    Abstract: Motivated by the implications from a stylized equilibrium pricing framework, we investigate empirically how individual equity prices respond to continuous, or \smooth," and jumpy, or \rough," market price moves, and how these different market price risks, or betas, are priced in the cross-section of expected returns. Based on a novel highfrequency dataset of almost one-thousand individual stocks over two decades, we find that the two rough betas associated with intraday discontinuous and overnight returns entail significant risk premiums, while the intraday continuous beta is not priced in the cross-section. An investment strategy that goes long stocks with high jump betas and short stocks with low jump betas produces significant average excess returns. These higher risk premiums for the discontinuous and overnight market betas remain significant after controlling for a long list of other firm characteristics and explanatory variables previously associated with the cross-section of expected stock returns.
    Keywords: Market price risks, jump betas, high-frequency data, cross-sectional return variation
    JEL: C13 C14 G11 G12
    Date: 2014–12–04

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