nep-rmg New Economics Papers
on Risk Management
Issue of 2015‒01‒14
eighteen papers chosen by

  1. Risk measuring under liquidity risk By Erindi Allaj
  2. Sensitivity analysis of scenario models for operational risk Advanced Measurement Approach By Chaudhary, Dinesh
  3. Denmark: Financial System Stability Assessment By International Monetary Fund. Monetary and Capital Markets Department
  4. A Simple Macroprudential Liquidity Buffer By Daniel C. Hardy; Philipp Hochreiter
  5. Financial Tail Risks and the Shapes of the Extreme Value Distribution: A Comparison between Conventional and Sharia-Compliant Stock Indexes By John W. Muteba Mwamba; Shawkat Hammoudeh; Rangan Gupta
  6. Denmark: Crisis Management, Bank Resolution, and Financial Sector Safety Nets - Technical Note By International Monetary Fund. Monetary and Capital Markets Department
  7. Методологічні проблеми фінансового управління в банківському секторі України: уроки кризи By Voloshyn, Ihor; Lubich, Oleksandr
  8. Tail Risk Constraints and Maximum Entropy By Donald Geman; H\'elyette Geman; Nassim Nicholas Taleb
  9. The Two Dimensions of Drawdown: Magnitude and Duration By Ola Mahmoud
  10. Econometric Analysis of Financial Derivatives: An Overview By Chia-Lin Chang; Michael McAleer
  11. Capital Requirements, Liquidity and Financial Stability: the case of Brazil By Sergio R. Stancato de Souza
  12. Portfolio Choice under Parameter Uncertainty: Bayesian Analysis and Robust Optimization Comparison By António Alberto Santos; Ana Margarida Monteiro; Rui Pascoal
  13. Capital Regulation in a Macroeconomic Model with Three Layers of Default. By L. Clerc; A. Derviz; C. Mendicino; S. Moyen; K. Nikolov; L. Stracca; J. Suarez; A. P. Vardoulakis
  14. Entropy-Based Financial Asset Pricing By Mihaly Ormos; David Zibriczky
  15. Identifying Speculative Bubbles: A Two-Pillar Surveillance Framework By Bradley Jones
  16. Common Factors in Return Seasonalities By Matti Keloharju; Juhani T. Linnainmaa; Peter Nyberg
  17. Capital Controls or Macroprudential Regulation? By Anton Korinek; Damiano Sandri
  18. Islamic Banking Regulation and Supervision: Survey Results and Challenges By Inwon Song; Carel Oosthuizen

  1. By: Erindi Allaj
    Abstract: We present a general framework for measuring the liquidity risk. The theoretical framework defines a class of risk measures that incorporate the liquidity risk into the standard risk measures. We consider a one-period risk measurement model. The liquidity risk is defined as the risk that a given security or a portfolio of securities cannot be easily sold or bought by the financial institutions without causing significant changes in prices. The new risk measures present some differences with respect to the standard risk measures. In particular, they are increasing monotonic and convex cash sub-additive on long positions. The contrary, in certain situations, holds for the sell positions. For the long positions case, we provide these new risk measures with a dual representation. In some specific cases also the sell positions can be equipped with a dual representation. We apply our framework to the situation in which ?financial institutions break up large trades into many small ones. Dual representation results are also obtained. We give many practical examples of risk measures and derive for each of them the respective capital requirement. As a particular example, we discuss the VaR measure.
    Date: 2014–12
  2. By: Chaudhary, Dinesh
    Abstract: Scenario Analysis (SA) plays a key role in determination of operational risk capital under Basel II Advanced Measurement Approach. However, operational risk capital based on scenario data may exhibit high sensitivity or wrong-way sensitivity to scenario inputs. In this paper, we first discuss scenario generation using quantile approach and parameter estimation using quantile matching. Then we use single-loss approximation (SLA) to examine sensitivity of scenario based capital to scenario inputs.
    Keywords: Operational risk; Sensitivity analysis; Scenario analysis; Advanced Measurement Approach
    JEL: D81 G21 G32
    Date: 2014–12–29
  3. By: International Monetary Fund. Monetary and Capital Markets Department
    Abstract: EXECUTIVE SUMMARY The Danish authorities have taken important steps in recent years to improve financial system resilience. Financial regulation and supervision have been strengthened. A new bank resolution framework that includes bail-in of creditors has been adopted and deployed to resolve small and medium-sized banks. An institutional framework for macroprudential policy has also been adopted. Recent legislation requires maturity extension of covered bonds in stress situations, with the aim of reducing refinancing risk in the mortgage finance system. Although stress tests suggest that financial stability risks are contained, the financial system’s large size and interconnectedness call for additional measures to further strengthen resilience. In a severe stress scenario, solvency levels at large banks and mortgage credit institutions (MCIs) remain well above regulatory requirements, owing to high current capital ratios. Stress tests also suggest that concentration risk and extreme increases in covered bond spreads would be manageable. However, this analysis cannot fully capture second-round and non-linear effects, and so may underestimate contagion risks that are material in light of the large size and interconnectedness of balance sheets in Denmark. For this reason, staff recommends the measures described below to further enhance systemic resilience. Given that covered bonds backed by mortgage loans are at the heart of the financial system, risks in mortgage finance should be reduced. The mortgage finance system has a long history of good performance based on important strengths, including a “balance principle” that limits most non-credit risks. However, the rapid growth of adjustable-rate and interest-only (IO) mortgage loans have increased the share of long-term loans funded by short-term covered bonds (refinancing risk), increased the risk of payment difficulties when interest rates rise (credit risk), and reduced resilience to house price declines. It would be advisable to use regulatory policies to encourage longer bond maturities, ensure that eventual interest-rate increases are better reflected in loan pricing and approvals, and increase buffers in loans with interest-only periods, e.g. by reducing the loan-to-value (LTV) ceiling. The proposed prudential limits on MCIs’ higher-risk activities are welcome. Prudential supervision is generally sound, but there is scope for further improvement. The intensity of the risk-based approach and the early and firm enforcement policy are areas of strength. However, additional resources are needed to increase the frequency of onsite inspections, including for AML/CFT supervision, and the operational independence of the Danish Financial Supervisory Authority (DFSA) should be ensured. In banking supervision, the information on operational and market risk that is reported routinely should be broadened, and systemic review of Pillar III disclosures should be implemented. In insurance supervision, a minimum solvency level should be established, and assessments of companies’ governance and management—as well as the supervision of market conduct, fraud, and AML/CFT—should be enhanced.
    Keywords: Financial sector;Stress testing;Banks;Bank supervision;Bank resolution;Insurance;Macroprudential Policy;International cooperation;Financial system stability assessment;Denmark;
    Date: 2014–12–09
  4. By: Daniel C. Hardy; Philipp Hochreiter
    Abstract: A mechanism is proposed that aims to reduce the risk of a banking sector liquidity crisis—which is a quintessentially systemic event and thus the object of macroprudential policy—and moderate the effects of a crisis should one occur. The instrument would give banks more incentive to build up buffers of systemically liquid assets as a proportion of their total liabilities, yet these buffers would be usable in times of stress. The modalities of the instrument are considered with a view to making it effective, efficient, and robust.
    Keywords: Banking sector;Liquidity;Bank financing;Systemic risk;Banking crisis;Macroprudential policies and financial stability;Crisis management;
    Date: 2014–12–22
  5. By: John W. Muteba Mwamba (Department of Economics and Econometrics, University of Johannesburg, Auckland Park, 2006, South Africa); Shawkat Hammoudeh (LeBow College of Business, Drexel University, Philadelphia, PA, USA); Rangan Gupta (Department of Economics, University of Pretoria)
    Abstract: This paper makes use of two types of extreme value distributions, namely: the generalised extreme value distribution often referred to as the block of maxima method (BMM), and the peak-over-threshold method (POT) of the extreme value distributions, to model the financial tail risks associated with the empirical daily log-return distributions of the sharia-compliant stock index and three regional conventional stock markets from 01/01/1998 to 16/09/2014. These include the Dow Jones Islamic market (DJIM), the U.S. S&P 500, the S&P Europe (SPEU), and the Asian S&P (SPAS50) indexes. Using the maximum likelihood (ML) method and the bootstrap simulations to estimate the parameters of these extreme value distributions, we find a significant difference in the tail risk behaviour between the Islamic and the conventional stock markets. We find that the Islamic market index exhibits fat tail behaviour in its right tail with high likelihood of windfall profit during extreme market conditions probably due to the ban on short selling strategies in Islamic finance. However, the conventional stock markets are found to be more risky than the Islamic markets, and exhibit fatter tail behaviour in both left and right tails. Our findings suggest that during extreme market conditions, short selling strategies lead to larger financial losses in the right tail than in the left tails.
    Keywords: Tail risks, extreme value distributions, expected shortfall, BMM and POT, value at risk
    JEL: G1 G13 G14
    Date: 2014–12
  6. By: International Monetary Fund. Monetary and Capital Markets Department
    Keywords: Financial Sector Assessment Program;Banking sector;Bank supervision;Bank resolution;Financial safety nets;Risk management;Denmark;
    Date: 2014–12–18
  7. By: Voloshyn, Ihor; Lubich, Oleksandr
    Abstract: The article demonstrates that the 2008-2009th financial crisis in Ukraine has had a significant and complex impact on its budget. It is shown that the banking crisis has led to a reduction in taxes revenue in the budget, diversion of public funds for the capitalization of state banks and the nationalization of systemic private banks. The main reasons for the negative impact were poor level of risk management and inefficient level of its implementation in the overall system of financial management. As a result, the risks of the banking system of Ukraine were significantly underestimated. To safeguard the state budget from unexpected increasing the expenses on the capitalization of state banks and the nationalization of private ones from reducing the taxes revenue were proposed to develop strategies of improving controllability of banks, to conduct simulation of the banking system of Ukraine on system-dynamic model base and to strengthen supervision of banks by introducing reporting about projected cash flows and cash flows at risk, to develop a corresponding methodology for assessing the risk of net cash bank loss before changes in operating assets and liabilities and for stress-testing of net cash profit and loss of the bank.
    Keywords: crisis, risk management, banking system, financial management, management reporting, controllability, observability, banking supervision, budget
    JEL: G21
    Date: 2014–12–28
  8. By: Donald Geman; H\'elyette Geman; Nassim Nicholas Taleb
    Abstract: In the world of modern financial theory, portfolio construction has traditionally operated under at least one of two central assumptions: the constraints are derived from a utility function and/or the multivariate probability distribution of the underlying asset returns is fully known. In practice, both the performance criteria and the informational structure are markedly different: risk-taking agents are mandated to build portfolios by primarily constraining the tails of the portfolio return to satisfy VaR, stress testing, or expected shortfall (CVaR) conditions, and are largely ignorant about the remaining properties of the probability distributions. As an alternative, we derive the shape of portfolio distributions which have maximum entropy subject to real-world left-tail constraints and other expectations. Two consequences are (i) the left-tail constraints are sufficiently powerful to overide other considerations in the conventional theory, rendering individual portfolio components of limited relevance; and (ii) the "barbell" payoff (maximal certainty/low risk on one side, maximum uncertainty on the other) emerges naturally from this construction.
    Date: 2014–12
  9. By: Ola Mahmoud
    Abstract: Multi-period measures of risk account for the path that the value of an investment portfolio takes. The most widely used such path-dependent indicator of risk is drawdown, which is a measure of decline from a historical peak in cumulative returns. In the context of probabilistic risk metrics, the focus has been on one particular dimension of drawdown, its magnitude, and not on its temporal dimension, its duration. In this paper, the concept of temporal path-dependent risk measure is introduced to capture the risk associated with the time dimension of a stochastic process. We formulate drawdown duration, which measures the length of excursions below a running maximum, and liquidation stopping time, which denotes the first time drawdown duration exceeds a subjective liquidation threshold, as temporal path-dependent risk measures and show that they, unlike drawdown magnitude, do not satisfy any of the axioms for coherent risk measures. Despite its non-coherence, we illustrate through an empirical example some of the insights gained from analyzing drawdown duration in the investment process. Remarks on the challenges of path-dependent risk estimation in practice are given in the conclusion.
    Date: 2015–01
  10. By: Chia-Lin Chang (Department of Applied Economics, Department of Finance, National Chung Hsing University, Taiwan); 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.)
    Abstract: One of the fastest growing areas in empirical finance, and also one of the least rigorously analyzed, especially from a financial econometrics perspective, is the econometric analysis of financial derivatives, which are typically complicated and difficult to analyze. The purpose of this special issue of the journal on “Econometric Analysis of Financial Derivatives” is to highlight several areas of research by leading academics in which novel econometric, financial econometric, mathematical finance and empirical finance methods have contributed significantly to the econometric analysis of financial derivatives, including market-based estimation of stochastic volatility models, the fine structure of equity-index option dynamics, leverage and feedback effects in multifactor Wishart stochastic volatility for option pricing, option pricing with non-Gaussian scaling and infinite-state switching volatility, stock return and cash flow predictability: the role of volatility risk, the long and the short of the risk-return trade-off, What’s beneath the surface? option pricing with multifrequency latent states, bootstrap score tests for fractional integration in heteroskedastic ARFIMA models, with an application to price dynamics in commodity spot and futures markets, a stochastic dominance approach to financial risk management strategies, empirical evidence on the importance of aggregation, asymmetry, and jumps for volatility prediction, non-linear dynamic model of the variance risk premium, pricing with finite dimensional dependence, quanto option pricing in the presence of fat tails and asymmetric dependence, smile from the past: a general option pricing framework with multiple volatility and leverage components, COMFORT: A common market factor non-Gaussian returns model, divided governments and futures prices, and model-based pricing for financial derivatives
    Keywords: Hedge Fund Diversi_cation, Spillover Index, Markowitz Analaysis, Downside Risk, CVaR, Draw-Down.
    JEL: C58 G23 G32
    Date: 2014
  11. By: Sergio R. Stancato de Souza
    Abstract: This paper simulates the effects of credit risk, changes in capital requirements and price shocks on the Brazilian banking system. We perform the analysis within the context of a model that integrates data on bilateral exposures in the interbank market with information about the liquidity profile of each financial institution. Asset prices in the model are determined endogenously as a function of the total volume of fire sales, thus creating the possibility that marking to market may trigger new rounds of fire sales and downward asset price spirals. The simulation results show that the Brazilian banking system is robust, as relatively large increases in the delinquency rate lead to only modest losses in the system. We also compute the contribution of each financial institution to systemic losses under severe shocks and find that contributions from medium-sized banks can be significant. However, if shocks become more severe, only large banks will contribute significantly to systemic losses
    Date: 2014–12
  12. By: António Alberto Santos (Faculty of Economics, University of Coimbra and GEMF, Portugal); Ana Margarida Monteiro (Faculty of Economics, University of Coimbra and GEMF, Portugal); Rui Pascoal (Faculty of Economics, University of Coimbra, Portugal)
    Abstract: Parameter uncertainty has been a recurrent subject treated in the financial literature. The normative portfolio selection approach considers two main kinds of decision rules: expected expected utility maximization and mean-variance criterion. Assuming that the mean-variance criterion is a good approximation to the expected utility maximization paradigm, a major factor of concern is parameter uncertainty which, when it is not taken into account, can lead to meaningless portfolios. A statistical approach, based on a Bayesian analysis, can be applied to parameter uncertainty. This can be compared with a robust optimization approach where it is assumed that the value of the unknown parameters can change within a given region. Comparisons over these two approaches are performed in this paper. We consider two measures to quantify the effects of the estimation risk, one of the measures is new and extends an existing one. The results allows us to distinguish the approaches and select the one that implies lower mean losses.
    Keywords: portfolio choice, Bayesian statistics, robust optimization, conic programming, semidefinite programming, loss distribution.
    JEL: C11 C13 C44 C58 C63 C87 G11 G32
    Date: 2014–12
  13. By: L. Clerc; A. Derviz; C. Mendicino; S. Moyen; K. Nikolov; L. Stracca; J. Suarez; A. P. Vardoulakis
    Abstract: We develop a dynamic general equilibrium model for the positive and normative analysis of macroprudential policies. Optimizing financial intermediaries allocate their scarce net worth together with funds raised from saving households across two lending activities, mortgage and corporate lending. For all borrowers (households, firms, and banks) external financing takes the form of debt which is subject to default risk. This “3D model” shows the interplay between three interconnected net worth channels that cause financial amplification and the distortions due to deposit insurance. We apply it to the analysis of capital regulation.
    Keywords: Macroprudential policy; Financial frictions; Default risk.
    JEL: E3 E44 G01 G21
    Date: 2014
  14. By: Mihaly Ormos; David Zibriczky
    Abstract: We investigate entropy as a financial risk measure. Entropy explains the equity premium of securities and portfolios in a simpler way and, at the same time, with higher explanatory power than the beta parameter of the capital asset pricing model. For asset pricing we define the continuous entropy as an alternative measure of risk. Our results show that entropy decreases in the function of the number of securities involved in a portfolio in a similar way to the standard deviation, and that efficient portfolios are situated on a hyperbola in the expected return - entropy system. For empirical investigation we use daily returns of 150 randomly selected securities for a period of 27 years. Our regression results show that entropy has a higher explanatory power for the expected return than the capital asset pricing model beta. Furthermore we show the time varying behaviour of the beta along with entropy.
    Date: 2015–01
  15. By: Bradley Jones
    Abstract: In the aftermath of the global financial crisis, the issue of how best to identify speculative asset bubbles (in real-time) remains in flux. This owes to the difficulty of disentangling irrational investor exuberance from the rational response to lower risk based on price behavior alone. In response, I introduce a two-pillar (price and quantity) approach for financial market surveillance. The intuition is straightforward: while asset pricing models comprise a valuable component of the surveillance toolkit, risk taking behavior, and financial vulnerabilities more generally, can also be reflected in subtler, non-price terms. The framework appears to capture stylized facts of asset booms and busts—some of the largest in history have been associated with below average risk premia (captured by the ‘pricing pillar’) and unusually elevated patterns of issuance, trading volumes, fund flows, and survey-based return projections (reflected in the ‘quantities pillar’). Based on a comparison to past boom-bust episodes, the approach is signaling mounting vulnerabilities in risky U.S. credit markets. Policy makers and regulators should be attune to any further deterioration in issuance quality, and where possible, take steps to ensure the post-crisis financial infrastructure is braced to accommodate a re-pricing in credit risk.
    Keywords: Asset bubbles;Asset prices;Capital markets;Corporate debt;Bond issues;Bond yields;Risk premium;Financial sector surveillance;Asset bubbles, Market efficiency, Financial stability, Financial crises.
    Date: 2014–11–19
  16. By: Matti Keloharju; Juhani T. Linnainmaa; Peter Nyberg
    Abstract: A strategy that selects stocks based on their historical same-calendar-month returns earns an average return of 13% per year. We document similar return seasonalities in anomalies, commodities, international stock market indices, and at the daily frequency. The seasonalities overwhelm unconditional differences in expected returns. The correlations between different seasonality strategies are modest, suggesting that they emanate from different common factors. Our results suggest that seasonalities are not a distinct class of anomalies that requires an explanation of its own---rather, they are intertwined with other return anomalies through shared common factors. A theory that is able to explain the risks behind any common factor is thus likely able to explain a part of the seasonalities.
    JEL: G12
    Date: 2014–12
  17. By: Anton Korinek; Damiano Sandri
    Abstract: We examine the effectiveness of capital controls versus macroprudential regulation in reducing financial fragility in a small open economy model in which there is excessive borrowing because of externalities associated with financial crises and contractionary exchange rate depreciations. We find that both types of instruments play distinct roles: macroprudential regulation reduces the indebtedness of leveraged borrowers whereas capital controls induce more precautionary behavior for the economy as a whole, including for savers. This reduces crisis risk by shoring up aggregate net worth and mitigating the transfer problem that occurs during crises. In advanced countries where the risk of large contractionary depreciations is more limited, the role for capital controls subsides. However, macroprudential regulation remains essential in our model to mitigate booms and busts in asset prices.
    JEL: E44 F34 F41
    Date: 2014–12
  18. By: Inwon Song; Carel Oosthuizen
    Abstract: The growing presence of Islamic banking needs to be accompanied by the development of effective regulation and supervision. This paper examines the results of the survey conducted by the International Monetary Fund to document international experiences and country practices related to legal and prudential frameworks governing Islamic banking activities. Although a number of countries have made considerable progress in creating legal, regulatory, and supervisory frameworks that accommodate Islamic banking, there are substantial differences. This paper also identifies a number of challenges faced by regulatory and supervisory agencies regarding Islamic banking.
    Keywords: Islamic banking;Commercial banks;Islamic banking supervision;Bank regulations;Bank deposits;Risk management;Transparency;Banking supervision, Islamic banks, regulatory framework
    Date: 2014–12–12

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