nep-rmg New Economics Papers
on Risk Management
Issue of 2015‒01‒31
twenty-one papers chosen by
Stan Miles
Thompson Rivers University

  1. Testing for systemic risk using stock returns By Paul H. Kupiec
  2. Efficient Monte Carlo Counterparty Credit Risk Pricing and Measurement By Ghamami, Samim ; Zhang, Bo
  4. Shortfall Deviation Risk By Marcelo Brutti Righi ; Paulo Sergio Ceretta
  5. Effect of Volatility Clustering on Indifference Pricing of Options by Convex Risk Measures By Rohini Kumar
  6. Georgia: Financial Sector Assessment Program-Stress Testing the Banking Sector-Technical Note By International Monetary Fund. Monetary and Capital Markets Department
  7. Modeling Path Dependent Counterparty Credit Risk By Zhou, Richard
  8. Generalized Momentum Asset Allocation Model By Piotr Arendarski ; Paweł Misiewicz ; Mariusz Nowak ; Tomasz Skoczylas ; Robert Wojciechowski
  9. The unintended consequences and challenges of the Basel III Leverage Ratio: supplementary leverage ratios By Ojo, Marianne
  10. Multiple-Item Risk Measures By Lukas Menkhoff ; Sahra Sakha
  11. Georgia: Financial Sector Assessment Program-Detailed Assessment of Observance of the Basel Core Principles for Effective Banking Supervision-Technical Note By International Monetary Fund. Monetary and Capital Markets Department
  12. How Relevant is the Choice of Risk Management Control Variable to Non-parametric Bank Profit Efficiency Analysis? By Richard Simper ; Maximilian J.B. Hall ; Wenbin B. Liu ; Valentin Zelenyuk ; Zhongbao Zhou
  13. Incorporating risk in a positive mathematical programming framework: a new methodological approach By Arata, Linda ; Donati, Michele ; Sckokai, Paolo ; Arfini, Filippo
  14. Republic of Korea: Financial Sector Assessment Program-Crisis Preparedness and Crisis Management Framework-Technical Note By International Monetary Fund. Monetary and Capital Markets Department
  15. Simulation model for income risk analyses at the sector level, case of Slovenia By Žgajnar, Jaka
  16. Will the New Dairy Margin Protection Program Reduce Risk for Dairies? By Mark, Tyler ; Burdine, Kenneth
  17. Do first time buyers default less? Implications for macro-prudential policy By Kelly, Robert ; O'Malley, Terry ; O'Toole, Conor
  18. Market Signals and the Cost of Credit Risk Protection: An Analysis of CDS Settlement Auctions By L. Zanforlin ; Nobuyuki Kanazawa
  19. Securitisation and banking risk: What do we know so far? By Yener Altunbas ; Alper Kara ; Aydin Ozkan
  20. Default and Risk Premia in Microfinance Group Lending By P Simmons (York) ; N Tantisantiwong (Southampton)
  21. Idiosyncratic Risk and the Manager By Oliver Levine ; Brent Glover

  1. By: Paul H. Kupiec (American Enterprise Institute )
    Abstract: Conditional value at risk (CoVaR) and marginal expected shortfall (MES) have been proposed as stock return based measures of the systemic risk created by individual financial institutions even though the literature provides no formal hypothesis test for detecting systemic risk. Our conclusion is that CoVaR and MES are not reliable measures of systemic risk.
    Keywords: systemic risk, AEI Economic Policy Working Paper Series, The Ledger, CoVaR, MES
    JEL: A
    Date: 2015–01
  2. By: Ghamami, Samim (Board of Governors of the Federal Reserve System (U.S.) ); Zhang, Bo (IBM Thomas J. Watson Research Center )
    Abstract: Counterparty credit risk (CCR), a key driver of the 2007-08 credit crisis, has become one of the main focuses of the major global and U.S. regulatory standards. Financial institutions invest large amounts of resources employing Monte Carlo simulation to measure and price their counterparty credit risk. We develop efficient Monte Carlo CCR estimation frameworks by focusing on the most widely used and regulatory-driven CCR measures: expected positive exposure (EPE), credit value adjustment (CVA), and effective expected positive exposure (EEPE). Our numerical examples illustrate that our proposed efficient Monte Carlo estimators outperform the existing crude estimators of these CCR measures substantially in terms of mean square error (MSE). We also demonstrate that the two widely used sampling methods, the so-called Path Dependent Simulation (PDS) and Direct Jump to Simulation date (DJS), are not equivalent in that they lead to Monte Carlo CCR estimators which are drastically different in terms of their MSE.
    Keywords: Basel II; Basel III; OTC derivatives market; risk management; counterparty credit ris; credit value adjustment; efficient Monte Carlo simulatio
    Date: 2014–12–17
  3. By: Haim Shalit (BGU )
    Keywords: Mutual funds, risk ranking, CVaR, riskiness, Lorenz curve.
    Date: 2014
  4. By: Marcelo Brutti Righi ; Paulo Sergio Ceretta
    Abstract: We present the Shortfall Deviation Risk (SDR), a risk measure that represents the expected loss that occur with certain probability penalized by the dispersion of results worse than such expectation. The SDR combines the Expected Shortfall (ES) and the Shortfall Deviation (SD), which we also introduce, contemplating the two fundamental pillars of the risk concept, the probability of adverse events (ES) and the variability of an expectation (SD), and considers extreme results. We demonstrate that the SD is a generalized deviation measure, whereas the SDR is a coherent risk measure. We achieve the dual representation of the SDR, and we discuss issues such as its representation by a weighted ES, acceptance sets, convexity, continuity and the relationship with stochastic dominance. Illustrations using Monte Carlo simulation and real data indicate that the SDR offers greater protection to measure risk than other measures, especially in turbulent times.
    Date: 2015–01
  5. By: Rohini Kumar
    Abstract: In this article, we look at the effect of volatility clustering on the risk indifference price of options described by Sircar and Sturm in their paper (Sircar, R., & Sturm, S. (2012). From smile asymptotics to market risk measures. Mathematical Finance. Advance online publication. doi:10.1111/mafi.12015). The indifference price in their article is obtained by using dynamic convex risk measures given by backward stochastic differential equations. Volatility clustering is modelled by a fast mean-reverting volatility in a stochastic volatility model for stock price. Asymptotics of the indifference price of options and their corresponding implied volatility are obtained in this article, as the mean-reversion time approaches zero. Correction terms to the asymptotic option price and implied volatility are also obtained.
    Date: 2015–01
  6. By: International Monetary Fund. Monetary and Capital Markets Department
    Abstract: The Georgian banking sector is sound and stable and has continued to perform well, but faces a number of key risks and vulnerabilities that need to be closely monitored. Particularly challenging among them are credit and funding risks related to dollarization, concentration in the banking sector, and reliance on nonresident deposits. While NPLs are gradually declining from their peak in 2009, credit growth is above its long-term sustainable trend. Dollarization presents specific challenges as it increases credit and liquidity risks. There are two major dollarization-related problems: First, most of the borrowers in U.S. dollars (USD) are unhedged, as their income and expenditures are in national currency (this is especially evident in case of households). Second, the NBG has limited ability to provide liquidity support in USD and other foreign currencies. However, it should be noted that the NBG is implementing a set of macroprudential measures aimed at making FX lending more expensive for banks. For example, current risk weights for FX loans are topped at 175 percent. Separate stress tests (STs) performed by the NBG and by the FSAP mission show that the banking system as a whole is able to withstand severe shocks, given that most banks maintain healthy capital buffers well above regulatory minimum. The tests were conducted in several scenarios ranging from slow growth to severe macroeconomic shocks, and the results show that major banks would generally remain adequately capitalized, taking into account current profits and introduction of Basel II. In adverse scenarios, recapitalization needs are manageable in terms of GDP (1.6 percent for the worst-case scenario). At the same time, uncertainty due to non-linearity of shocks related to lari depreciation warrant continuation of build-up of capital buffers as long as FX denominated loans constitute substantial share of banks’ loan portfolios. Credit portfolio concentration risks are limited: default by the largest three borrowers would require additional capital of GEL 50 million for five banks. Market risks are very limited, and trading books do not exist. However, some banks are particularly vulnerable and need to strengthen their capital buffers and to mitigate funding risks. These banks exceed the minimum capital requirement by only a few percentage points (p.p.), which limits their loss-absorption capacity. The high level of profitability and solid net interest margins would go down during crisis periods, driving down net interest and other income. To avoid this pitfall, it is important to introduce Individual Capital Guidance, especially for the weakest banks. When it comes to funding risks, further diversification of funding sources and de-dollarization could help to minimize identified vulnerabilities.
    Keywords: Financial Sector Assessment Program;Banking sector;Liquidity;Credit risk;Stress testing;Economic models;Statistical annexes;Georgia;
    Date: 2015–01–08
  7. By: Zhou, Richard
    Abstract: Path dependent counterparty credit risk exposure modeling poses challenges. In this paper, we discuss practical models for consistent and accurate estimation of counterparty credit exposure involving path-dependent derivatives. We derive analytical formulas for standalone expected exposure (EE), potential future exposure (PFE) and unilateral CVA for swap, swaption and barrier option. These formulas are of practical importance to financial institutions that use standalone exposure profiles, as well as to facilitate model validation and benchmarking.
    Keywords: Counterparty credit risk, path-dependent, PFE, EE
    JEL: C02 C6
    Date: 2015–01–08
  8. By: Piotr Arendarski (Poznan University of Economics ); Paweł Misiewicz (Quantitative Finance Research Group, University of Warsaw ); Mariusz Nowak (Quantitative Finance Research Group, University of Warsaw ); Tomasz Skoczylas (Faculty of Economic Sciences, University of Warsaw ); Robert Wojciechowski (Faculty of Economic Sciences, University of Warsaw )
    Abstract: In this paper we propose Generalized Momentum Asset Allocation Model (GMAA). GMAA is a new approach to construct optimal portfolio and is based on close examination of asset’s returns distribution. GMAA tries to capture certain market phenomena and use information they contain as predictors for future returns. Our model is validated using MSCI Indexes with MSCI World Index set as a benchmark. We find results rather promising as we managed to significantly reduce portfolio volatility and obtain stable path of cumulative returns of portfolio. Our model outperforms benchmark in terms of Information Ratio or Maximum Drawdown. Detailed sensitivity analysis was conducted at the end of this paper and it shows that our strategy is sensitive to a few optimization parameters thus further research may be required.
    Keywords: asset allocation, diversification, momentum, trading strategy, capital asset pricing models, returns forecasting, efficient risk and return measures
    JEL: C53 G11 G14 G15 G23 C61 C22
    Date: 2014
  9. By: Ojo, Marianne
    Abstract: The U.S standard leverage ratio, which is not as stringent as the U.S Supplementary Leverage Ratio, did not include Off Balance Sheet exposures - unlike the Basel leverage ratio. Hence the 3% Supplementary Leverage Ratio was established as part of measures to facilitate the inclusion of Off Balance Sheet exposures in July 2013 - even though many still consider the scope of such inclusion as not being extensive enough - since Secured Financing Transaction Exposures are still excluded. Furthermore, the Enhanced Supplementary Leverage Ratio increased the 3% leverage ratio to 5% (a 2% buffer) for globally systemic important banks (GSIBs) bank holding companies and 6 % for their banking subsidiaries. In respect of securities financing transaction exposures, however, U.S banks are considered to enjoy competitive advantage, since the exclusion of such exposures still persist - even though it is also argued that recent liquidity coverage and net stable funding ratio provisions should serve to address these exposures - this also being in line with the complementary functions of liquidity standards and leverage ratios within the risk-based capital adequacy framework. As well as contributing to the extant literature on supplementary leverage ratios, this paper will seek to illustrate why calibration between the risk capital adequacy framework, liquidity standards, and Basel leverage ratio is even more important than merely a focus on the relationship between the risk capital adequacy framework and the Basel leverage ratio. Meanwhile as regards Europe, there are also concerns relating to sovereign credit risks and the “inadequate pricing” of such risks which results in under capitalisation of banks, as well as potential consequences relating to serious distortions in financial stability whose effects could have repercussions extending beyond the Euro zone and globally. This paper considers two headings which have generated controversial discussions - particularly in respect of Basel III leverage ratio implementation, namely, under capitalisation of banks and the issue of calibration. It aims to illustrate why these constitute areas which are still in need of redress - even though tremendous efforts have been made to align the Basel III Leverage Ratio with the Supplementary Leverage Ratios. The paper will also demonstrate that whilst there are concerns related to the issue of calibration, certain jurisdictions such as the UK, have also introduced supplementary leverage ratios - as well as considered alternatives to the Basel leverage ratio.
    Keywords: supplementary leverage ratios; short term funding; financial stability; OBS exposures; Standardised Approach to Counterparty Credit Risk (SA-CCR); credit conversion factors (CCF)
    JEL: E6 G14 G2 G28 K2
    Date: 2015–01–15
  10. By: Lukas Menkhoff ; Sahra Sakha
    Abstract: We compare seven established risk elicitation methods and investigate how they explain an extensive set of risky behavior from a large household survey. We find overall positive correlation between items and low explanatory power in terms of behavior. Using an average of seven risk elicitation methods reduces measurement noise and yields more predictive power. A reduced set of risk items yields the same external validity as the average of all seven methods. Hence, our multiple-item risk measures offer a more reliable way to measure risk preferences. Our results caution against the reliability of one risk method alone due to noise
    Keywords: Risk attitude; lab-in-the-field experiments; household survey; economic development
    JEL: D81 C93 O12
    Date: 2014–12
  11. By: International Monetary Fund. Monetary and Capital Markets Department
    Abstract: There have been significant improvements in both the quality of regulation and the supervisory approach since the 2007 FSAP. Many amendments to existing laws, new laws, and regulations have been introduced, aimed at addressing shortfalls identified in the 2007 FSAP. These improvements will be evident throughout this assessment. At the same time, a number of weaknesses have been identified. Among these is an operational risk within the NBG’s own Banking Supervisory Department. There has been a very high level of staff turnover in recent years due to a lack of salary competitiveness vis-à-vis the commercial banks, and there appears to be over-reliance on key personnel. Also, the level and type of staff training need to be expanded. While the NBG puts significant effort into understanding the risk profile of each individual bank and the banking system as a whole, more attention is needed to improve the quality of risk management of the banks. In a number of areas, notably bank licensing, the NBG relies on its broad supervisory powers to carry out its functions in the absence of detailed explicit powers. While this regime generally seems to work well in practice, it could leave the NBG open to challenge where these broad powers are not supported by more granular powers. Recently, several amendments to the legislation have been introduced in order to address these shortcomings.
    Keywords: Financial Sector Assessment Program;Banking sector;Bank supervision;Reports on the Observance of Standards and Codes;Georgia;
    Date: 2015–01–08
  12. By: Richard Simper (University of Nottingham, England ); Maximilian J.B. Hall (Loughborough University, England ); Wenbin B. Liu (University of Kent, England ); Valentin Zelenyuk (School of Economics, The University of Queensland ); Zhongbao Zhou (Hunan University, P. R. China )
    Abstract: Adopting a profit-based approach to the estimation of the technical efficiency of South Korean banks over the 2007Q3 to 2011Q2 period, we systematically analyse, within a non-parametric DEA analysis, how the choice of risk management control variable impacts upon such estimates. Using the model of Liu et al. (2010), we examine the dependency of the estimated technical efficiency scores on the chosen risk control variables embracing loan loss provisions and equity as good inputs and non-performing loans as a bad output. We duly find that, both for individual banks and banking groups, the mean estimates are indeed model dependent although, for the former, rank correlations do not change much at the extremes. Based on the application of the Simar and Zelenyuk (2006) adapted Li (1996) test, we then find that, if only one of the three risk control variables is to be included in such an analysis, then it should be loan loss provisions. We also show, however, that the inclusion of all three risk control variable is to be preferred to just including one, but that the inclusion of two such variables is about as good as including all three. We therefore conclude that the optimal approach is to include (any) two of the three risk control variables identified. The wider implication for research into bank efficiency is that the optimal choice of risk management control variable is likely to be crucial to both the delivery of un-biased estimates of bank efficiency and the specification of the model to be estimated.
    Keywords: South Korean Banks,Risk Management,Efficiency,DEA
    JEL: C23 C52 G21
    Date: 2014–12
  13. By: Arata, Linda ; Donati, Michele ; Sckokai, Paolo ; Arfini, Filippo
    Abstract: In this paper we develop a new methodological proposal to incorporate risk into a farm level Positive Mathematical Programming (PMP) model. Our model presents some innovations with respect to the previous literature and estimates simultaneously the resource shadow prices, the farm non-linear cost function and a farm-specific coefficient of absolute risk aversion. The proposed model has been applied to three farm samples and the estimation results confirm the calibration ability of the model and show values for risk aversion coefficients consistent with the literature. Finally we simulate different scenarios of crop price volatility to test the model reactions as well as the potential role of an agri-environmental scheme as risk management tool.
    Keywords: risk aversion, positive mathematical programming, farm behaviour, Research Methods/ Statistical Methods, Risk and Uncertainty,
    Date: 2014–08
  14. By: International Monetary Fund. Monetary and Capital Markets Department
    Abstract: Korea experienced significant financial distress in the late 1990s along with some of its Asian neighbors. The authorities’ experience in handling this crisis and the experience in handling the fallout from the global financial crisis in 2007–08 helped them establish a broad crisis management framework in Korea. Improving and formalizing the framework for crisis management would help preserve and build upon institutional memory. Authorities can consider formally setting up an apex forum for leading the inter-agency cooperation and coordination work on crisis preparedness and crisis management. With a view to avoid duplication, the authorities may consider upgrading the Macroeconomic Financial Meeting (MEFM) with participation by the heads of the Ministry of Strategy and Finance (MOSF), Financial Services Commission (FSC), Financial Supervisory Service (FSS), Bank of Korea (BOK), and Korea Deposit Insurance Corporation (KDIC) as members, and by including crisis preparedness and crisis management as an explicit mandate. The essential elements of a financial safety net are available in Korea, and the Emergency Liquidity Assistance (ELA) framework and deposit insurance system can be improved to make the safety net more responsive. For ELA, this can be achieved by reviewing and revising the legal and procedural aspects to remove any scope for delays in actual disbursement of funds. For deposit insurance system, improvements can be made by bringing the deposit insurance fund out of deficit, and assuring a back-up funding. The financial safety net is well supported by an efficient framework of financial sector supervision. While the corrective action framework has some of the main elements in place it can, among others, be improved in the following areas for better effectiveness: (a) reviewing the triggers for corrective actions and improving their objectivity to enable timely intervention, including even before banks breach regulatory thresholds; and (b) putting in place norms and guidance determining the use of the powers to postpone or suspend corrective actions.
    Keywords: Financial Sector Assessment Program;Financial sector;Financial risk;Crisis prevention;Bank supervision;Bank resolution;Financial safety nets;Deposit insurance;Risk management;Korea, Republic of;
    Date: 2015–01–09
  15. By: Žgajnar, Jaka
    Abstract: This paper presents possible approach how different sources of data at farm level, national statistics and analytical models could be merged in simulation process to analyse income risk at the sector level. Baseline is production structure resumed out of annual subsidy applications as key information per each agricultural holding within the sector. Presented approach utilises potential of random number generator and random distributions of Monte Carlo to roughly reconstruct different sources of risks in different states of nature that may occur with diverse probabilities at the particular farm. In such a manner income situation at sector level is analysed. The developed approach is tested on the 21 farm types further divided into 13 economic classes. Obtained preliminary results suggest that this could be useful approach for rough estimation of income risk and points on some limitations and drawbacks that should be further improved.
    Keywords: Income risk, Monte Carlo simulation, Agriculture, Farm types, Production Economics, Risk and Uncertainty,
    Date: 2014–09
  16. By: Mark, Tyler ; Burdine, Kenneth
    Keywords: Farm Management, Production Economics,
    Date: 2015
  17. By: Kelly, Robert (Central Bank of Ireland ); O'Malley, Terry (Central Bank of Ireland ); O'Toole, Conor (Central Bank of Ireland )
    Abstract: Macro-prudential policy is designed to address risk at a systemwide level, an example of which is mortgage default following excessive residential property lending in Ireland. Policy tools to address this risk, such as caps on loan- to-value and loan-to-income ratios, are used to build balance sheet resilience and by design should re ect the risk profile of borrower groups. This research considers whether default rates are different between first time buyers and second and subsequent buyers and finds that first time buyers have lower default rates having controlled for borrower and loan characteristics. This research is consistent with differential regulatory treatment of first time buyers with default risk remaining comparable to the remainder of mortgage lending.
    Date: 2014–12
  18. By: L. Zanforlin ; Nobuyuki Kanazawa
    Abstract: We study the link between the probability of default implied by Credit Default Swaps (CDS) spreads and the final prices of the defaulted bonds as established at the CDS settlement auctions. We observe that the post-default recovery rates at the observed spreads imply markets were often “surprised†by the credit event. We find that the prices of the bonds that are deliverable at the auctions imply probabilities of default that are systematically different than the default probabilities estimated prior to the event of default using standard methodologies. We discuss the implications for CDS pricing models. We analyze the discrepancy between the actual and theoretical CDS spreads and we find it is significantly associated both to the CDS market microstructure at the time of the settlement auction and to the general macroeconomic background. We discuss the potential for strategic bidding behavior at the CDS settlement auctions.
    Keywords: Credit default swap;Financial markets;Credit risk;Bonds;Auctions;Credit Default Swaps, Market signals, Derivative Markets.
    Date: 2014–12–24
  19. By: Yener Altunbas (Bangor University ); Alper Kara (University of Hull ); Aydin Ozkan (University of Bradford )
    Abstract: Bank securitisation is deemed to have been a major contributing factor to the 2007/08 financial crises via fuelling credit growth accompanied by lower banksÕ credit standards. Yet, prior to the crisis a common view was that securitisation activity makes the financial system more stable as risk was more easily diversified, managed and allocated economy-wide. In this survey paper we review the extant literature to explore the so far generated knowledge on the impact of securitisation on banking risks. In particular, we examine the theoretical arguments and empirical studies on securitisation and banking risks before and after the global financial crisis of 2007/08. We identify the limitations of empirical studies and assess the comparability of findings. Theoretical literature univocally accentuate the undesirable consequences of securitisation, which may promote retention of riskier loans, undermine banksÕ screening and monitoring incentives and enhance banksÕ risk appetite. However, empirical evidence does not uniformly support the theoretical conclusions. If banks are securitisation active they lend more to risky borrowers, have less diversified portfolios and hold less capital, retain riskier loans and are aggressive in loan pricing. Others argue that securitisation reduces banks insolvency risk, increases profitability, provides liquidity and leads to greater supply of loans. Mortgage securitisation is an area where there is consistent evidence of bank risk taking via securitisation.
    Keywords: securitisation,banking risks, financial crisis
    Date: 2014–10
  20. By: P Simmons (York) ; N Tantisantiwong (Southampton)
    Abstract: For a risk neutral lender and a group of borrowers facing identical revenue risks we compare individual loans and group lending. We stress the importance of group liquidity in defining the necessary risk premium. There are no welfare differences between the loan forms. However, the default rates and risk premia vary ambiguously between the loan forms. Simulations replicating empirical interest rates and default rates show that the group interest rate is lower for a larger group while the effect of group size on default risk is ambiguous. We then consider the case of identical correlated risks between borrowers. Positive correlation of projects gives a higher downward risk, so a higher group interest rate and a higher fraction of successes are required. Unlike independent group lending, the interest rate and the default risk are not lower in the larger group loan with correlated returns. Simulations using beta-binomial distributionsare presented.
    Keywords: Group lending, default rate, interest rate, correlated outcomes
    JEL: G21 O16
    Date: 2014–12
  21. By: Oliver Levine (University of Wisconsin-Madison ); Brent Glover (Carnegie Mellon University )
    Abstract: Compensating a manager with equity-based pay induces effort but also exposes the manager to firm-specific risk. In comparison to a diversified shareholder, this distorts the manager's discount rate and, in turn, investment and financing decisions. We embed this agency conflict in a structural model of the firm and estimate its effect on firm policies. We estimate the agency friction for a large panel of U.S. public firms and find significant cross-sectional and time-series variation in a manager's incentive to over- or under-invest. Our panel of incentive estimates helps to explain a broad set of empirical patterns, including investment, leverage, cash holdings, valuation ratios, and acquisition activity.
    Date: 2014

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