nep-rmg New Economics Papers
on Risk Management
Issue of 2015‒02‒05
nineteen papers chosen by

  1. Risk models–at–risk By Christophe M. Boucher; Jon Danielsson; Patrick S. Kouontchou; Bertrand B. Maillet
  2. Model risk of risk models By Jon Danielsson; Kevin R. James; Marcela Valenzuela; Ilknur Zer
  3. Multivariate Stop loss Mixed Erlang Reinsurance risk: Aggregation, Capital allocation and Default risk By Gildas Ratovomirija
  4. Insurability of Cyber Risk: An Empirical Analysis By Biener, Christian; Eling, Martin; Wirfs, Jan Hendrik
  5. The Impact of Credit Risk Transfer on Islamic Banks Lending Behavior and Financial Stability By Elzahi , Abd elrahman; Ali, Saaid
  6. Systemic losses due to counterparty risk in a stylized banking system By Annika Birch; Tomaso Aste
  7. Extreme Risk, excess return and leverage: the LP formula. By Olivier Le Marois; Julia Mikhalevski; Raphaël Douady
  8. Chasing Volatility. A Persistent Multiplicative Error Model With Jumps By Massimiliano Caporin; Eduardo Rossi; Paolo Santucci De Magistris
  9. Risk Management and Portfolio Optimization for Gas- and Coal-fired Power Plants in Germany: A Multivariate GARCH Approach By Charalampous, Georgios; Madlener, Reinhard
  10. A Markov chain model for contagion By Angelos Dassios; Hongbiao Zhao
  11. Network Formation and Systemic Risk, Second Version By Selman Erol; Rakesh Vohra
  12. Return dynamics and volatility spillovers between FOREX and MENA stock markets: what to remember for portfolio choice? By Arfaoui, Mongi; Ben Rejeb, Aymen
  13. The determinants of systemic importance By Kyle Moore; Chen Zhou
  14. A proposal for an open-source financial risk model By Jong Ho Hwang
  15. Risk-adjusted pricing of bank’s assets based on cash flow matching matrix By Voloshyn, Ihor; Voloshyn, Mykyta
  16. Exact simulation of Hawkes process with exponentially decaying intensity By Angelos Dassios; Hongbiao Zhao
  17. Option-Based Credit Spreads By Culp, Christopher L.; Nozawa, Yoshio; Veronesi, Pietro
  18. The role of insurance in reducing direct risk: the case of flood insurance By Swenja Surminski
  19. Expert assessment on agri-food implications of March 2011 earthquake, tsunami and Fukushima nuclear accident in Japan By Bachev, Hrabrin

  1. By: Christophe M. Boucher; Jon Danielsson; Patrick S. Kouontchou; Bertrand B. Maillet
    Abstract: The experience from the global financial crisis has raised serious concerns about the accuracy of standard risk measures as tools for the quantification of extreme downward risk. A key reason for this is that risk measures are subject to model risk due, e.g., to specification and estimation uncertainty. While the authorities would like financial institutions to assess model risk, there is no accepted approach for such computations. We propose a remedy for this by a general framework for the computation of risk measures robust to model risk by empirically adjusting imperfect risk forecasts by outcomes from backtesting, considering the desirable quality of VaR models such as the frequency, independence and magnitude of violations. We also provide a fair comparison between the main risk models using the same metric that corresponds to model risk required corrections.
    Keywords: model risk; value–at–risk; backtesting
    JEL: F3 G3
    Date: 2013–12–13
  2. By: Jon Danielsson; Kevin R. James; Marcela Valenzuela; Ilknur Zer
    Abstract: This paper evaluates the model risk of models used for forecasting systemic and market risk. Model risk, which is the potential for different models to provide inconsistent outcomes, is shown to be increasing with and caused by market uncertainty. During calm periods, the underlying risk forecast models produce similar risk readings, hence, model risk is typically negligible. However, the disagreement between the various candidate models increases significantly during market distress, with a no obvious way to identify which method is the best. Finally, we discuss the main problems in risk forecasting for macro prudential purposes and propose an evaluation criteria for such models.
    Keywords: Value-at-Risk; expected shortfall; systemic risk; model risk; CoVaR; MES;financial stability; risk management; Basel III
    JEL: J1
    Date: 2014–04–30
  3. By: Gildas Ratovomirija
    Abstract: In this paper, we address the aggregation of dependent stop loss reinsurance risks where the dependence among the ceding insurer(s) risks is governed by the Sarmanov distribution and each individual risk belongs to the class of Erlang mixtures. We investigate the e?ects of the ceding insurer(s) risk dependencies on the reinsurer risk profile by deriving a closed formula for the distribution function of the aggregated stop loss reinsurance risk. Furthermore, diversification e?ects from aggregating reinsurance risks are examined by deriving a closed expression for the risk capital needed for the whole portfolio of the reinsurer and also the allocated risk capital for each business unit under the TVaR capital allocation principle. Moreover, given the risk capital that the reinsurer holds, we express the default probability of the reinsurer analytically. In case the reinsurer is in default, we determine analytical expressions for the amount of the aggregate reinsured unpaid losses and the unpaid losses of each reinsured line of business of the ceding insurer(s). These results are illustrated by numerical examples.
    Date: 2015–01
  4. By: Biener, Christian; Eling, Martin; Wirfs, Jan Hendrik
    Abstract: This paper discusses the adequacy of insurance for managing cyber risk. To this end, we extract 994 cases of cyber losses from an operational risk database and analyze their statistical properties. Based on the empirical results and recent literature, we investigate the insurability of cyber risk by systematically reviewing the set of criteria introduced by Berliner (1982). Our findings emphasize the distinct characteristics of cyber risks compared to other operational risks and bring to light significant problems resulting from highly interrelated losses, lack of data, and severe information asymmetries. These problems hinder the development of a sustainable cyber insurance market. We finish by discussing how cyber risk exposure may be better managed and make several suggestions for future research.
    Keywords: Cyber Risk, Cyber Insurance, Operational Risk, Insurability
  5. By: Elzahi , Abd elrahman (The Islamic Research and Teaching Institute (IRTI)); Ali, Saaid (The Islamic Research and Teaching Institute (IRTI))
    Abstract: The recent financial crisis has further emphasized the importance of investigating the application of risk management techniques in Islamic banks. Previous conventional studies have showed that banks can be less risk averse in their credit portfolio management when they apply any sort of risk transfer techniques. In this study, data from 60 Islamic banks have been collected and analyzed in a panel pooled framework to investigate the impact of credit risk transfer (CRT) techniques on the lending behavior of Islamic banks. Results have showed that Islamic banks may expand their lending portfolios when practicing some sort of credit risk transfer techniques. These results are consistent with the results achieved in conventional banking studies. Hence the study concludes that despite the theoretical differences, Islamic banks may behave like conventional banks when using some sort of risk management methods. Given the recent global financial instability, the results of this study give strong policy implications to the Islamic banks management as well as to the regulators.
    Keywords: Financial Stability; Islamic Banks Risk Management
    Date: 2015–01–20
  6. By: Annika Birch; Tomaso Aste
    Abstract: We report a study of a stylized banking cascade model investigating systemic risk caused by counterparty failure using liabilities and assets to define banks' balance sheet. In our stylized system, banks can be in two states: normally operating or distressed and the state of a bank changes from normally operating to distressed whenever its liabilities are larger than the banks' assets. The banks are connected through an interbank lending network and, whenever a bank is distressed, its creditor cannot expect the loan from the distressed bank to be repaid, potentially becoming distressed themselves. We solve the problem analytically for a homogeneous system and test the robustness and generality of the results with simulations of more complex systems. We investigate the parameter space and the corresponding distribution of operating banks mapping the conditions under which the whole system is stable or unstable. This allows us to determine how financial stability of a banking system is influenced by regulatory decisions, such as leverage; we discuss the effect of central bank actions, such as quantitative easing and we determine the cost of rescuing a distressed banking system using re-capitalisation. Finally, we estimate the stability of the UK and US banking systems comparing the years 2007 and 2012 by using real data.
    Keywords: banking crisis; counterparty risk; random field ising model; systemic risk
    JEL: N0
    Date: 2014–09
  7. By: Olivier Le Marois (Fluks); Julia Mikhalevski (FEDERIS Gestion d'actif); Raphaël Douady (Centre d'Economie de la Sorbonne et Riskdata)
    Abstract: The LP formula is based upon the substitution of the exogenous risk aversion hypothesis by a credit equilibrium hypothesis. This leads to a trade-off between expected blue-sky return – the expected return excluding default scenarios – and extreme risk estimated from scenarios leading to default. An empirical study on the past 90 years shows that this trade-off curve is almost identical across asset classes. In equilibrium, an asset expected blue-sky return is proportional to its contribution to extreme risk. Assuming normal returns, we obtain CAPM as a sub-case of the LP relation. This relationship makes extreme risk underestimation a strong driver of asset price bubbles.
    Keywords: Asset allocation, extreme risk, CAPM, risk budgeting, equilibrium.
    JEL: G11
    Date: 2014–12
  8. By: Massimiliano Caporin (University of Padova); Eduardo Rossi (University of Pavia); Paolo Santucci De Magistris (University of Aahrus)
    Abstract: The realized volatility of financial returns is characterized by persistence and occurrence of unpredictable large increments. To capture those features, we introduce the Multiplicative Error Model with jumps (MEM-J). When a jump component is included in the multiplicative specification, the conditional density of the realized measure is shown to be a countably infinite mixture of Gamma and K distributions. Strict stationarity conditions are derived. A Monte Carlo simulation experiment shows that maximum likelihood estimates of the model parameters are reliable even when jumps are rare events. We estimate alternative specifications of the model using a set of daily bipower measures for 7 stock indexes and 16 individual NYSE stocks. The estimates of the jump component confirm that the probability of jumps dramatically increases during the financial crises. Compared to other realized volatility models, the introduction of the jump component provides a sensible improvement in the fit, as well as for in-sample and out-of-sample volatility tail forecasts.
    Keywords: Multiplicative Error Model with Jumps, Jumps in volatility, Realized measures, Volatility-at-Risk.
    JEL: C22 C58 G10
    Date: 2014–09
  9. By: Charalampous, Georgios (International Hellenic University); Madlener, Reinhard (E.ON Energy Research Center, Future Energy Consumer Needs and Behavior (FCN))
    Abstract: This study revisits risk management in the German power market, specifically focusing on conventional thermal power generation. The subsidizing and prioritizing of electricity produced from renewable energy sources (RES) by means of the Renewable Energy Sources Act (EEG) has changed the market’s structure. Specifically, it has led to an erosion of the revenues gained by coal- and natural-gas-fired power plants and, therefore, undermined the competitiveness of traditional power generation. This fact has brought to the forefront the necessity of mitigating the risk exposure in order to tackle the worsening situation for conventional power plant owners. The approach adopted in this paper is to assess and choose the optimum forward contract for hedging the power output and fuel purchase simultaneously. This is done by evaluating the hedging effectiveness of the futures contracts available at the European Energy Exchange (EEX) in Leipzig. The hedging performance is evaluated on the basis of a multivariate GARCH model (the BEKK model). Finally, in the framework of portfolio optimization, we construct the efficient frontier, so as to identify the point at which the combination of spot and forward prices gives the minimization of risk exposure.
    Keywords: Risk management; Energy markets; Energy derivatives; Hedging strategies
    JEL: G11 Q59
    Date: 2013–12
  10. By: Angelos Dassios; Hongbiao Zhao
    Abstract: We introduce a bivariate Markov chain counting process with contagion for modelling the clustering arrival of loss claims with delayed settlement for an insurance company. It is a general continuous-time model framework that also has the potential to be applicable to modelling the clustering arrival of events, such as jumps, bankruptcies, crises and catastrophes in finance, insurance and economics with both internal contagion risk and external common risk. Key distributional properties, such as the moments and probability generating functions, for this process are derived. Some special cases with explicit results and numerical examples and the motivation for further actuarial applications are also discussed. The model can be considered a generalisation of the dynamic contagion process introduced by Dassios and Zhao (2011).
    Keywords: risk model; contagion risk; bivariate point process; Markov chain model; discretised dynamic contagion process; dynamic contagion process
    JEL: F3 G3
    Date: 2014–11–05
  11. By: Selman Erol (Department of Economics, University of Pennsylvania); Rakesh Vohra (Department of Economics, and Department of Electrical & Systems Engineering, University of Pennsylvania)
    Abstract: This paper introduces a model of endogenous network formation and systemic risk. In it, strategic agents form networks that efficiently trade-off the possibility of systemic risk with the benefits of trade. Efficiency is a consequence of the high risk of contagion which forces agents to endogenize their externalities. Second, fundamentally ‘safer’ economies generate much higher interconnectedness, which in turn leads to higher systemic risk. Third, the structure of the network formed depends crucially on whether the shocks to the system are believed to be correlated or independent of each other. This underlines the importance of specifying the shock structure before investigating a given network as a particular network and shock structure could be incompatible.
    Keywords: Network Formation, Systemic Risk, Contagion, Rationalizability, Core
    JEL: D85 G01
    Date: 2014–08–29
  12. By: Arfaoui, Mongi; Ben Rejeb, Aymen
    Abstract: This article investigates stock-forex markets interdependence in MENA countries for the period spanning from February 26, 1999 to June 30, 2014. The analysis has been performed through three competing models; the VAR-CCC-GARCH model, the VAR-BEKK-GARCH model and the VAR-DCC-GARCH model. Our findings confirm that both markets are interdependent and corroborate with stock and flow oriented approaches. We find also that, comparing to optimal weights, hedge ratios are typically low, which denote that hedging effectiveness is quite good. Estimation of hedging effectiveness allow concluding that the incorporation of foreign exchange in a full stock portfolio increase the risk-adjusted return while reducing its variance. We note here that the forex market is overweighed for both portfolio designs and hedging strategies. More importantly, this evidence holds for all countries as well as for all considered models. These findings open up new insights for managerial and governmental policy purpose.
    Keywords: MENA markets, Foreign exchange, flow oriented model, portfolio balance approach, volatility spillovers, portfolio designs, hedging effectiveness
    JEL: C1 G1 G11
    Date: 2015–01–04
  13. By: Kyle Moore; Chen Zhou
    Abstract: This paper empirically analyses the determinants of banks’ systemic importance. With applying a novel measure on the systemic importance to US bank holding companies in 2000–2010, we show that size is an important determinant of systemic importance, but banks with size above a certain threshold have equal systemic importance. On top of size, engaging heavily in non-traditional banking activities, such as relying on money market fund and generating non-interest income, is also related to high systemic importance. Therefore, in addition to “Too big to fail”, systemically important financial institutions can also be identified by a “Too non-traditional to fail” principle.
    Keywords: too-big-to-fail; systemic risk; extreme value theory
    JEL: J1
    Date: 2014–07–31
  14. By: Jong Ho Hwang
    Abstract: This paper presents a policy proposal for building a new framework for gathering, measuring and disclosing financial risk information in the global economy. The paper examines the current state of the financial risk framework, notes its advantages and disadvantages and proposes a new construct that aims to address some of the shortcomings that are currently in place. The proposed open-source financial risk model separates the dual function that internal risk models perform within financial institutions, first to attempt to optimize the risk-return profile of mostly private economic rent-seeking entities, and second to maximize safety and soundness considerations for the public which is at risk of bearing the consequences of financial actors. The goals of a robust financial risk model are examined in order to determine the design of the proposed risk framework.
    Keywords: open; source; risk; financial; models; governance; public; regulation; supervision; global; institutions
    JEL: F3 G3
    Date: 2013–08–16
  15. By: Voloshyn, Ihor; Voloshyn, Mykyta
    Abstract: To price bank’s assets correctly, it is important to know cost of funds. But funding cost calculation is complicated due to the fact that banks fund long term assets through short-term liabilities. As a result, assets with a given time to maturity are usually financed by several liabilities with different maturities. To calculate funding cost it needs to know how cash flows are matched between assets and liabilities. For this it`s used cash flow matching matrix or funding matrix. In the paper, a new algorithm of filling of a two-dimensional funding matrix that is based on the golden rule of banking and modified RAROC approach is proposed. It provides positive definiteness and uniqueness of the matrix. The matrix shows terms to maturity and amounts of liability cash flows which fund the asset cash flow with a given term to maturity. Examples of partially and fully filled matrices are presented. It is proposed an approach to risk-adjusted pricing that is based on this funding matrix and RAROC-approach adapted to cash flows. The developed approach to pricing integrates organically credit and liquidity risks. It takes into consideration expected credit losses and economic capital (unexpected credit losses) for all lifetime of asset cash flows and not one-year period traditionally used in RAROC.
    Keywords: asset pricing, funding matrix, economic capital, cash flow at risk,risk-adjusted return on capital (RAROC), cash flow matching, interest rate, asset, liability
    JEL: G12 G21
    Date: 2013–12–31
  16. By: Angelos Dassios; Hongbiao Zhao
    Abstract: We introduce a numerically efficient simulation algorithm for Hawkes process with exponentially decaying intensity, a special case of general Hawkes process that is most widely implemented in practice. This computational method is able to exactly generate the point process and intensity process, by sampling interarrival-times directly via the underlying analytic distribution functions without numerical inverse, and hence avoids simulating intensity paths and introducing discretisation bias. Moreover, it is flexible to generate points with either stationary or non-stationary intensity, starting from any arbitrary time with any arbitrary initial intensity. It is also straightforward to implement, and can easily extend to multi-dimensional versions, for further applications in modelling contagion risk or clustering arrival of events in finance, insurance, economics and many other fields. Simulation algorithms for one dimension and multi-dimension are represented, with numerical examples of univariate and bivariate processes provided as illustrations.
    JEL: C1
    Date: 2013–07
  17. By: Culp, Christopher L.; Nozawa, Yoshio; Veronesi, Pietro
    Abstract: Theoretically, corporate debt is economically equivalent to safe debt minus a put option on the firm’s assets. We empirically show that indeed portfolios of long Treasuries and short traded put options ("pseudo bonds") closely match the properties of traded corporate bonds. Pseudo bonds display a credit spread puzzle that is stronger at short horizons, unexplained by standard risk factors, and unlikely to be solely due to illiquidity. Our option-based approach also offers a novel, model-free benchmark for credit risk analysis, which we use to run empirical experiments on credit spread biases, the impact of asset uncertainty, and bank-related rollover risk.
    Keywords: credit spreads; default; Merton model; options
    JEL: G1 G12 G13 G21 G24 G3
    Date: 2014–12
  18. By: Swenja Surminski
    Abstract: The provision of flood insurance is a patchwork, with countries showing varying degrees of penetration, coverage types, demand levels, and design structures. This article explores the current understanding of flood insurance with a specific focus on the ability of flood insurance to contribute to direct risk reduction. The starting point is a consideration of the existing provision of flood insurance, both in established insurance markets and in developing countries. A review of efforts to analyse and explain the use and design of flood insurance highlights how the understanding of supply and demand determinants is steadily growing, while clear gaps also emerge. Particularly the question of utilizing flood insurance in the context of climate change and as a lever for physical risk reduction would benefit from further empirical and theoretical analysis. The article concludes with a reflection on current efforts to reform and design flood insurance and offers some pointers for future research.
    Keywords: Flood insurance; Disaster risk reduction; Flood risk management; Insurance; Climate change; Natural hazards; Adaptation
    JEL: N0
    Date: 2014–12–18
  19. By: Bachev, Hrabrin
    Abstract: The March 11, 2011 earthquake, tsunami and nuclear plant accident have had immense impacts on Japanese agri-food sector. Previous analysis has demonstrated that some of the impacts that triple disaster are difficult to identify and assess due to the insufficient information, controversial data, continuing challenges and uncertainties, etc. In order to expend the assessments we have organized two expert assessments in order to identify the 2011 disasters’ short and longer terms impacts on agriculture, food industries and consumers as well as factors for persistence of negative impacts, and longer-term impacts on major resources, productions, organisations, efficiency, etc. in the most affected regions and the rest of Japan. This paper presents the results of the experts’ assessments on socio-economic impacts of the March 2011 earthquake, tsunami and the Fukushima nuclear disaster on the Japanese agriculture and food sector. Nearly four years after the triple disaster, it gives some tentative assessment on the diverse (specific, combined, short-term, long-term, functional) impacts of the 2011 earthquake, tsunami and nuclear accident on agriculture, food industries, and food consumption in different regions of the country.
    Keywords: great east Japan eartquake, tsunami, Fukushima nuclear accident, social, economic, environmental impacts, agriculture, food industry, food consumption, agri-food chains, disaster risk management
    JEL: Q1 Q12 Q13 Q15 Q18 Q5
    Date: 2015–01

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