
on Risk Management 
Issue of 2015‒03‒05
nineteen papers chosen by 
By:  Patrick Bolton; Neng Wang; Jinqiang Yang 
Abstract:  We formulate a dynamic financial contracting problem with risky inalienable human capital. We show that the inalienability of the entrepreneur’s risky human capital not only gives rise to endogenous liquidity limits but also calls for dynamic liquidity and risk management policies via standard securities that firms routinely pursue in practice, such as retained earnings, possible line of credit drawdowns, and hedging via futures and insurance contracts. 
JEL:  G3 G32 
Date:  2015–02 
URL:  http://d.repec.org/n?u=RePEc:nbr:nberwo:20979&r=rmg 
By:  Alankar, Ashwin (Alliance Bernstein); Blaustein, Peter (Oak Hill Advisors); Scholes, Myron S. (Stanford University) 
Abstract:  Traditional academic literature has relied on socalled "limits to arbitrage" theories to explain why investment managers are unable to eliminate the effects of investor "irrational" preferences (either the assetpricing anomalies or the behavioral finance literature) on asset pricing. We demonstrate, however, that investment managers may not eliminate the observed assetpricing anomalies because they may contribute to their existence. We show that if managers face constraints such as a "trackingerror constraint," coupled with the need to hold liquidity to meet redemptions or to activelymanage investments, they optimally hold highervolatility securities in their portfolios. Investment constraints, such as trackingerror constraints, however, reduce the principalagent problems inherent in delegated asset management and serve as effective riskcontrol tools. Liquidity reserves allow managers to meet redemptions or redeploy risks efficiently. We prove that investment managers will combine a portfolio of active risks (a socalled "alpha portfolio") for a given level of liquidity with a hedging portfolio designed to control tracking error. As the demand for either liquidity or active management increases presumably because of confidence in alpha, the cost of maintaining the trackingerror constraint increases in that the investment managers must finance these demands by selling more lowervolatility securities and holding more higher volatility securities. With more demand for the "alpha" portfolio, managers are forced to buy more of the trackingerror control portfolio. Investment managers and their investors are willing to hold inefficient portfolios and to give up returns, if necessary, to control the trackingerror of their portfolios. Given the liquidity and trackingerror constraints, investment managers concentrate more of their holdings in higher volatility (higher beta) securities. And, we show that it is optimal for investors to limit their manager's use of leverage, which implies that leverage has a different cost other than the cost of borrowing exceeding the return from lending. Empirically, we show that active investment managers, such as mutual funds, hold portfolios that concentrate in higher volatility securities. Moreover, when they change their holdings of their "alpha" portfolios (reduce or increase their tracking error by choice), the relative prices of higher volatility stocks change according to the predictions of the model. That is, if investment managers move closer to a market portfolio, the prices of lowervolatility stocks rise more than the prices of highervolatility stocks given changes in the prices of other market factors. 
Date:  2014–07 
URL:  http://d.repec.org/n?u=RePEc:ecl:stabus:3086&r=rmg 
By:  Ferrari, Stijn; Pirovano, Mara 
Abstract:  This paper presents a novel methodology to calculate thresholds in an early warning signalling framework for extracting signals useful to predict the occurrence of banking crises. The conditional moments based methodology does not rely on assumptions on an objective function trading off Type I and Type II errors and leads to the identification of zones corresponding to different intensities of the signal. The signalling performance of these signalling zones is similar to that of the traditional early warning method based on the optimisation of a policymaker’s loss function; our methodology in fact outperforms the latter for a number of indicators. The methodology is then extended to allow for country specificities, which leads to a substantial improvement of the signalling power. On average, across all indicators, the countryspecific signalling zones outperform the pooled approach, resulting in a larger average true positive rate and a lower false alarms rate. 
Keywords:  Earlywarning indicators; banking crises; panel data; macro prudential policy 
JEL:  C23 E58 G01 
Date:  2015–02 
URL:  http://d.repec.org/n?u=RePEc:pra:mprapa:62406&r=rmg 
By:  Zachary Feinstein; Birgit Rudloff; Stefan Weber 
Abstract:  Systemic risk refers to the risk that the financial system is susceptible to failures due to the characteristics of the system itself. The tremendous cost of this type of risk requires the design and implementation of tools for the efficient macroprudential regulation of financial institutions. The current paper proposes a novel approach to measuring systemic risk. Key to our construction is a rigorous derivation of systemic risk measures from the structure of the underlying system and the objectives of a financial regulator. The suggested systemic risk measures express systemic risk in terms of capital endowments of the financial firms. Their definition requires two ingredients: first, a cash flow or value model that assigns to the capital allocations of the entities in the system a relevant stochastic outcome. The second ingredient is an acceptability criterion, i.e. a set of random variables that identifies those outcomes that are acceptable from the point of view of a regulatory authority. Systemic risk is measured by the set of allocations of additional capital that lead to acceptable outcomes. The resulting systemic risk measures are setvalued and can be studied using methods from setvalued convex analysis. At the same time, they can easily be applied to the regulation of financial institutions in practice. We explain the conceptual framework and the definition of systemic risk measures, provide an algorithm for their computation, and illustrate their application in numerical case studies. We apply our methodology to systemic risk aggregation as described in Chen, Iyengar & Moallemi (2013) and to network models as suggested in the seminal paper of Eisenberg & Noe (2001), see also Cifuentes, Shin & Ferrucci (2005), Rogers & Veraart (2013), and Awiszus & Weber (2015). 
Date:  2015–02 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1502.07961&r=rmg 
By:  Glauben, Thomas; Prehn, Sören; Dannemann, Tebbe; Brümmer, Bernhard; Loy, JensPeter 
Abstract:  Options trading is increasingly important in more volatile agricultural markets. Options allow for unilateral hedging of price risks, e. g. against falling prices only, and are an indispensable risk management instrument for farmers and grain dealers. Concerns that soaring options trading could spark incremental volatility of international agricultural commodity prices have not been empirically verified to date. Econometric assessments for the MATIF grain maize market suggest that option trading does not have a volatility increasing effect. 
Abstract:  Auf volatileren Agrarmärkten gewinnt der Handel mit Optionen zunehmend an Bedeutung. Optionen gestatten die einseitige Absicherung von Preisrisiken, z. B. nur gegen fallende Preise, und stellen ein zunehmend bedeutenderes Instrument für das Risikomanagement von Landwirten und Landhändlern dar. Befürchtungen, dass der zunehmende Handel mit Optionen zu einer erhöhten Volatilität internationaler Agrarrohstoffpreise führen könnte, sind bisher empirisch nicht nachzuweisen. Ökonometrische Schätzungen für den MATIFKörnermaismarkt weisen darauf hin, dass kein volatilitätserhöhender Effekt durch den Optionshandel festzustellen ist. 
Date:  2014 
URL:  http://d.repec.org/n?u=RePEc:zbw:iamopb:20e&r=rmg 
By:  Stefano Battiston; Marco D'Errico; Stefano Gurciullo; Guido Caldarelli 
Abstract:  We develop a novel stresstest framework to monitor systemic risk in financial systems. The modular structure of the framework allows to accommodate for a variety of shock scenarios, methods to estimate interbank exposures and mechanisms of distress propagation. The main features are as follows. First, the framework allows to estimate and disentangle not only firstround effects (i.e. shock on external assets) and secondround effects (i.e. distress induced in the interbank network), but also thirdround effects induced by possible fire sales. Second, it allows to monitor at the same time the impact of shocks on individual or groups of financial institutions as well as their vulnerability to shocks on counterparties or certain asset classes. Third, it includes estimates for loss distributions, thus combining network effects with familiar risk measures such as VaR and CVaR. Fourth, in order to perform robustness analyses and cope with incomplete data, the framework features a module for the generation of sets of networks of interbank exposures that are coherent with the total lending and borrowing of each bank. As an illustration, we carry out a stresstest exercise on a dataset of listed European banks over the years 20082013. We find that secondround and thirdround effects dominate firstround effects, therefore suggesting that most current stresstest frameworks might lead to a severe underestimation of systemic risk. 
Date:  2015–03 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1503.00621&r=rmg 
By:  Ogneva, Maria (?); Piotroski, Joseph D. (Stanford University); Zakolyukina, Anastasia A. (?) 
Abstract:  This paper introduces a new measure of a firm's exposure to systematic distress riskthe probability of a recession at the time of a firm's failure. For stocks in the top quintile of the probability of failure, a median hedge portfolio based on our measure generates a positive risk premium of 5%8% per annum. Our results differ from the previously documented distressrisk anomalya negative correlation between the probability of failure and stock returns. We argue that the probability of failure does not capture systematic distress risk well because it does not differentiate between failures occurring in recessions and expansions. 
Date:  2014–09 
URL:  http://d.repec.org/n?u=RePEc:ecl:stabus:3252&r=rmg 
By:  Meryem Duygun (School of Management, University of Leicester, UK); Juan Carlos MatallínSáez (Department of Finance & Accounting, Universitat Jaume I, Castellón, Spain); Amparo SolerDomínguez (Department of Finance & Accounting, Universitat Jaume I, Castellón, Spain); Emili TortosaAusina (IVIE, Valencia and Department of Economics, Universitat Jaume I, Castellón, Spain) 
Abstract:  This paper analyses the relationship between active management and performance in US equity mutual funds over the period 20012011 for both gross and net returns. Mutual funds achieve nonzero abnormal performance through strategies that produce differentiated results which are not captured by risk factors. Active management is measured by timevarying parameters, idiosyncratic risk and turnover. The results show a negative aggregate performance close to zero. Performance is worse for nonsurvivor mutual funds. A Ushaped relation is found between active management and performance, thus both the best and the worst mutual funds show a higher level of active management. This behaviour is also found in the relationship between expenses and performance. Active management therefore implies selecting different strategies or investment bets with higher expenses and an unequal performance is achieved. However some level of persistence in the success of these bets is only fond for the best mutual funds. Moreover the results of these bets show a low level of similarity in terms of herding between the best funds. In contrast, the failures of the worst mutual funds are not persistent before expenses are considered, but there is a higher level of herding among these funds. In sum, the best funds reflect persistence and particular skills, whereas the worst present nonpersistence and common failures. 
Keywords:  Mutual fund, performance, active management, expenses, persistence, herding 
JEL:  G23 G11 
Date:  2015 
URL:  http://d.repec.org/n?u=RePEc:jau:wpaper:2015/01&r=rmg 
By:  Piergiorgio Alessandri (Bank of Italy); Sergio Masciantonio (Bank of Italy); Andrea Zaghini (Bank of Italy) 
Abstract:  We develop a methodology to identify and rank ‘systemically important financial institutions’ (SIFIs). Our approach is consistent with that followed by the Financial Stability Board but, unlike the latter, it is free of judgment and it is based entirely on publicly available data, thus filling the gap between the official views of the regulator and those that market participants form with their own information set. We apply the methodology on three samples of banks (global, EU and euro area) for the years 200712. 
Keywords:  systemic risk, too big to fail 
JEL:  G21 G01 G18 
Date:  2015–01 
URL:  http://d.repec.org/n?u=RePEc:bdi:opques:qef_259_15&r=rmg 
By:  Thomas Lux (Department of Economics, University of Kiel, Kiel, Germany); Mawuli Segnon (Department of Economics, University of Kiel, Germany); Rangan Gupta (Department of Economics, University of Pretoria) 
Abstract:  This paper uses the Markovswitching multifractal (MSM) model and generalized autoregressive conditional heteroscedasticity (GARCH)type models to forecast oil price volatility over the time periods from January 02, 1875 to December 31, 1895 and from January 03, 1977 to March 24, 2014. Based on six dierent loss functions and by means of the superior predictive ability (SPA) test, we evaluate and compare their forecasting performance at short and long horizons. The empirical results indicate that none of our volatility models can uniformly outperform other models across all six different loss functions. However, the new MSM model comes out as the model that most often across forecasting horizons and subsamples cannot be outperformed by other models, with long memory GARCHtype models coming out second best. 
Keywords:  Crude oil prices, GARCH, Multifractal processes, SPA test 
JEL:  C52 C53 C22 
Date:  2015–03 
URL:  http://d.repec.org/n?u=RePEc:pre:wpaper:201511&r=rmg 
By:  AmelZadeh, Amir (?); Barth, Mary E. (Stanford University); Landsman, Wayne R. (?) 
Abstract:  We describe analytically commercial bank behavior focusing on actions banks take in response to economic gains and losses on their assets to meet regulatory leverage requirements. Our analysis shows that absent differences in regulatory risk weights across assets, leverage cannot be procyclical. We test the analytical description's predictions using a sample of US commercial banks, during economic upturns and downturns, including the recent financial crisis. Although we find a significantly positive relation between change in leverage and change in assets, this procyclical relation evaporates when change in each bank's weighted average regulatory risk weight is included in the estimating equation. We also find that all changes in equity, including those arising from fair value accounting, are significantly negatively related to change in leverage, which is inconsistent with fair value accounting contributing to procyclical leverage. In addition, we find no evidence of a relation between change in leverage and the interaction between change in assets arising from fair value accounting and other changes in assets. Taken together, the empirical evidence indicates that fair value accounting is not a source of procyclical leverage. The key conclusion we draw is that bank regulatory requirements, particularly regulatory leverage determined using regulatory riskweighted assets, explain why banks' leverage can be procyclical, and that fair value accounting does not. 
Date:  2014–03 
URL:  http://d.repec.org/n?u=RePEc:ecl:stabus:3073&r=rmg 
By:  Stephane Crepey; Andrea Macrina; Tuyet Mai Nguyen; David Skovmand 
Abstract:  We develop a multicurve term structure setup in which the modelling ingredients are expressed by rational functionals of Markov processes. We calibrate to LIBOR swaptions data and show that a rational twofactor lognormal multicurve model is sufficient to match market data with accuracy. We elucidate the relationship between the models developed and calibrated under a riskneutral measure Q and their consistent equivalence class under the realworld probability measure P. The consistent Ppricing models are applied to compute the risk exposures which may be required to comply with regulatory obligations. In order to compute counterpartyrisk valuation adjustments, such as CVA, we show how positive default intensity processes with rational form can be derived. We flesh out our study by applying the results to a basis swap contract. 
Date:  2015–02 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1502.07397&r=rmg 
By:  Luc Bissonnette; Michael Hurd; PierreCarl Michaud 
Abstract:  In this paper, we compare individual survival curves constructed from objective (actual mortality) and elicited subjective information (probability of survival to a given target age). We develop a methodology to estimate jointly subjective and objective individualsurvival curves accounting for rounding on subjective reports of perceived mortality risk. We make use of the long followup period in the Health and Retirement Study and the high quality of mortality data to estimate individual survival curves which feature both observed and unobserved heterogeneity. This allows us to compare objective and subjective estimates of remaining life expectancy for various groups, evaluate subjective expectations of joint survival and widowhood by household, and compare objective and subjective mortality with standard lifecycle models of consumption. 
Keywords:  Subjective probabilities, old age mortality, joint survival of couples, 
JEL:  C81 D84 I10 
Date:  2015–02–25 
URL:  http://d.repec.org/n?u=RePEc:cir:cirwor:2015s08&r=rmg 
By:  Gornall, Will (Stanford University); Strebulaev, Ilya A. (Stanford University) 
Abstract:  We develop a model of the joint capital structure decisions of banks and their borrowers. Strikingly high bank leverage emerges naturally from the interplay between two sets of forces. First, seniority and diversification reduce bank asset volatility by an order of magnitude relative to that of their borrowers. Second, previously unstudied supply chain effects mean that highly levered financial intermediaries can offer the lowest interest rates. Low asset volatility enables banks to take on high leverage safely; supply chain effects compel them to do so. Firms with low leverage also arise naturally, as borrowers internalize the systematic risk costs they impose on their lenders. Because risk assessment techniques from the Basel framework underlie our model, we can quantify the impact capital regulation and other government interventions have on leverage and fragility. Deposit insurance and the expectation of government bailouts increase not only bank risk taking, but also borrower risk taking. Capital regulation lowers bank leverage but can lead to compensating increases in the leverage of borrowers, which can paradoxically lead to riskier banks. Doubling current capital requirements would reduce the default risk of banks exposed to high moral hazard by up to 90%, with only a small increase in bank interest rates. 
Date:  2014–04 
URL:  http://d.repec.org/n?u=RePEc:ecl:stabus:3102&r=rmg 
By:  Bokusheva, Raushan 
Abstract:  The study develops the methodology for a copulabased weather index insurance rating. As the copula approach is better suited for modeling tail dependence than the standard linear correlation method, we suppose that copulas are more adequate for pricing a weather index insurance contract against extreme weather events. To capture the dependence structure in the left tail of the joint distribution of a weather variable and the farm yield, we employ the Gumbel survival copula. Our results indicate that, given the choice of an appropriate weather index to signal extreme drought occurrence, a copulabased weather insurance contact might provide higher risk reduction compared to a regressionbased indemnification. 
Keywords:  catastrophic insurance, weather index insurance, copula, insurance contract design 
JEL:  C18 G22 Q14 
Date:  2014–01–22 
URL:  http://d.repec.org/n?u=RePEc:pra:mprapa:62339&r=rmg 
By:  Gordy, Michael B. (Board of Governors of the Federal Reserve System (U.S.)); Szerszen, Pawel J. (Board of Governors of the Federal Reserve System (U.S.)) 
Abstract:  We estimate a reducedform model of credit risk that incorporates stochastic volatility in default intensity via stochastic timechange. Our Bayesian MCMC estimation method overcomes nonlinearity in the measurement equation and statedependent volatility in the state equation. We implement on firmlevel timeseries of CDS spreads, and find strong insample evidence of stochastic volatility in this market. Relative to the widelyused CIR model for the default intensity, we find that stochastic timechange offers modest benefit in fitting the crosssection of CDS spreads at each point in time, but very large improvements in fitting the timeseries, i.e., in bringing agreement between the moments of the default intensity and the modelimplied moments. Finally, we obtain modelimplied outofsample density forecasts via auxiliary particle filter, and find that the timechanged model strongly outperforms the baseline CIR model. 
Keywords:  Bayesian estimation; CDS; CIR process; credit derivatives; MCMC; particle filter; stochastic time change 
JEL:  C11 C15 C58 G12 G17 
Date:  2015–01–06 
URL:  http://d.repec.org/n?u=RePEc:fip:fedgfe:201502&r=rmg 
By:  Conrad, Christian; Loch, Karin 
Abstract:  We propose a new measure of the expected variance risk premium that is based on a forecast of the conditional variance from a GARCHMIDAS model. We find that the new measure has strong predictive ability for future U.S. aggregate stock market returns and rationalize this result by showing that the new measure effectively isolates fundamental uncertainty as the factor that drives the variance risk premium. 
Keywords:  Variance risk premium; return predictability; VIX; GARCHMIDAS; economic uncertainty; volofvol 
Date:  2015–02–27 
URL:  http://d.repec.org/n?u=RePEc:awi:wpaper:0583&r=rmg 
By:  Jan Jurczyk; Alexander Eckrot; Ingo Morgenstern 
Abstract:  It has been shown, that the systemic risk contained in financial markets can be indicated by the change of crosscorrelation between different indices and stocks. This change is tracked by using principle component analysis (PCA). We use this technique to investigate the systemic risk contained in European economy by comparing government long term bonds and indices. 
Date:  2015–02 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1502.07367&r=rmg 
By:  Kowalik, Michal 
Keywords:  Banking; Liquidity; Interbank markets; Secondary markets 
JEL:  G21 G28 
Date:  2014–12–01 
URL:  http://d.repec.org/n?u=RePEc:fip:fedkrw:rwp1418&r=rmg 