nep-rmg New Economics Papers
on Risk Management
Issue of 2015‒04‒02
fourteen papers chosen by

  1. Systemic Risk and Bank Size By Simone Varotto; Lei Zhao
  2. Predicting Systemic Risk with Entropic Indicators By Nikola Gradojevic; Marko Caric
  3. New class of distortion risk measures and their tail asymptotics with emphasis on VaR By Chuancun Yin
  4. Static versus dynamic longevity-risk hedging By Clemente De Rosa; Elisa Luciano; Luca Regis
  5. A Robust Statistics Approach to Minimum Variance Portfolio Optimization By Liusha Yang; Romain Couillet; Matthew R. McKay
  6. Similarity and Clustering of Banks: Application to the Credit Exposures of the Czech Banking Sector By Josef Brechler; Vaclav Hausenblas; Zlatuse Komarkova; Miroslav Plasil
  7. Higher order elicitability and Osband's principle By Tobias Fissler; Johanna F. Ziegel
  8. Uncertainty Aversion and Systemic Risk By Dicks, David L.; Fulghieri, Paolo
  9. Liquidity Risk Premia in the International Shipping Derivatives Market By Amir Alizadeh; Konstantina Kappou; Dimitris Tsouknidis; Ilias Visvikis
  10. The Exposure of Microfinance Institutions to Financial Risk By Gietzen, Thomas
  11. Modeling and forecasting crude oil price volatility: Evidence from historical and recent data By Lux, Thomas; Segnon, Mawuli; Gupta, Rangan
  12. Innovations in transferring insurable risk to capital markets – Insurance-Linked Securities (ILS) application by the non-financial companies By Monika Wieczorek-Kosmala; Joanna Błach; Maria Gorczyńska; Anna Doś
  13. A dynamic approach to intraday liquidity needs By Freddy Cepeda L.; Fabio Ortega C.
  14. Bonus caps, deferrals and bankers' risk-taking By Jokivuolle, Esa; Keppo, Jussi; Yuan , Xuchuan

  1. By: Simone Varotto (ICMA Centre, Henley Business School, University of Reading); Lei Zhao
    Abstract: In this paper we analyse aggregate and firm level systemic risk for US and European banks from 2004 to 2012. We observe that common systemic risk indicators are primarily driven by firm size which implies an overriding concern for “too-big-to-fail” institutions. However, smaller banks may still pose considerable systemic threats, as exemplified by the Northern Rock debacle in 2007. By introducing a simple standardisation, we obtain a new risk measure that identifies Northern Rock as a top ranking systemic institution up to 4 quarters before its bailout. The new indicator also appears to have a superior ability to predict which banks would be affected by the most severe stock price contractions during the 2007-2009 sub-prime crisis. In addition we find that a bank’s balance sheet characteristics can help to forecast its systemic importance and, as a result, may be useful early warning indicators. Interestingly, the systemic risk of US and European banks appears to be driven by different factors.
    Keywords: systemic risk, financial crisis, bank regulation, contingent claim analysis
    JEL: G01 G21 G28
    Date: 2014–12
  2. By: Nikola Gradojevic (IÉSEG School of Management (LEM-CNRS), Lille Catholic University, France; Faculty of Technical Sciences, University of Novi Sad, Serbia; The Rimini Centre for Economic Analysis, Italy); Marko Caric (Faculty of Economics and Engineering Management, Business Academy, Serbia)
    Abstract: This paper concentrates on quantifying the behavioral aspects of systemic risk by using a novel approach based on entropy. More specifically, we study aggregate market expectations and the predictability of the systemic risk before and during the financial crisis in 2008. Two underlying signals for estimating entropic risk measures are considered: 1) skewness premium of deepest out-of-the-money options, and 2) implied volatility ratio in regards to deepest out-of-the-money options. The findings confirm the predictive and contemporaneous usefulness of our entropy setting in market risk management. The degree of predictability is closely linked to both the type of entropy and the nature of the underlying signal.
    Date: 2015–03
  3. By: Chuancun Yin
    Abstract: Distortion risk measures are extensively used in finance and insurance applications because of their appealing properties. We present three methods to construct new class of distortion functions and measures. The approach involves the composting methods, the mixing methods and the approach that based on the theory of copula. Subadditivity is an important property when aggregating risks in order to preserve the benefits of diversification. However, Value at risk (VaR), as the most well-known example of distortion risk measure is not always globally subadditive, except of elliptically distributed risks. In this paper, instead of study subadditivity we investigate the tail subadditivity for VaR and other distortion risk measures. In particular, we demonstrate that VaR is tail subadditive for the case where the support of risk is bounded. Various examples are also presented to illustrate the results.
    Date: 2015–03
  4. By: Clemente De Rosa; Elisa Luciano; Luca Regis
    Abstract: This paper provides the static, swap-based hedge for an annuity, and compares it with the dynamic, delta-based hedge, achieved using longevity bonds. We assume that the longevity intensity is distributed according to a CIR-type process and provide closed-form derivatives prices and hedges, also in presence of an analogous CIR process for interest rate risk. Our calibration to 65-year old UK males shows that – once interest rate risk is perfectly hedged – the average hedging error of the dynamic hedge is moderate, and both its variance and the thickness of the tails of its distribution are decreasing with the rebalancing frequency. The spread over the basic "swap rate" which makes 99.5% quantile of the distribution of the dynamic hedging error equal to the cost of the static hedge lies between 0.01 and 0.04%.
    Keywords: longevity risk, static vs. dynamic hedging, longevity swaps, longevity bonds.
    JEL: G22 G32
    Date: 2015
  5. By: Liusha Yang; Romain Couillet; Matthew R. McKay
    Abstract: We study the design of portfolios under a minimum risk criterion. The performance of the optimized portfolio relies on the accuracy of the estimated covariance matrix of the portfolio asset returns. For large portfolios, the number of available market returns is often of similar order to the number of assets, so that the sample covariance matrix performs poorly as a covariance estimator. Additionally, financial market data often contain outliers which, if not correctly handled, may further corrupt the covariance estimation. We address these shortcomings by studying the performance of a hybrid covariance matrix estimator based on Tyler's robust M-estimator and on Ledoit-Wolf's shrinkage estimator while assuming samples with heavy-tailed distribution. Employing recent results from random matrix theory, we develop a consistent estimator of (a scaled version of) the realized portfolio risk, which is minimized by optimizing online the shrinkage intensity. Our portfolio optimization method is shown via simulations to outperform existing methods both for synthetic and real market data.
    Date: 2015–03
  6. By: Josef Brechler; Vaclav Hausenblas; Zlatuse Komarkova; Miroslav Plasil
    Abstract: After the recent events in the global financial system there has been significant progress in the literature focusing on the sources of systemic importance of financial institutions. However, the concept of systemic importance is in practice often simplified to the problem of size and contagion due to interbank market interconnectedness. Against this backdrop, we explore additional features of systemic importance stemming from similarities between bank asset portfolios and investigate whether they can contribute to the build-up of systemic risks. We propose a set of descriptive methods to address this aspect empirically in the context of the Czech banking system. Our main findings suggest that the overall measure of the portfolio similarity of individual banks is relatively stable over time and is driven mainly by large and well-established banks. However, we identified several clusters of very similar banks whose market share is small individually but which could become systemically important when considered as a group. After taking into account the credit risk characteristics of portfolios we conclude that the importance of these clusters is even higher.
    Keywords: Contagion, correlation, financial stability, systemic risk, too-many-to-fail
    JEL: B12 B52
    Date: 2014–12
  7. By: Tobias Fissler; Johanna F. Ziegel
    Abstract: A statistical functional, such as the mean or the median, is called elicitable if there is a scoring function or loss function such that the correct forecast of the functional is the unique minimizer of the expected score. Such scoring functions are called strictly consistent for the functional. The elicitability of a functional opens the possibility to compare competing forecasts and to rank them in terms of their realized scores. In this paper, we explore the notion of elicitability for multi-dimensional functionals and give both necessary and sufficient conditions for strictly consistent scoring functions. We cover the case of functionals with elicitable components, but we also show that one-dimensional functionals that are not elicitable can be a component of a higher order elicitable functional. In the case of the variance this is a known result. However, an important result of this paper is that spectral risk measures with a spectral measure with finite support are jointly elicitable if one adds the `correct' quantiles. A direct consequence of applied interest is that the pair (Value at Risk, Expected Shortfall) is jointly elicitable under mild conditions that are usually fulfilled in risk management applications.
    Date: 2015–03
  8. By: Dicks, David L.; Fulghieri, Paolo
    Abstract: We propose a new theory of systemic risk based on Knightian uncertainty (or "ambiguity"). We show that, due to uncertainty aversion, beliefs on future asset returns are endogenous, and bad news on one asset class induces investors to be more pessimistic about other asset classes as well. This means that idiosyncratic risk can create contagion and snowball into systemic risk. Furthermore, in a Diamond and Dybvig (1983) setting, we show that, surprisingly, uncertainty aversion causes investors to be less prone to run individual banks, but runs will be systemic. In addition, we show that bank runs are associated with stock market crashes and flight to quality. Finally, we argue that increasing uncertainty makes the financial system more fragile and more prone to crises. We conclude with implications for the current public policy debate on the management of financial crisis
    Keywords: Ambiguity Aversion; Bank Runs; Financial Crises; Systemic Risk
    JEL: G01 G21 G28
    Date: 2015–03
  9. By: Amir Alizadeh (Cass Business School); Konstantina Kappou (ICMA Centre, Henley Business School, University of Reading); Dimitris Tsouknidis (Regents University London); Ilias Visvikis (World Maritime University)
    Abstract: The study examines the existence of liquidity risk premia on freight derivatives returns. The Amihud liquidity ratio and bid-ask spreads are utilized to assess the existence of liquidity premia. Other macroeconomic variables are used to control for market risk. Results indicate that liquidity risk is priced and both liquidity measures have a significant role in determining freight derivatives returns. Consistent with expectations, both liquidity measures are found to have positive and significant effects on the returns of near-month freight derivatives contracts. The results have important implications for modeling freight derivatives returns, and consequently, for trading and risk management purposes.
    Keywords: forward freight agreements, liquidity risk, bid–ask spreads, shipping, panel data
    JEL: G12 G13 G14 C23
    Date: 2014–12
  10. By: Gietzen, Thomas
    Abstract: This study examines the exposure of microfinance institutions to liquidity, interest rate and foreign exchange (FX) risk. It builds on a manually collected set of data on FX positions and the maturity structure of assets and liabilities of the largest microfinance institutions worldwide. The data suggests that microfinance institutions in the sample, on average, face no liquidity risk and that exposure to FX risk is lower than commonly assumed. Linking risk exposure to institutional characteristics, I find that legal status and regional affiliation are correlated with risk exposure while regulatory quality is not.
    Keywords: Microfinance, Financial Risk, Liquidity Risk, FX Risk, Ownership, Regulation
    JEL: G21 G32 O16
    Date: 2015–03
  11. By: Lux, Thomas; Segnon, Mawuli; Gupta, Rangan
    Abstract: This paper uses the Markov-switching 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 different 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 GARCH-type models coming out second best.
    Keywords: Crude oil prices,GARCH,Multifractal processes,SPA test
    JEL: C52 C53 C22
    Date: 2015
  12. By: Monika Wieczorek-Kosmala (University of Economics in Katowice); Joanna Błach (University of Economics in Katowice); Maria Gorczyńska (University of Economics in Katowice); Anna Doś (University of Economics in Katowice)
    Abstract: In this paper we focus on financial innovations that have emerged as a result of the convergence of the capital market and insurance market. These new solutions called Insurance-Linked Securities (ILS) were created in 1990s. by insurers and reinsurers in order to improve the liquidity of insurance market by providing the opportunity to transfer insurable risk to capital market. However, nowadays the application of ILS have been extended beyond financial sector. In particular, the application of ILS in the new, different way by the non-financial companies is regarded here as innovations.The prime purpose of the paper is to justify a statement that in recent years, capital market innovations within transferring insurable risk to capital markets (ILS) have grown on diversity. Our objective is to critically analyze the innovative solutions within transferring insurable risk to capital market, and assess their potential for the use by non-financial companies. We address the limitations and possible consequences of these solutions. To achieve the expected results we use the document analysis and select important information in order to provide systemized characteristics of Insurance-Linked Securities. Our intention is also to initiate a debate on the possible use of insurance-linked securities in non-financial sector, focusing on their potential advantages and positive consequences for the non-financial companies as well as on potential limitations and obstacles.From the analyzed group of insurance-linked securities available on the capital market, we have selected these solutions that can be applied by the non-financial companies, i.e.: cat bonds, insurance-linked derivatives (including weather derivatives) and contingent capital structures. These innovations may be applied in order to improve the integrated risk management process in the non-financial companies in two ways: (1) as an alternative (substitute) to traditional risk management instruments (e.g. insurance policy) conditional upon their efficiency (similar protection at lower costs or better protection at comparable costs); (2) as a complementary solutions to traditional instruments, if they provide access to tools and mechanisms not available directly by the application of traditional solutions. However, there are many constraints, both on the supply and demand side of the ILS market that limit their application by non-financials. Further research may be focused on the analysis of the solutions that can be applied in order to overcome these problems and improve the development of the ILS innovations offered to non-financials.
    Keywords: Risk management, financial innovations, non-financial companies, insurance-linked securities, cat bonds, insurance derivatives, weather derivatives, contingent capital
    JEL: G30 G32 G22
    Date: 2014–06
  13. By: Freddy Cepeda L. (Banco de la República de Colombia); Fabio Ortega C. (Banco de la República de Colombia)
    Abstract: This paper presents a methodology to estimate the intraday liquidity that systemically important entities (SIE) need to fulfill all its obligations in a timely fashion, when a simulated failure-to-pay from its main liquidity supplier by discretionary concepts of payment occurs. Using the Bank of Finland’s simulator and the fund transfer data from Colombian large value payment system, we achieve a dynamic estimation measuring three types of effects (direct, second round and feedback). The results validate the existence of a non-linear relationship between the initial failure-to-pay of a specific institution and extended failures-to-pay to the rest of system. An Intraday Liquidity Sufficiency Index is proposed to quantify the average amount of additional liquidity needed to fulfill timely all SIE’s obligations without generating second-round effects. Our methodology and recommendations contribute to the international discussion on management intraday liquidity risk, to efficiency and security of the payment system, and ultimately to financial stability. Classification JEL: D53, D85, E51, C63, G21, G23
    Keywords: Large value payment system, intraday liquidity, counterparty stress test, discretionary payments, simulation, direct effect, second-round effect, feedback effect, network topology.
    Date: 2015–03
  14. By: Jokivuolle, Esa (Bank of Finland Research); Keppo, Jussi (NUS Business School and Risk Management Institute National University of Singapore); Yuan , Xuchuan (Risk Management Institute National University of Singapore)
    Abstract: We model a banker's future bonuses as a series of call options on the bank's profits and show that bonus caps and deferrals reduce risk-taking. However, the banker's optimal risk-taking also depends on the costs of risk-taking. We calibrate the model to US banking data and show that lengthening the standard one-year bonus payment interval has no material impact, whereas capping the bonus at the level of the base salary substantially reduces the bankers’ risk-taking. Our results suggest that the European Union's bonus cap reduces risk-taking whereas bonus clawbacks as prescribed in the Dodd-Frank Act appear to be ineffective.
    Keywords: banking; bonuses; regulation; compensation; Dodd-Frank Act
    JEL: G01 G21 G28 J33 M52
    Date: 2015–03–04

General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.