nep-rmg New Economics Papers
on Risk Management
Issue of 2015‒05‒02
thirteen papers chosen by
Stan Miles
Thompson Rivers University

  1. Funding Liquidity Risk From a Regulatory Perspective By Gouriéroux, Christian; Héam, Jean-Cyprien
  2. Model Risk - From Epistemology to Management. Ipse se nihil scire id unum sciat. (Socrates' Plato) By Bertrand K Hassani
  3. Operational risk modeled analytically II: the consequences of classification invariance By Vivien Brunel
  4. Forecasting Coherent Volatility Breakouts By Didenko, Alexander; Dubovikov, Michael; Poutko, Boris
  5. Unifying Portfolio Diversification Measures Using Rao's Quadratic Entropy By Kevin Moran; Benoît Carmichael; Gilles Boevi Koumou
  6. Network Structure and Counterparty Credit Risk By Alexander von Felbert
  7. The effects of contingent convertible (CoCo) bonds on insurers' capital requirements under Solvency II By Niedrig, Tobias; Gründl, Helmut
  8. Consistent Risk Acceptance Criteria through Networks By Cerqueti, Roy; Lupi, Claudio
  9. On matrix-exponential distributions in risk theory By Alessandra Carleo; Mariafortuna Pietroluongo
  10. Land Resilience and Tail Dependence among Crop Yield Distributions By Xiaodong Du; David A. Hennessy; Hongli Feng
  11. Countercyclical Capital Buffers: bayesian estimates and alternatives focusing on credit growth By Rodrigo Barbone Gonzalez; Joaquim Lima; Leonardo Marinho
  12. Is gold good for hedging? lessons from the Malaysian sectoral stock indices By Rahim, Yasmin; Masih, Mansur
  13. Does the shariah index move together with the conventional equity indexes? By Park, Kwang Suk; Masih, Mansur

  1. By: Gouriéroux, Christian; Héam, Jean-Cyprien
    Abstract: In the Basel regulation the required capital of a financial institution is based on conditional measures of the risk of its future equity value such as Value-at-Risk, or Expected Shortfall. In Basel 2 the uncertainty on this equity value is captured by means of changes in asset prices (market risk) and default of borrowers (credit risk), and mainly concerns the asset component of the balance-sheet. Our paper extends this analysis by taking also into account the funding and market liquidity risks. The latter risks are consequences of changes in customers or investors’ behaviors and usu- ally concern the liability component of the balance sheet. In this respect our analysis is in the spirit of the most recent Basel 3 and Solvency 2 regulations. Our analysis highlights the role of the different types of risks in the total required capital. Our analysis leads to clearly distinguish defaults due to liquidity shortage and defaults due to a lack of solvency and, in a regulatory perspective, to introduce two reserve accounts, one for liquidity risk, another one for solvency risk. We explain how to fix the associated required capitals.
    Keywords: Regulation; Funding Liquidity Risk; Liquidity Shortage; Solvency 2; Value-at-Risk; Asset/Liability Management;
    JEL: D81 G32
    Date: 2014–07
  2. By: Bertrand K Hassani (Grupo Santander et Centre d'Economie de la Sorbonne)
    Abstract: One of the main concern and regulatory topic financial institutions have to deal with is the model risk. Senior managers tend to consider more and more model risk as one of the highest exposure a financial institution has (as illustrated by the lastest EBA paper related to Advanced Measurement Approach (AMA) for Operational Risk Capital calculation). Though, while the concept seems relatively simple, the definition of the model risk (traditional and regulatory), the origins of this one (from dogmas to mis-use) and the way to manage it (from engineering conservatism into models to a proper governance process) are not necessarily well handled by practitioners, academics and regulators. Giving a clear definition and understanding the root cause of a model failure allows adopting the appropriate management style to deal with the potential issue that could lead to dramatic failures. In this paper we are proposing an analysis of the model risk trying to understand the main issues leading to the failure and the best way to address them
    Keywords: Model Risk; Operational Risk; Risk Management, Risk Measurement, Epistemology
    JEL: C60 H12 G32
    Date: 2015–03
  3. By: Vivien Brunel
    Abstract: Most of the banks' operational risk internal models are based on loss pooling in risk and business line categories. The parameters and outputs of operational risk models are sensitive to the pooling of the data and the choice of the risk classification. In a simple model, we establish the link between the number of risk cells and the model parameters by requiring invariance of the bank's loss distribution upon a change in classification. We provide details on the impact of this requirement on the domain of attraction of the loss distribution, on diversification effects and on cell risk correlations.
    Date: 2015–04
  4. By: Didenko, Alexander; Dubovikov, Michael; Poutko, Boris
    Abstract: The paper develops an algorithm for making long-term (up to three months ahead) predictions of volatility reversals based on long memory properties of financial time series. The approach for computing fractal dimension using sequence of the minimal covers with decreasing scale is used to decompose volatility into two dynamic components: specific and structural. We introduce two separate models for both, based on different principles and capable of catching long uptrends in volatility. To test statistical significance of its abilities we introduce several estimators of conditional and unconditional probabilities of reversals in observed and predicted dynamic components of volatility. Our results could be used for forecasting points of market transition to an unstable state.
    Keywords: stock market; price risk; fractal dimension; market crash; ARCH-GARCH; range-based volatility models; multi-scale volatility; volatility reversals; technical analysis.
    JEL: C14 C49 C5 C58
    Date: 2015–03
  5. By: Kevin Moran; Benoît Carmichael; Gilles Boevi Koumou
    Abstract: This paper extends the use of Rao (1982b)'s Quadratic Entropy (RQE) to modern portfolio theory. It argues that the RQE of a portfolio is a valid, exible and unifying approach to measuring portfolio diversification. The paper demonstrates that portfolio's RQE can encompass most existing measures, such as the portfolio variance, the diversification ratio, the normalized portfolio variance, the diversification return or excess growth rates, the Gini-Simpson indices, the return gaps, Markowitz's utility function and Bouchaud's general free utility. The paper also shows that assets selected under RQE can protect portfolios from mass destruction (systemic risk) and an empirical illustration suggests that this protection is substantial.
    Keywords: Portfolio diversification, Rao's quadratic entropy, diversification return, diversification ratio, portfolio variance normalized, Gini-Simpson index, Markowitz's utility, function, Bouchaud's General free utility,
    JEL: G11
    Date: 2015–04–16
  6. By: Alexander von Felbert
    Abstract: In this paper we offer a novel type of network model, which is capable of capturing the precise structure of a financial market based, for example, on empirical findings. With the attached stochastic framework it is further possible to study how an arbitrary network structure and its expected counterparty credit risk are analytically related to each other. This allows us, for the first time, to model and to analytically analyse the precise structure of a financial market. It further enables us to draw implications for the study of systemic risk. We apply the powerful theory of characteristic functions and Hilbert transforms, which have not been used in this combination before. We then characterise Eulerian digraphs as distinguished exposure structures and we show that considering the precise network structures is crucial for the study of systemic risk. The introduced network model is then applied to study the features of an over-the-counter and a centrally cleared market. We also give a more general answer to the question of whether it is more advantageous for the overall counterparty credit risk to clear via a central counterparty or classically bilateral between the two involved counterparties. We then show that the exact market structure is a crucial factor in answering the raised question.
    Date: 2015–04
  7. By: Niedrig, Tobias; Gründl, Helmut
    Abstract: The Liikanen Group proposes contingent convertible (CoCo) bonds as a potential mechanism to enhance financial stability in the banking industry. Especially life insurance companies could serve as CoCo bond holders as they are already the largest purchasers of bank bonds in Europe. We develop a stylized model with a direct financial connection between banking and insurance and study the effects of various types of bonds such as non-convertible bonds, write-down bonds and CoCos on banks' and insurers' risk situations. In addition, we compare insurers' capital requirements under the proposed Solvency II standard model as well as under an internal model that ex-ante anticipates additional risks due to possible conversion of the CoCo bond into bank shares. In order to check the robustness of our findings, we consider different CoCo designs (write-down factor, trigger value, holding time of bank shares) and compare the resulting capital requirements with those for holding nonconvertible bonds. We identify situations in which insurers benefit from buying CoCo bonds due to lower capital requirements and higher coupon rates. Our results highlight how the Solvency II standard model can mislead insurers in their CoCo investment decision due to economically irrational incentives.
    Keywords: Contingent Convertible Capital,CoCo Bond,Basel III,Solvency II,Life Insurance,Interconnectedness
    JEL: G11 G21 G22 G28 G32
    Date: 2015
  8. By: Cerqueti, Roy; Lupi, Claudio
    Abstract: In decision theory projects are usually evaluated in terms of their riskiness, and often decision under risk is intended as the one-shot-type binary choice of accepting or not accepting the risk. This paper elaborates on the concept of risk acceptance, and aims at developing a theoretical framework based on networks theory. In doing this, the interconnections between the random quantities involved in the decision are taken into account. The conditions to be satisfied in order for the risk-acceptance criterion to be consistent with the axiomatization of standard expected utility theory are also explored. In accordance with existing literature, we obtain that a risk evaluation problem can be meaningful even if it is not consistent with the standard axiomatization of expected utility. Some illustrative examples are also provided.
    Keywords: Risk acceptance, networks, decision theory, expected utility, insurance
    JEL: D81 D85 G22
    Date: 2015–04–20
  9. By: Alessandra Carleo; Mariafortuna Pietroluongo (-)
    Abstract: In this paper, a particular class of matrix-exponential distributions is described, also with respect to its use in risk theory, namely phase-type distributions. Phase-type distributions have the important advantage of being suitable for approximating most of other distributions as well as being mathematically tractable. After a review on phase-type distributions and their properties, a possible use in risk theory is illustrated. Modelling both interarrival claim times and individual claim sizes with this class of distributions an explicit formula for the probability of ultimate ruin is given.
    Keywords: Matrix-exponential distribution, Phase-type distribution, Ruin probability, Markov chain.
    Date: 2014–06–02
  10. By: Xiaodong Du; David A. Hennessy (Center for Agricultural and Rural Development (CARD)); Hongli Feng
    Abstract: Rate setting procedures for United States crop yield and revenue insurance contracts employ methods that presume correlations to be state invariant. Whether this is true matters. If yield-yield correlations strengthen when crops are subject to widespread stress, then diversification opportunities for private insurers weaken when most needed, and an insurer's portfolio of retained business may not be as diversified as standard statistics would suggest. For government outlays, such tail dependence will increase the transactions and political costs of reallocations from the general fund. In this paper we propose a simple model of yield correlations according to interactions between a weather outcome and a land unit's yield resilience to adverse shocks, as might be measured by the United States Soil Conservation Service's land capability classification. Our model shows that yield-yield tail dependence is to be expected and, furthermore, should take a particular form. In better growing regions, yield correlations across units should be stronger in right tails than in left tails, whereas in marginal growing regions the reverse should apply. Using USDA Risk Management Agency unit level data and a variety of statistics, we find strong evidence in favor of this land yield resilience hypothesis. Our findings call into question the appropriateness of current USDA rate-setting methodologies, which posit constant state-conditional ordinal correlations by implicitly assuming that yields can be represented by a Gaussian copula. A goodness-of-fit test rejects the standard Gaussian copula model, implying that existing RMA rate-setting methods are deficient.
    Keywords: actuarial fairness; crop insurance; Gaussian copula; geography of yield distributions; reinsurance; systemic risk. JEL Codes: G12, Q18, C1.
    Date: 2015–04
  11. By: Rodrigo Barbone Gonzalez; Joaquim Lima; Leonardo Marinho
    Abstract: We re-evaluate the proposed framework of the Basel Committee on Banking Supervision (BCBS) to look into the credit-to-GDP gap as a leading indicator related to the Countercyclical Capital Buffer (CCB) and propose an alternative approach focusing at credit-to-GDP growth. We follow earlier work that the Hodrick-Prescott (HP) filter, especially with the proposed smoothing factor calibration, HP(400k), could possibly create spurious cycles. Moreover, it would not properly fit short credit series. With that in mind, we estimate Bayesian STMs for 34 countries and evaluate on-line (one-sided) estimates of their state components as well as other variables derived from their joint posterior distributions to anticipate crisis. The probabilities associated with the slope of the credit-to-GDP estimated using a one-sided STM have lower noise-to-signal ratios (NS) than the credit-to-GDP gap, especially considering a robustness exercise comprise of short series. The slope of the one-sided HP(150), which is simpler but closely related to our STM in its gain function, also performs better in anticipating crisis both in short and long series when compared to the credit-to-GDP gap. Finally, we put forward an exercise of CCB using the last available data point and our five leading indicators in all 34 countries
    Date: 2015–04
  12. By: Rahim, Yasmin; Masih, Mansur
    Abstract: Econometricians had been blamed for the financial crises that occurred due to their giving a ‘false hope’ to investors and policy makers using untested theoretical assumptions. Therefore, econometricians had been challenged to reform their studies by grounding them more solidly on reality. The theory of Markowitz 1952 in the context of investment portfolio urged the investor ‘not to put all eggs in one basket’ implying to diversify their investment portfolio as a mechanism to minimize the risk. Controversies pertaining to the role of gold and its stability to diversify the investment portfolio had been raised and had been puzzling the investors till to date. Normally, the variable used to represent the stock index of a country is in terms of indices and very limited research is found to apply sectoral indices. Therefore, this research is an humble attempt to examine the correlation and causality between the Malaysian sectoral stock indices and gold applying multivariate standard time series techniques using monthly observations ranging from January 2007 until September 2014. We found that gold was the most independent (exogenous) variable compared to the sectoral stock indices even during the 2008 financial crisis period and the most dependent sectors were construction and financial. Therefore, we believe that gold could be a hedging instrument against these sectors. Hence, we humbly suggest to the investors and investment portfolio managers to include gold as part of their investment portfolios.
    Keywords: sectoral stock indices, gold, Granger-causality, time series techniques
    JEL: C22 C58 E44 G11
    Date: 2015–01–25
  13. By: Park, Kwang Suk; Masih, Mansur
    Abstract: Generally, Shariah (Islamic) indices are considered to have lower portfolio betas relative to conventional ones. The lower portfolio beta of Islamic indexes is a logical result of Shariah screening. As Shariah screening eliminates stocks with high financial leverage, the resulting portfolio beta ought to be lower because a stock’s beta is reflective of the underlying business risk and financial risk (leverage). With this motivation and background, we have tried to find out whether we can have diversification opportunities with combining Shariah index and conventional indexes. The results of analysis revealed the absence of cointegration between the DJIM index and three conventional indexes such as DAX, HangSeng, KL. This means that diversification opportunities exist for the mentioned indices. But for the S&P and DJIM, we found that they are cointegrated, which implies there exists long run theoretical relationship among the indices. Presence of cointegration indicates the absence of diversification opportunities in the concerned indices. So if we want to get diversification effect, we have to avoid setting up the portfolio with S&P and DJIM with the balanced weight. Because these two variables move together, the investors are not likely to get the positive portfolio effect particularly in the long term.
    Keywords: Shariah (Islamic) Index, diversification, cointegration
    JEL: C22 C58 E44 G15
    Date: 2015–01–20

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