nep-rmg New Economics Papers
on Risk Management
Issue of 2015‒05‒16
twenty papers chosen by

  1. Tail Risk in Hedge Funds: A Unique View from Portfolio Holdings By Agarwal, Vikas; Ruenzi, Stefan; Weigert, Florian
  2. Wrong-Way Bounds in Counterparty Credit Risk Management By Amir Memartoluie; David Saunders; Tony Wirjanto
  3. Paving the way for better telecom performance: Evidence from the telecommunication sector in MENA countries By Catherine Bruneau; Alexis Flageollet; Zhun Peng
  4. Hedging of defaultable claims in a structural model using a locally risk-minimizing approach By Ramin Okhrati; Alejandro Balb\'as; Jos\'e Garrido
  5. An entropy-based early warning indicator for systemic risk By Monica Billio; Roberto Casarin; Michele Costola; Andrea Pasqualini
  6. Improved Algorithms for Computing Worst Value-at-Risk: Numerical Challenges and the Adaptive Rearrangement Algorithm By Marius Hofert; Amir Memartoluie; David Sunders; Tony Wirjanto
  7. On the impact of leveraged buyouts on bank systemic risk By Grupp, Marcel
  8. Safeguarding the Banking System - a New Perspective on the Consolidation of the Macroprudential Regulation* By Irina-Raluca Badea
  9. RISK MANAGEMENT IN ORGANIC FARMING By Venelin Terziev; Ekaterina Arabska; Vesela Radovic
  10. Cyclicality in Losses on Bank Loans By Bart Keijsers; Bart Diris; Erik Kole
  11. The statistical combination procedure in measures for risk in financial systems By Francesca Parpinel
  12. The impact of internal audit on the financial risk management of SMEs in Romania in the context of fiscal harmonization By Mihaela Daciana Nanu
  13. Rewarding Prudence: Risk Taking, Pecuniary Externalities and Optimal Bank Regulation By Kogler, Michael
  14. Does Regulation Matter? Riskiness in Pension Asset Allocation By Sandra Rigot
  15. A New Risk Appetite Index and CDS spreads: Evidence from an Emerging Market By Fatih Kiraz; Ozgur Uysal; Yakup Ergincan
  16. Study on the relationship between the quality of external audit - financial performance, solvency and risk management in the Romanian banking system By Mariana Nedelcu (Bunea)
  17. Approximate hedging with proportional transaction costs in stochastic volatility models with jumps By Thai Huu Nguyen; Serguei Pergamenschchikov
  18. Catastrophic Risk, Rare Events, and Black Swans: Could There Be a Countably Additive Synthesis? By Hammond, Peter
  19. A Framework for Modelling Whole-Farm Financial Risk By Nordblom, Thomas L.; Hutchings, Timothy R.; Hayes, Richard C.; Li, Guangdi D.
  20. Size Matters: Tail Risk, Momentum and Trend Following in International Equity Portfolios By Andrew Clare; James Seaton; Peter N. Smith; Stephen Thomas

  1. By: Agarwal, Vikas; Ruenzi, Stefan; Weigert, Florian
    Abstract: We develop a new tail risk measure for hedge funds to examine the impact of tail risk on fund performance and to identify the sources of tail risk. We find that tail risk affects the cross-sectional variation in fund returns, and investments in both, tail-sensitive stocks as well as options, drive tail risk. Moreover, managerial incentives and discretion as well as exposure to funding liquidity shocks are important determinants of tail risk. We find evidence that is consistent with funds being able to time tail risk exposure prior to the recent financial crisis.
    Keywords: Hedge Funds, Tail Risk, Portfolio Holdings, Funding Liquidity Risk
    JEL: G11 G23
    Date: 2015–05
  2. By: Amir Memartoluie; David Saunders; Tony Wirjanto
    Abstract: We study the problem of ?finding the worst-case joint distribution of a set of risk factors given prescribed multivariate marginals and a nonlinear loss function. We show that when the risk measure is CVaR, and the distributions are discretized, the problem can be conveniently solved using linear programming technique. The method has applications to any situation where marginals are provided, and bounds need to be determined on total portfolio risk. This arises in many financial contexts, including pricing and risk management of exotic options, analysis of structured ?finance instruments, and aggregation of portfolio risk across risk types. Applications to counterparty credit risk are emphasized, and they include assessing wrong-way risk in the credit valuation adjustment, and counterparty credit risk measurement. Lastly a detailed application of the algorithm for counterparty risk measurement to a real portfolio case is also presented in this paper.
    Date: 2015–05
  3. By: Catherine Bruneau (Centre d'Economie de la Sorbonne); Alexis Flageollet (Natixis Asset Management); Zhun Peng (EPEE - Université d'Evry)
    Abstract: In this paper, we propose a flexible tool to estimate the risk sensitivity of a high-dimensional portfolio composed of different classes of assets, especially in extreme risk circumstances. We build a so-called Cvine Risk Factors Model (CRFM), which is a non-linear version of a risk factor model in a copula framework. Our tool allows us to decompose the risk of any asset and any portfolio into specific risk directions depending on the context. As an application, we compare the sensitivity of different types of portfolios to extreme risks. We also give an example of a view-type analysis as usually performed by portfolio managers who examine what their portfolio becomes under specific circumstances: here we examine the case of a low inflation context. These analyses allow us to detect changes in the diversification opportunities over time
    Keywords: Regular vine copula; factorial model; extreme risks; risk management; portfolio management; diversification
    JEL: G11 G17 G32
    Date: 2015–04
  4. By: Ramin Okhrati; Alejandro Balb\'as; Jos\'e Garrido
    Abstract: In the context of a locally risk-minimizing approach, the problem of hedging defaultable claims and their Follmer-Schweizer decompositions are discussed in a structural model. This is done when the underlying process is a finite variation Levy process and the claims pay a predetermined payout at maturity, contingent on no prior default. More precisely, in this particular framework, the locally risk-minimizing approach is carried out when the underlying process has jumps, the derivative is linked to a default event, and the probability measure is not necessarily risk-neutral.
    Date: 2015–05
  5. By: Monica Billio (Department of Economics, University Of Venice Cà Foscari); Roberto Casarin (Department of Economics, University Of Venice Cà Foscari); Michele Costola (Department of Economics, University Of Venice Cà Foscari); Andrea Pasqualini (Department of Economics, University Of Venice Cà Foscari)
    Abstract: The purpose of this paper is the construction of an early warning indicator for systemic risk using entropy measures. The analysis is based on the cross-sectional distribution of marginal systemic risk measures such as Marginal Expected Shortfall, Delta CoVaR and network connectedness. These measures are conceived at a single institution for the financial industry in the Euro area. We estimate entropy on these measures by considering different definitions (Shannon, Tsallis and Renyi). Finally, we test if these entropy indicators show forecasting abilities in predicting banking crises. In this regard, we use the variable presented in Babeck? et al. (2012) and Alessi and Detken (2011) from European Central Bank. Entropy indicators show promising forecast abilities to predict financial and banking crisis. The proposed early warning signals reveal to be effective in forecasting financial distress conditions.
    Keywords: Entropy, systemic risk measures, early warning indicators, aggregation.
    JEL: C10 C11 G12 G29
    Date: 2015
  6. By: Marius Hofert; Amir Memartoluie; David Sunders; Tony Wirjanto
    Abstract: Numerical challenges inherent in algorithms for computing worst Value-at-Risk in homogeneous portfolios are identified and words of warning concerning their implementation are raised. Furthermore, both conceptual and computational improvements to the Rearrangement Algorithm for approximating worst Value-at-Risk for portfolios with arbitrary marginal loss distributions are provided. In particular, a novel Adaptive Rearrangement Algorithm is introduced and investigated. These algorithms are implemented using the R package qrmtools.
    Date: 2015–05
  7. By: Grupp, Marcel
    Abstract: Although banks are at the center of systemic risk, there are other institutions that contribute to it. With the publication of the leveraged lending guideline in March 2013, the U.S. regulators show that they are especially worried about the private equity firms with their high-risk deals. Given these risks and the interconnectedness of the banks through the LBO loan syndicates, I shed light on the impact of a bank's LBO loan exposure on its systemic risk. By using 3,538 observations between 2000 and 2013 from 165 global banks, I show that banks with higher LBO exposure also have a higher level of systemic risk. Other loan purposes do not show this positive relationship. The main drivers influencing this relationship positively are the bank's interconnectedness to other LBO financing banks and its size. Lending experience with a specific PE sponsor, experience with leading LBO syndicates or a bank's credit rating, however, lead to a lower impact of the LBO loan exposure on systemic risk.
    Keywords: leveraged buyouts,syndicated loans,systemic risk
    JEL: G21 G23 G28
    Date: 2015
  8. By: Irina-Raluca Badea (University of Craiova, Faculty of Economics and Business Administration)
    Abstract: The aftermath of the global financial crisis revealed the weaknesses of the financial system and the monetary incentives to be taken into consideration by the policy-makers. Whether it is exposed to specific risks or to systemic risk, the banking system has to be heavily regulated in order to prevent it from collapsing. The macroprudential regulation promotes the stability of the financial system as a whole, and also treats systemic risk as a trigger of a chain reaction caused by the interlinkages in the financial system. Therefore, this paper outlines the role of the macroprudential regulation for achieving the financial stability goal in the context of systemic turbulences. The safeguarding of financial stability should not be understood as a zero tolerance of bank failures or of an avoidance of market volatility but it should avoid financial disruptions that lead to real economic costs.On the one hand, an overlook on the progress of the prudential regulation points out the procyclical aspects of the regulatory requirements so far, such as capital requirements, risk assessment, provisioning; on the other hand, the present paper identifies the improvements of the most recent recommendations on banking regulations, embodied in the Basel III Accord. Hence, the Basel III requirements in terms of capital adequacy, liquidity, the capital and conservation buffers against procyclicality represent unquestionable improvements for the macroprudential regulation. Given the fact that Basel III has established phase-in arrangements from 2013 to 2019, it is important to analyze the progress of its implementation and its impact on the banking system resilience. *This work was cofinanced from the European Social Fund through Sectoral Operational Programme for Human Resources Development 2007-2013, under the project number POSDRU/159/1.5/S/140863 with the title „ Competitive Researchers in Europe in the Field of Humanities and Socio –Economic Sciences. A Multi-regional Research Network”.
    Keywords: financial stability, systemic risk, banking system, Basel III requirements, regulation
    JEL: E52 E58 G01
  9. By: Venelin Terziev (Vasil Levski National Military University); Ekaterina Arabska (University of Agribusiness and Regional Development); Vesela Radovic (EDUCONS University)
    Abstract: Considering organic production as a system of specific breeding or production of plants and animals, plant or animal products, processing and marketing, the paper discusses risk management in organic farming as a major task in sector development and management on different levels. The questions of risk management are concerned by the point of view that there should be a clear understanding of different sources and kinds of risks, as well as of the complexity of actions and responses. The study presents a summary of the risks in organic production, the relationship risk-profit and the process of risk management in organic farming.
    Keywords: risk classification, risk management, risk communication, organic farming
    JEL: P49 P49
  10. By: Bart Keijsers (Erasmus University Rotterdam, the Netherlands); Bart Diris (Erasmus University Rotterdam, the Netherlands); Erik Kole (Erasmus University Rotterdam, the Netherlands)
    Abstract: Cyclicality in the losses of bank loans is important for bank risk management. Because loans have a different risk profile than bonds, evidence of cyclicality in bond losses need not apply to loans. Based on unique data we show that the default rate and loss given default of bank loans share a cyclical component, related to the business cycle. We infer this cycle by a new model that distinguishes loans with large and small losses, and links them to the default rate and macro variables. The loss distributions within the groups stay constant, but the fraction of loans with large losses increases during downturns. Our model implies substantial time-variation in banks' capital reserves, and helps predicting the losses.
    Keywords: Loss-given-default; default rates; credit risk; capital requirements; dynamic factor models
    JEL: C32 C58 G21 G33
    Date: 2015–05–04
  11. By: Francesca Parpinel (Department of Economics, University Of Venice Cà Foscari)
    Abstract: In the literature of risk analysis different synthetic indices are built on the bases of some indicators and in this work we propose to use, alternatively to PCA, a combination statistical procedure. The univariate indices that we use are those proposed by _V-lab_ using a nonparametric combination of dependent rankings. The combination technique may also be considered to perform nonparametric inference, suitable to the treatment of non gaussian distributions as in the case of indices. So we propose to highlight systemic risk in a network of companies performing a nonparametric test to reveal heterogeneity behaviour; in this case the rankings may be used to create different behavioural groups.
    Keywords: Systemic risk, ranking, nonparametric combination
    JEL: C12 C38 C43
    Date: 2015
  12. By: Mihaela Daciana Nanu (Faculty of Accounting and Management Information Systems The Accounting and Audit Department University of Economic Studies)
    Abstract: The study has the following objective:The analysis of SME behaviour in the management of the risk, of the risk appetite, as factor of impact on the process of planning and performance of the internal audit within the context of internationalization of the Romanian accounting and of harmonization of tax legislation with European norms in the field.The premises of this work are meant to be a starting point for a systematic analysis of the current knowledge level concerning the integration of the internal audit for the risk management in order to reach the optimum risk balance of the entity’s results. The international financial environment is affected by the new exposures generated by the European sovereign debt crisis, concerns caused by the slowing down of world economy.Having been politically and culturally influenced by the countries of European Union, Romania represents an interesting environment for research, in order to raise awareness that the internal audit and the risk management bring additional value to the entity and they are integral part of the risk equation. For the recent years the use of the procedures and policies of integrated risk management at entity level (ERM-Enterprise Risk Management) has extended, the entities thus acknowledging the advantages of risk management approach.The internal audit has the purpose of providing safety and consultancy while contributing to the risk management. The relationship between the internal audit and the risk management starts from the presentation of the global economic context where they act and manifest themselves, following the influences that define their mutual relationship, from the national perspective anchored in the European perspective.The general research area is given by the sciences of management accounting, taxation and integration of the internal audit in the risk management process, respectively, so that at the level of the theoretical research, a deductive type of approach is observed, based on the existing concepts, in order to singularize them at the level of SMEs.Research is fundamental, deductive-inductive, aiming at measuring the awareness of the need to apply risk management, its management in terms of the economic efficiency of the entity, by explaining the current national and international legislative context of the analyzed interdisciplinary phenomenon.It is envisaged that information will be acquired in what concerns the status of the analyzed phenomenon, anchored in the national economic reality, the capitalization of the information available in the analyzed field of interest, the exchange of experiences and good practices.
    Keywords: risk management , management accounting, internal audit,planning and performance of the internal audit
    JEL: A10 D03 H32
  13. By: Kogler, Michael
    Abstract: This paper provides a new rationale for macroprudential regulation and studies its optimal design, implementation, and distributional consequences. In a partial equilibrium model where bank risk taking is subject to moral hazard, we show that although private contracting can solve the bank's agency (i.e., risk shifting) problem, the market outcome is constrainedinefficient: The combination of moral hazard and competition for deposits that are not supplied elastically leads to a pecuniary externality as raising deposits ultimately increases the deposit rate and exacerbates risk shifting of all other banks. As a result, banks are too large, have too much leverage, and take excessive risk. This generic inefficiency provides a strong rationale for regulation even in the absence of classical frictions such as social cost of bank failure or incorrectly priced deposit insurance. The pecuniary externality can be internalized by standard regulatory tools such as capital requirements or by issuing a specific number of banking licenses. Related to the idea of financial restraint, optimal regulation creates rent opportunities to reward prudent banks. This also leads to redistribution from depositors to banks and firms with access to the capital market such that optimal regulation is not a Pareto improvement.
    Keywords: Bank Regulation, Bank Competition, Risk Taking, Moral Hazard
    JEL: D60 D62 G21 G28
    Date: 2015–05
  14. By: Sandra Rigot (University Paris North)
    Abstract: We investigate the influence of investment regulations on the riskiness and procyclcality of defined-benefit (DB) pension funds' asset allocations. We provide a global comparison of the regulatory framework for public, corporate and industry pension funds in the US, Canada and the Netherlands. Derived from panel data analysis of a unique set of close to 600 detailed funds’ asset allocations, our results highlight that regulatory factors are vitally important – more so than the funds’ individual and institutional characteristics, in shaping these asset allocations. In particular, risk-based capital requirements, balance sheet recognition of unfunded liabilities, lower liability discount rates, and shorter recovery periods lead pension funds to decrease their asset allocation to risky assets. Risk-based capital requirements reduce overall risky asset allocation by as much as 5%, but they do not affect the asset classes identically. While equities, real estate and mortgages are at a disadvantage, high yield bonds and commodities are slightly favored.
    Keywords: Solvency, Pension funds, Defined Benefit, Liability discount rate, Valuation requirements, Financial stability, Regulation
    JEL: G28 G11
  15. By: Fatih Kiraz (MKK (Central Securities Depository of Turkey)); Ozgur Uysal (MKK (Central Securities Depository of Turkey)); Yakup Ergincan (MKK (Central Securities Depository of Turkey))
    Abstract: The aim of this study is introducing a new risk appetite index (RISE) methodology and then elaborating especially on its benefits while dealing with sovereign default probabilities. More specifically, providing two types of risk appetite indices, both calculated at individual investor level before aggregation, we present the relationships of these indices with 5y CDS spreads and then discuss the possibility of some new financial instruments which could well be used for hedging or speculating. The core weekly data include all investors’ individual holdings of all securities on the stock exchange (BIST) of Turkey, closing prices of largest 100 firms’ index (BIST100), and 5y CDS spreads of Turkey since 2008. Because of data limitations, the evidence comes from only one developing country but generalization of the main finding seems to be quite possible and testable since the new methodology introduced is flexible enough to be applied in different settings and / or countries.
    Keywords: Risk appetite, CDS, Sovereign, Emerging markets, Turkey
    JEL: E44 G00 G01
  16. By: Mariana Nedelcu (Bunea) (Bucharest University of Economic Studies)
    Abstract: At the European level - and even global – the prolonged economic and financial crisis was a challenge for the financial institutions, negatively affecting the banking system and beyond. The impact of the global crisis has affected gradually overwhelmingly the profitability of the banking industry, affecting all types of banking products and services offered to the customers, the models of supervision and the evaluation methods known so far. The audit function has an important role in the corporate mechanism, especially by extra value conferred to the governance process, so who, over time, this issue was debated assiduously in a series of studies and analysis on information transparency at the level of companies.The purpose of this article is to provide a more comprehensive analysis of the relationship between the quality of external audit and the financial performance, the solvency and requirements of capital adequacy at risk at the level of the Romanian banking system. Thus, concentrating attention on the quality of external audit, we tried to find answers motivated by the empirical analysis results to the general question "How influences the quality of external audit the performance of the banking system? How is the value added by the quality of external audit at the level of credit institutions?".In order to test the formulated hypotheses, the research methodology used is mainly quantitative, based on a statistical analysis deductive and having as starting point the agency theory having as objective the testing and possible links from cause - effect, and also analyzing the significance level thereof.
    Keywords: corporate governance, banking system, solvency, audit
    JEL: G20 G30 M40
  17. By: Thai Huu Nguyen; Serguei Pergamenschchikov
    Abstract: We study the problem of option replication under constant proportional transaction costs in models where stochastic volatility and jumps are combined to capture market's important features. In particular, transaction costs can be approximately compensated applying the Leland adjusting volatility principle and asymptotic property of the hedging error due to discrete readjustments is characterized. We show that jump risk is approximately eliminated and the results established in continuous diffusion models are recovered. The study also confirms that for constant trading cost rate, the results established by Kabanov and Safarian (1997) and Pergamenshchikov (2003) are valid in jump-diffusion models with deterministic volatility using the classical Leland parameter.
    Date: 2015–05
  18. By: Hammond, Peter (Department of Economics and CAGE (Competitive Advantage in the Global Economy), University of Warwick and CAGE)
    Abstract: Catastrophic risk, rare events, and black swans are phenomena that require special attention in normative decision theory. Several papers by Chichilnisky integrate them into a single framework with finitely additive subjective probabilities. Some precursors include: (i) following Jones-Lee (1974), undefined willingness to pay to avoid catastrophic risk; (ii) following Rényi (1955, 1956) and many successors, rare events whose probability is infinitesimal. Also, when rationality is bounded, enlivened decision trees can represent a dynamic process involving successively unforeseen "true black swan" events. One conjectures that a different integrated framework could be developed to include these three phenomena while preserving countably additive probabilities. JEL classification:
    Date: 2015
  19. By: Nordblom, Thomas L.; Hutchings, Timothy R.; Hayes, Richard C.; Li, Guangdi D.
    Keywords: Productivity Analysis, Risk and Uncertainty,
    Date: 2015–02
  20. By: Andrew Clare; James Seaton; Peter N. Smith; Stephen Thomas
    Abstract: We investigate the relationship between size and momentum across a wide range of international equity markets. A distinction is made between relative momentum where assets are ranked according to their performance against each other, and absolute momentum (or trend following) where assets are categorized according to whether they have recently exhibited positive, nominal return characteristics. We find only limited evidence for the outperformance of relative momentum portfolios. Trend following, however, is observed to be a very effective strategy over the study period delivering superior risk-adjusted returns across a range of size categories in both developed and emerging markets while not reversing the performance superiority of smaller firms. We also find, contrary to popular perception, that it is the mid cap-sector that dominates in emerging markets and suggest that this sector should be considered as the equivalent to developed economy small-cap investing.
    Keywords: International equity markets, firm size, momentum, trend following, tail risk
    JEL: G0 G11 G15
    Date: 2015–05

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