nep-rmg New Economics Papers
on Risk Management
Issue of 2015‒06‒20
eighteen papers chosen by
Stan Miles
Thompson Rivers University

  1. A risk management approach to capital allocation By V\'eronique Maume-Deschamps; Didier Rulli\`ere; Khalil Said
  2. The Bank Capital Regulation (BCR) Model By Hyejin Cho
  3. Default near-the-default-point: the value of and the distance to default By Alfredo Ibáñez
  4. The Network of Counterparty Risk: Analysing Correlations in OTC Derivatives By Vahan Nanumyan; Antonios Garas; Frank Schweitzer
  5. Macroeconomic Factors Strike Back: A Bayesian Change-Point Model of Time-Varying Risk Exposures and Premia in the U.S. Cross-Section By Daniele Bianchi; Massimo Guidolin; Francesco Ravazzolo
  6. Captive Funds and Banks' Capital By Arayssi, Mahmoud
  7. Credit Ratings and Their Information Value: Evidence from the Recent Financial Crisis By Gabriela Kuvikova
  8. Un Modelo Macroeconómico del Riesgo de Crédito en Uruguay By Gabriel Illanes; Alejandro Pena; Andrés Sosa
  9. Requerimiento de capital contra-cíclico. El caso uruguayo By Cecilia Dassatti; Alejandro Pena; Jorge Ponce; Magdalena Tubio
  10. Numerical analysis on local risk-minimization forexponential L\'evy models By Takuji Arai; Yuto Imai; Ryoichi Suzuki
  11. The Gordon Gekko Effect: The Role of Culture in the Financial Industry By Andrew W. Lo
  12. Novel and improved insurance instruments for risk reduction By Swenja Surminski; Paul Hudson; Jeroen Aerts; Wouter Botzen; M.Conceição Colaço; Florence Crick; Jill Eldridge; Anna Lorant; António Macedo; Reinhard Mechler; Carlos Neto; Robin Nicolai; Dionisio Pérez-Blanco; Francisco Rego
  13. A Practical Approach to Financial Crisis Indicators Based on Random Matrices By Antoine Kornprobst; Raphael Douady
  14. Financial Soundness Index for the Private Corporate Sector in Colombia By Juan S. Lemus-Esquivel; Carlos A. Quicazán-Morenoy; Jorge L. Hurtado-Guarínz; Angélica Lizarazo-Cuéllarx
  15. The scale of predictability By Federico M. Bandi; Benoit Perron; Andrea Tamoni; Claudio Tebaldi
  16. Volatility Modeling with a Generalized t-distribution By Andrew Harvey and Rutger-Jan Lange
  17. House Price Volatility and the Housing Ladder By James Banks; Richard Blundell; Zoé Oldfield; James P. Smith
  18. Gold as a safe haven asset? Empirical evidence from a comparison of different financial assets By Franco Panfili; Francesco Daini; Francesco Potente; Giuseppe Reale

  1. By: V\'eronique Maume-Deschamps (ICJ); Didier Rulli\`ere (SAF); Khalil Said (SAF)
    Abstract: The European insurance sector will soon be faced with the application of Solvency 2 regulation norms. It will create a real change in risk management practices. The ORSA approach of the second pillar makes the capital allocation an important exercise for all insurers and specially for groups. Considering multi-branches firms, capital allocation has to be based on a multivariate risk modeling. Several allocation methods are present in the literature and insurers practices. In this paper, we present a new risk allocation method, we study its coherence using an axiomatic approach, and we try to define what the best allocation choice for an insurance group is.
    Date: 2015–06
  2. By: Hyejin Cho (CES - Centre d'économie de la Sorbonne - UP1 - Université Panthéon-Sorbonne - CNRS)
    Abstract: The motivation of this article is to induce the bank capital management solution for banks and regulation bodies on commercial banks. The goal of the paper is intended to mitigate the risk of a banking area and also provide the right incentive for banks to support the real economy.
    Date: 2015–02
  3. By: Alfredo Ibáñez (Bankia)
    Abstract: We show that the default event defined by endogenous credit-risk models (i.e. low asset values) can likewise be described in terms of low equity prices and negative net cash-flows (high debt service and/or negative earnings). Specifically, distance-to-default (DD), a volatility-adjusted measure of leverage, is given by the ratio of equity prices to negative net cash flows. This implies that the probability of default is the probability of this ratio becoming small, which then depends on the path of these two variables. This helps to explain why just equity prices (price per share, past return, and volatility) and firm’s debt and profitability are significant in reduced-form models that predict default while Merton’s DD becomes redundant if we control for them [Campbell et al. (2008)]. In endogenous models, default is triggered by depressed equity prices and a negative flow to shareholders (rather than low asset value). And, inversely, default concerns are readily lessened by easing refinancing costs (e.g. sovereigns for which default is costly and which regularly roll over their debts), lowering the principal (underwater mortgages or subprime consumer loans, which increases equity value), or raising equity (troubled banks).
    Keywords: credit-risk, default-risk, Merton’s distance-to-default, equity prices to negative net cash-flow ratio, endogenous default
    JEL: G13 G21 G28 G33
    Date: 2015–06
  4. By: Vahan Nanumyan; Antonios Garas; Frank Schweitzer
    Abstract: Counterparty risk denotes the risk that a party defaults in a bilateral contract. This risk not only depends on the two parties involved, but also on the risk from various other contracts each of these parties hold. In rather informal markets, such as the OTC (over-the-counter) derivative market, institutions only report their aggregated quarterly risk exposure, but no details about their counterparties. Hence, little is known about the diversification of counterparty risk. In this paper, we reconstruct the weighted and time-dependent network of counterparty risk in the OTC derivative market of the United States between 1998 and 2012. To proxy unknown bilateral exposures, we first study the co-occurrence patterns of institutions based on their quarterly activity and ranking in the official report. The network obtained this way is further analysed by a weighted k-core decomposition, to reveal a core-periphery structure. This allows us to compare the activity-based ranking with a topology-based ranking, to identify the most important institutions and their mutual dependencies. We also analyse correlations in these activities, to show strong similarities in the behavior of the core institutions. Our analysis clearly demonstrates the clustering of counterparty risk in a small set of about a dozen US banks. This not only increases the default risk of the central institutions, but also the default risk of peripheral institutions which have contracts with the central ones. Hence, all institutions indirectly have to bear (part of) the counterparty risk of all others, which needs to be better reflected in the price of OTC derivatives.
    Date: 2015–06
  5. By: Daniele Bianchi; Massimo Guidolin; Francesco Ravazzolo
    Abstract: This paper proposes a Bayesian estimation framework for a typical multi-factor model with timevarying risk exposures to macroeconomic risk factors and corresponding premia to price U.S. publicly traded assets. The model assumes that risk exposures and idiosynchratic volatility follow a break-point latent process, allowing for changes at any point on time but not restricting them to change at all points. The empirical application to 40 years of U.S. data and 23 portfolios shows that the approach yields sensible results compared to previous two-step methods based on naive recursive estimation schemes, as well as a set of alternative model restrictions. A variance decomposition test shows that although most of the predictable variation comes from the market risk premium, a number of additional macroeconomic risks, including real output and inflation shocks, are significantly priced in the cross-section. A Bayes factor analysis massively favors of the proposed change-point model. Keywords: Structural breaks, Stochastic volatility, Multi-factor linear models, Asset Pricing. JEL codes: G11, E44, C11, C53
    Date: 2015
  6. By: Arayssi, Mahmoud
    Abstract: A simple leverage ratio restriction is not efficient because it does not discriminate between risky and safe banks.We use a structural and comprehensive model of the firm’s asset growth to describe the equity buyout portfolios’ stylized facts for two types of banks.We derive a leverage ratio that depends on the level of risky investments, and balances between the spread on such investments, the cost of capital and the overall power of the supervisor to enforce the capital requirements. This method is more transparent and requires fewer parameters than other commonly used methods. We obtain an incentive-compatible constraint on banks to carry the minimal adequate amount of capital. This constraint enhances the supervisors’ ability to enforce the rules ex post, and provide banks with a further incentive to reveal their risk type truthfully.
    Keywords: private equity; captive funds; banks; capital requirements; leveraged ratio restriction; Basel II; Basel III
    JEL: G21 G28
    Date: 2015–05–01
  7. By: Gabriela Kuvikova
    Abstract: This paper examines the accuracy and timeliness of credit ratings in explaining the financial health of debt issuers over the recent financial crisis. Using annual financial statement data and macroeconomic indicators covering 2005-2013 for 2500 financial and non-financial institutions, this paper identifies the determinants of credit rating changes by two incumbent rating agencies: Moody’s and Standard & Poor’s. Empirical evidence suggests that while Moody’s is consistently more conservative in the assessment of default risk for non-financial institutions, Standard and Poor’s is consistently more conservative in the assessment of default risk for financial institutions. Fitch’s increasing market share deepens the rating disagreement between S&P and Moody’s. The results also suggest that sovereign ceilings cease to be restrictive for non-financial institutions over the recent financial crisis. S&P is a follower in its rating actions when compared to Moody’s for both financial and nonfinancial institutions.
    Keywords: credit rating agencies; rating change; information value;
    JEL: G20 G24
    Date: 2015–06
  8. By: Gabriel Illanes (Centro de Matemática, Facultad de Ciencias, Universidad de la República (Uruguay)); Alejandro Pena (Banco Central del Uruguay); Andrés Sosa (Centro de Matemática, Facultad de Ciencias, Universidad de la República (Uruguay))
    Abstract: This paper deals with credit risk in the Uruguayan aggregate economy and therefore correspond to financial stability purposes. To analyze the risk associated with a portfolio of loans a nonlinear parametric model based on Merton's approach is used. "Elasticities" of impact of the relevant macroeconomic factor on credit risk are reported for commercial and households lending, both in local currency and dollars. The coefficients are obtained by the statistical technique of maximum likelihood
    Abstract: Este trabajo evalúa el riesgo de crédito a nivel de la economía en su conjunto, teniendo como propósito el análisis de la estabilidad financiera. Para el análisis del riesgo asociado a un portafolio de préstamos se utiliza un modelo paramétrico no lineal basado en el enfoque de Merton. Se estiman las “elasticidades” a los factores económicos relevantes en las categorías crediticias correspondientes al crédito comercial y al crédito a familias, tanto en moneda nacional como en dólares. Los parámetros son obtenidos mediante la técnica estadística de Máxima Verosimilitud
    Keywords: banking, credit risk, latent factor model, default rate, stress test; bancos, riesgo de crédito, modelo de factor latente, probabilidad de default, análisis de tensión
    JEL: G21 G28 G33
    Date: 2014
  9. By: Cecilia Dassatti (Banco Central del Uruguay); Alejandro Pena (Banco Central del Uruguay); Jorge Ponce (Banco Central del Uruguay); Magdalena Tubio (Banco Central del Uruguay)
    Abstract: We study the counter-cyclical capital buffer introduced by Basel III and its complementarities with other regulation, particularly dynamic provisioning. We simulate different activation, adjust and deactivation rules for the buffer using historical data for Uruguay. The design and introduction of a counter-cyclical capital buffer following the principles in Basel III should complement actual regulation and serve as an extra tool to mitigate systemic risk in the Uruguayan banking sector.
    Abstract: En este documento se analizan las principales características del requerimiento de capital contra-cíclico sugerido por Basilea III y se estudia su complementariedad con otras herramientas regulatorias, en particular con las previsiones dinámicas. Se realiza un ejercicio de aplicación del requerimiento de capital contra-cíclico utilizando datos históricos de Uruguay y diferentes reglas de activación, ajuste y desactivación. Se concluye que el diseño e introducción de un requerimiento de capital contra-cíclico siguiendo los principios de Basilea III complementaría las regulaciones existentes y ampliaría el conjunto de herramientas para mitigar el riesgo sistémico en el sector bancario de Uruguay
    Keywords: Counter-cyclical capital, Basel III, Uruguay; Requerimiento de capital contra-cíclico, Basilea III, Uruguay
    JEL: G28
    Date: 2014
  10. By: Takuji Arai; Yuto Imai; Ryoichi Suzuki
    Abstract: We illustrate how to compute local risk minimization (LRM) of call options for exponential L\'evy models. We have previously obtained a representation of LRM for call options; here we transform it into a form that allows use of the fast Fourier transform method suggested by Carr & Madan. In particular, we consider Merton jump-diffusion models and variance gamma models as concrete applications.
    Date: 2015–06
  11. By: Andrew W. Lo
    Abstract: Culture is a potent force in shaping individual and group behavior, yet it has received scant attention in the context of financial risk management and the recent financial crisis. I present a brief overview of the role of culture according to psychologists, sociologists, and economists, and then present a specific framework for analyzing culture in the context of financial practices and institutions in which three questions are answered: (1) What is culture?; (2) Does it matter?; and (3) Can it be changed? I illustrate the utility of this framework by applying it to five concrete situations—Long Term Capital Management; AIG Financial Products; Lehman Brothers and Repo 105; Société Générale’s rogue trader; and the SEC and the Madoff Ponzi scheme—and conclude with a proposal to change culture via “behavioral risk management.”
    JEL: G01 G28 G3 M14 Z1
    Date: 2015–06
  12. By: Swenja Surminski; Paul Hudson; Jeroen Aerts; Wouter Botzen; M.Conceição Colaço; Florence Crick; Jill Eldridge; Anna Lorant; António Macedo; Reinhard Mechler; Carlos Neto; Robin Nicolai; Dionisio Pérez-Blanco; Francisco Rego
    Abstract: Managing risk and adapting to climate change is essential to minimise the losses and damages during and after disasters and extreme weather events. Several risk management approaches exist, one of which is the use of economic instruments (EI). Examples of EIs include taxes, subsidies and insurance to deliver financial protection in the event of a disaster, yet their design and the way in which they operate is essential to their success in mitigating and minimising hazard loss. Insurance is one example of an EI and functions as a tool to share and transfer risks and losses and is useful in aiding adaptation to climate change. Within this context insurance may be delivered using a range of approaches, which together contribute to its feasibility for delivery and operation as well as the potential for incentivising behavioural change. Yet undesirable aspects also exist and can include a lack of comprehensive information and cognitive biases, as well as financial constraints and moral hazard.
    Date: 2015–04
  13. By: Antoine Kornprobst (Centre d'Economie de la Sorbonne, Labex RéFi); Raphael Douady (Centre d'Economie de la Sorbonne, Labex RéFi)
    Abstract: The aim of this work is to build financial crisis indicators based on market data time series. After choosing an optimal size for a rolling window, the market data is seen every trading day as a random matrix from which a covariance and correlation matrix is obtained. Our indicators deal with the spectral properties of these covariance and correlation matrices. Our basic financial intuition is that correlation and volatility are like the heartbeat of the financial market: when correlations between asset prices increase or develop abnormal patterns, when volatility starts to increase, then a crisis event might be around the corner. Our indicators will be mainly of two types. The first one is based on the Hellinger distance, computed between the distribution of the eigenvalues of the empirical covariance matrix and the distribution of the eigenvalues of a reference covariance matrix. As reference distribution we will use the theoretical Marchenko Pastur distribution and, mainly, simulated ones using a random matrix of the same size as the empirical rolling matrix and constituted of Gaussian or Student-t coefficients with some simulated correlations. The idea behind this first type of indicators is that when the empirical distribution of the spectrum of the covariance matrix is deviating from the reference in the sense of Hellinger, then a crisis may be forthcoming. The second type of indicators is based on the study of the spectral radius and the trace of the covariance and correlation matrices as a mean to directly study the volatility and correlations inside the market. The idea behind the second type of indicators is the fact that large eigenvalues are a sign of dynamic instability
    Keywords: Quantitative Finance; Econometrics; Mathematical Methods; Statistical Simulation Methods; Forecasting and Prediction Methods; Large Data Sets Modeling and Analysis; Computational Techniques; Simulation Modeling; Financial Crises; Random Matrix Theory
    JEL: B16 C01 C02 C15 C53 C58 C63 G01
    Date: 2015–06
  14. By: Juan S. Lemus-Esquivel (Banco de la República de Colombia); Carlos A. Quicazán-Morenoy (Banco de la República de Colombia); Jorge L. Hurtado-Guarínz (Banco de la República de Colombia); Angélica Lizarazo-Cuéllarx (Banco de la República de Colombia)
    Abstract: This paper evaluates the importance of building a composite metric of financial soundness for the private corporate sector in Colombia. Instead of relying on the individual and sometimes restrictive financial ratio analysis approach, the purpose of this document is to provide a single metric aimed at measuring the financial health of firms. Said metric, the fiancial soundness index, is derived by employing the crosssection approach of principal component analysis. For the time period of 2000-2013,the results allow to identify which industries have a weak, strong or similar balance sheet performance relative to that observed for the private corporate sector as a whole. Furthermore, validation tests on the index confirm the apparent relationship between accounting data of private firms that are debtors of the Colombian financial system and the credit risk perception of and materialization for financial intermediaries.
    Keywords: Frms' financial soundness, principal component analysis, financial ratios, composite indices, financial stability
    JEL: L25 G30 G32 C3
  15. By: Federico M. Bandi; Benoit Perron; Andrea Tamoni; Claudio Tebaldi
    Abstract: Stock return predictive relations found to be elusive when using raw data may hold true for different layers in the cascade of economic shocks. Consistent with this logic, we model stock market returns and their predictors as aggregates of uncorrelated components (details) operating over different scales and introduce a notion of scale-specific predictability, i.e., predictability on the details. We study and formalize the link between scale-specific predictability and aggregation. Using both direct extraction of the details and aggregation, we provide strong evidence of risk compensations in long-run stock market returns - as well as of an unusually clear link between macroeconomic uncertainty and uncertainty in financial markets - at frequencies lower than the business cycle. The reported tent-shaped behavior in long-run predictability is shown to be a theoretical implication of our proposed modelling approach.
    Keywords: : long run, predictability, aggregation, risk-return trade-off, Fisher hypothesis,
    JEL: C22 E32 E44 G12 G17
    Date: 2015–05–29
  16. By: Andrew Harvey and Rutger-Jan Lange
    Abstract: Beta-t-EGARCH models in which the dynamics of the logarithm of scale are driven by the conditional score are known to exhibit attractive theoretical properties for the t-distribution and general error distribution (GED). The generalized-t includes both as special cases. We derive the information matrix for the generalized-t and show that, when parameterized with the inverse of the tail index, it remains positive definite as the tail index goes to infinity and the distribution becomes a GED. Hence it is possible to construct Lagrange multiplier tests of the null hypothesis of light tails against the alternative of fat tails. Analytic expressions may be obtained for the unconditional moments in the EGARCH model and the information matrix for the dynamic parameters obtained. The distribution may be extended by allowing for skewness and asymmetry in the shape parameters and the asymptotic theory for the associated EGARCH models may be correspondingly extended. For positive variables, the GB2 distribution may be parameterized so that it goes to the generalised gamma in the limit as the tail index goes to infinity. Again dynamic volatility may be introduced and properties of the model obtained. Overall the approach offers a unified, flexible, robust and practical treatment of dynamic scale.
    Keywords: Asymmetric price transmission, cost pass-through, electricity markets, price theory, rockets and feathers
    Date: 2015–06–11
  17. By: James Banks; Richard Blundell; Zoé Oldfield; James P. Smith
    Abstract: This paper investigates the effects of spatial housing price risk on housing choices over the first half of the life-cycle. Housing price risk can be substantial but, unlike other risky assets which people can avoid, most people want to eventually own their home thereby creating an insurance demand early in life. Our contribution focuses on the importance of home ownership as a hedge against future house price risk for individuals that plan to move up the housing ladder. We use a simple theoretical model to show that people living in places with higher housing price risk should own their first home at a younger age, live in larger homes, and be less likely to refinance. These predictions are shown to hold using panel data from the United States and United Kingdom.
    JEL: D12 D91
    Date: 2015–06
  18. By: Franco Panfili (Bank of Italy); Francesco Daini (Bank of Italy); Francesco Potente (Bank of Italy); Giuseppe Reale (Bank of Italy)
    Abstract: This work verifies the safe haven property of gold during market turmoil. Gold is also compared with other potential safe haven assets (Bunds and US Treasuries). The empirical analysis confirms the role of gold as a safe haven, especially ahead of shocks related to euro-government-bond markets with higher credit risk premiums. These results prove the essential role of gold in the balance sheet of Eurosystem central banks.
    Keywords: gold, safe haven, financial markets, uncertainty
    JEL: G10 G11 G14 G15
    Date: 2015–06

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