nep-rmg New Economics Papers
on Risk Management
Issue of 2015‒08‒13
eleven papers chosen by
Stan Miles
Thompson Rivers University

  1. Managing Systematic Mortality Risk in Life Annuities: An Application of Longevity Derivatives By Man Chung Fung; Katja Ignatieva; Michael Sherris
  2. Conditional Systemic Risk with Penalized Copula By Ostap Okhrin; Alexander Ristig; Jeffrey Sheen; Stefan Trück
  3. Yards implementation of Basel prudential framework and IFRS: some ideas for African banks. By SIDIBE, Tidiani
  4. Modeling Dependence Structure and Forecasting Market Risk with Dynamic Asymmetric Copula By Mario Cerrato; John Crosby; Minjoo Kim; Yang Zhao
  5. Procyclicality of credit rating systems: how to manage it By Tatiana Cesaroni
  6. Variation of Wrong-Way Risk Management and Its Impact on Security Price Changes By Tetsuya Adachi; Yoshihiko Uchida
  7. Statistical Emulators for Pricing and Hedging Longevity Risk Products By James Risk; Michael Ludkovski
  8. Constant Bet Size? Don't Bet on It! Testing Expected Utility Theory on Betfair Data By Frantisek Kopriva
  9. Is the European banking system more robust? An evaluation through the lens of the ECB's Comprehensive Assessment By Guillaume Arnould; Salim Dehmej
  10. A New International Database on Financial Fragility By Svetlana Andrianova; Badi Baltagi; Thorsten Beck; Panicos Demetriades; David Fielding; Stephen Hall; Steven Koch; Robert Lensink; Johan Rewilak; Peter Rousseau
  11. Can Governance Quality Predict Stock Market Returns? New Global Evidence By Paresh K Narayan; Susan S Sharma; Kannan Thuraisamy

  1. By: Man Chung Fung; Katja Ignatieva; Michael Sherris
    Abstract: This paper assesses the hedge effectiveness of an index-based longevity swap and a longevity cap. Although swaps are a natural instrument for hedging longevity risk, derivatives with non-linear pay-offs, such as longevity caps, also provide downside protection. A tractable stochastic mortality model with age dependent drift and volatility is developed and analytical formulae for prices of these longevity derivatives are derived. Hedge effectiveness is considered for a hypothetical life annuity portfolio. The hedging of the life annuity portfolio is comprehensively assessed for a range of assumptions for the market price of longevity risk, the term to maturity of the hedging instruments, as well as the size of the underlying annuity portfolio. The model is calibrated using Australian mortality data. The results provide a comprehensive analysis of longevity hedging, highlighting the risk management benefits and costs of linear and nonlinear payoff structures.
    Date: 2015–08
  2. By: Ostap Okhrin; Alexander Ristig; Jeffrey Sheen; Stefan Trück
    Abstract: Financial contagion and systemic risk measures are commonly derived from conditional quantiles by using imposed model assumptions such as a linear parametrization. In this paper, we provide model free measures for contagion and systemic risk which are independent of the speci- cation of conditional quantiles and simple to interpret. The proposed systemic risk measure relies on the contagion measure, whose tail behavior is theoretically studied. To emphasize contagion from extreme events, conditional quantiles are specied via hierarchical Archimedean copula. The parameters and structure of this copula are simultaneously estimated by imposing a non-concave penalty on the structure. Asymptotic properties of this sparse estimator are derived and small sample properties illustrated using simulations. We apply the proposed framework to investigate the interconnectedness between American, European and Australasian stock market indices, providing new and interesting insights into the relationship between systemic risk and contagion. In particular, our ndings suggest that the systemic risk contribution from contagion in tail areas is typically lower during times of nancial turmoil, while it can be signicantly higher during periods of low volatility.
    Keywords: Conditional quantile, Copula, Financial contagion, Spill-over eect, Stepwise penalized ML estimation, Systemic risk, Tail dependence
    JEL: C40 C46 C51 G1 G2
    Date: 2015–08
  3. By: SIDIBE, Tidiani
    Abstract: This article is striving to present the Basel prudential framework (Basel II and Basel III) following the international financial crisis from 2007 to 2008 and interfer ences with IAS / IFRS-IASB. Clearly these two sites for African banks are structuring projects under the path taken by their European counterparts. The purpose of this document is to present the two standards in a brief and succinct manner to facilitate understanding and issues related thereto to readers; and show some interference between them and justify the usefulness of conducting two projects simultaneously in order to save budgetary burdens.
    Keywords: Credit risk; market risk; operational risk; securitization; equity; weighted net assets; Basel, IAS / IFRS; prudential ratios; standard method; internal ratings.
    JEL: E58 G18 G21 G28
    Date: 2015–07–29
  4. By: Mario Cerrato; John Crosby; Minjoo Kim; Yang Zhao
    Abstract: We investigate the dynamic and asymmetric dependence structure between equity portfolios from the US and UK. We demonstrate the statistical significance of dynamic asymmetric copula models in modelling and forecasting market risk. First, we construct “high-minus-low" equity portfolios sorted on beta, coskewness, and cokurtosis. We find substantial evidence of dynamic and asymmetric de- pendence between characteristic-sorted portfolios. Second, we consider a dynamic asymmetric copula model by combining the generalized hyperbolic skewed t copula with the generalized autoregressive score (GAS) model to capture both the multivariate non-normality and the dynamic and asymmetric dependence between equity portfolios. We demonstrate its usefulness by evaluating the forecasting performance of Value-at-Risk and Expected Shortfall for the high-minus-low portfolios. From back- testing, we find consistent and robust evidence that our dynamic asymmetric copula model provides the most accurate forecasts, indicating the importance of incorporating the dynamic and asymmetric dependence structure in risk management.
    Keywords: asymmetry, tail dependence, dependence dynamics, dynamic skewed t copulas, VaR and ES forecasting
    JEL: C32 C53 G17 G32
    Date: 2015–02
  5. By: Tatiana Cesaroni
    Abstract: The recent Eurozone financial crisis has highlighted the need for stable rating systems to assess portfolio banks risks exposures abstracting from the current cyclical conditions. This paper evaluates the characteristics of a Point in Time (PiT) rating approach for the estimation of firms' credit risk in terms of pro-cyclicality. To this end I first estimate a logit model for the probability default (PD) of a set of Italian non financial firms during the period 2006-2012, then, in order to address the issue of the rating stability (rating changes hedging) during the financial crisis, I study the effectiveness of an ex post PDs smoothing in terms of obligors' migration among rating risk grades. As bi-product I further discuss and analyze the role played by the rating scale definition (choice) in producing ratings stability. The results show that an ex post PD smoothing is able to remove business cycle effects on the credit risk estimates and to produce a mitigation of obligors' migration among risk grades over time. The rating scale choice also has a significant impact on the rating stability. These findings have important policy implications in banking sector practices in terms of financial system stability.
    Keywords: PiT rating system, business cycle, financial stability, long run probability default, procyclicality
    Date: 2015–07
  6. By: Tetsuya Adachi (Economist, Institute for Monetary and Economic Studies, Bank of Japan (currently, Deputy Director, Prudential Standards Office, Supervisory Coordination Division, Supervisory Bureau, Financial Services Agency, Government of Japan, E-mail:; Yoshihiko Uchida (Director and Senior Economist, Institute for Monetary and Economic Studies, Bank of Japan (currently, Director, Supervisory Coordination Division, Supervisory Bureau, Financial Services Agency, Government of Japan, E-mail:
    Abstract: Wrong-way risk arises when an unexpected adverse change in interdependency among financial products or financial variables (such as interest rates, equities, exchange rates, credits, and commodities) triggers huge losses in portfolios. During the global financial crisis of 2007-09, financial institutions suffered huge losses due to the materialization of wrong-way risk. While its importance has been recognized by market participants, however, they have not reached a consensus on how to model and measure it. This paper proposes a method to model wrong-way risk in pricing and risk management and investigate the mechanism in which it can generate booms and busts in security prices. This paper assumes that there exist two types of investors with differing views on the management of the wrong-way risk and that they trade a derivative security with two underlying assets. The prudent (imprudent) investors are supposed to have a heavy (thin) tail structure in the joint distributions of risky assets in their models. This assumption implies that the reservation value on the security held by imprudent investors is higher than that by prudent investors. In this setup, a numerical analysis shows that (1) as time passes from the latest materialization of wrong-way risk and many investors tend to be imprudent, the market price is bidden up; and (2) once the wrong-way risk materializes, many imprudent investors realize the necessity for prudent management of wrong- way risk and thus the price drops suddenly to the lowest level.
    Keywords: Wrong-way risk, Systemic risk, Jump-diffusion process, Asset pricing, Market microstructure
    JEL: G12 G13 G32
    Date: 2015–07
  7. By: James Risk; Michael Ludkovski
    Abstract: We propose the use of statistical emulators for the purpose of valuing mortality-linked contracts in stochastic mortality models. Such models typically require (nested) evaluation of expected values of nonlinear functionals of multi-dimensional stochastic processes. Except in the simplest cases, no closed-form expressions are available, necessitating numerical approximation. Rather than building ad hoc analytic approximations, we advocate the use of modern statistical tools from machine learning to generate a flexible, non-parametric surrogate for the true mappings. This method allows performance guarantees regarding approximation accuracy and removes the need for nested simulation. We illustrate our approach with case studies involving (i) a Lee-Carter model with mortality shocks, (ii) index-based static hedging with longevity basis risk; (iii) a Cairns-Blake-Dowd stochastic survival probability model.
    Date: 2015–08
  8. By: Frantisek Kopriva
    Abstract: I analyze the risk preferences of bettors using data from the world's largest betting exchange, Betfair. The assumption of a constant bet size, commonly used in the current literature, leads to an unrealistic model of bettors' decision making as a choice between a high return - low variance and low return - high variance bet, automatically implying risk-loving preferences of bettors. However, the data show that bettors bet different amounts on different odds. Thus, simply by introducing the computed average bet size at given odds I transform the bettor's decision problem into a standard choice between low return - low variance and high return - high variance bets, and I am able to correctly estimate the risk attitudes of bettors. Results indicate that bettors on Betfair are either risk neutral (tennis and soccer markets) or slightly risk loving (horse racing market). I further use the information on the average bet size to test the validity of Expected utility theory (EUT). The results suggest that, when facing a number of outcomes with different winning probabilities, bettors tend to overweight small and underweight large differences in probabilities, which is in direct contradiction to the linear probability weighting function implied by EUT.
    Keywords: decision making under risk; expected utility theory; betting exchanges;
    JEL: D01 D03 D81
    Date: 2015–07
  9. By: Guillaume Arnould (Centre d'Economie de la Sorbonne - Labex Régulation Financière (Réfi)); Salim Dehmej (Centre d'Economie de la Sorbonne - Labex Régulation Financière (Réfi))
    Abstract: The results of the Comprehensive Assessment (CA) conducted by the ECB seem to attest the soundness of the European banking system since only 8 of 130 assessed banks still need to raise €6 billion. However it would be a mistake to conclude that non failing banks are completely healthy. Using data provided by the ECB and the ECB and the EBA after the CA, we assess the capital shortfalls for each banks by considering the transitional arrangements, an implementation of Basel III sovereign debt requirements and an enhancement of the leverage ratio. In addition we show, that if the CA has been a very complex exercise, it is not the best lens through which the soundness of the eurozone banking system should be evaluated. The assumptions used for the Asset Quality Review (AQR) and the stress-tests lead to week scenarios and requirements that undermine the reliability of the results. Finally we show that the low profitability, the massive dividend distribution and the incurred fines, give rise to concern on the ability of eurozone banks to meet the incoming capital requirements
    Keywords: financial stability; stress tests; banking; financial regulation; Basel III
    JEL: G21 G28
    Date: 2015–07
  10. By: Svetlana Andrianova; Badi Baltagi; Thorsten Beck; Panicos Demetriades; David Fielding; Stephen Hall; Steven Koch; Robert Lensink; Johan Rewilak; Peter Rousseau
    Abstract: We present a new database on financial fragility for 124 countries over 1998 to 2012. In addition to commercial banks, our database incorporates investment banks and real estate and mortgage banks, which are thought to have played a central role in the recent financial crisis. Furthermore, it also includes cooperative banks, savings banks and Islamic banks, that are often thought to have different risk appetites than do commercial banks. As a result, the total value of financial assets in our database is around 50% higher than that accounted for by commercial banks alone. We provide eight different measures of financial fragility, each focussing on a different aspect of vulnerability in the financial system. Alternative selection rules for our variables distinguish between institutions with different levels of reporting frequency.
    Date: 2015–07
  11. By: Paresh K Narayan (Deakin University); Susan S Sharma (Deakin University); Kannan Thuraisamy (Deakin University)
    Abstract: We develop country-level governance indices using governance risk factors and examine whether country-level governance can predict stock market returns. We find that country-level governance predicts stock market returns only in countries where governance quality is poor. For countries with well-developed governance, there is no evidence that governance predicts returns. Our findings also confirm that investors in countries with weak governance can utilise information contained in country-level governance indicators to devise profitable portfolio strategies.
    Keywords: Predictability; Returns; Governance; Country characteristics.

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