nep-rmg New Economics Papers
on Risk Management
Issue of 2015‒11‒15
fourteen papers chosen by

  1. An asymptotic test for the Conditional Value-at-Risk By Vékás, Péter
  2. Down-side Risk Metrics as Portfolio Diversification Strategies across the GFC By David E. Allen; Michael McAleer; Robert J. Powell; Abbay K. Singh
  3. Extreme risk interdependence By Polanski, Arnold; Stoja, Evarist
  4. Capital allocation and risk appetite under Solvency II framework By Ivan Granito; Paolo De Angelis
  5. Envelope Condition Method with an Application to Default Risk Models By Viktor Tsyrennikov; Serguei Maliar; Lilia Maliar; Cristina Arellano
  6. Nonstationary Z-score measures By Mare, Davide Salvatore; Moreira, Fernando; Rossi, Roberto
  7. Federal Reinsurance for Terrorism Risk: An Update By Congressional Budget Office
  8. Risk governance and performance of the Italian banks: an empirical analysis By Elisa Cavezzali; Gloria Gardenal
  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. Climate change mitigation as catastrophic risk management By Simon Dietz
  11. Pitfalls of downside performance measures with arbitrary targets By Benedikt Hoechner; Peter Reichling; Gordon Schulze
  12. Does Credit Risk Impact Liquidity Risk? Evidence from Credit Default Swap Markets By Hertrich, Markus
  13. On the C-property and $w^*$-representations of risk measures By Niushan Gao; Foivos Xanthos
  14. Living in a Stochastic World and Managing Complex Risks By Dacorogna, Michel; Kratz, Marie

  1. By: Vékás, Péter
    Abstract: Conditional Value-at-Risk (equivalent to the Expected Shortfall, Tail Value-at-Risk and Tail Conditional Expectation in the case of continuous probability distributions) is an increasingly popular risk measure in the fields of actuarial science, banking and finance, and arguably a more suitable alternative to the currently widespread Value-at-Risk. In my paper, I present a brief literature survey, and propose a statistical test of the location of the CVaR, which may be applied by practising actuaries to test whether CVaR-based capital levels are in line with observed data. Finally, I conclude with numerical experiments and some questions for future research.
    Keywords: risk measures, Conditional Value-at-Risk, hypothesis testing, actuarial science
    JEL: C01
    Date: 2015–10–21
  2. By: David E. Allen (University of Sidney, University of South Australia, Australia); Michael McAleer (National Tsing Hua University, Taiwan; Erasmus University Rotterdam, the Netherlands; Complutense University of Madrid, Spain); Robert J. Powell (Edith Cowan University, Australia); Abbay K. Singh (Edith Cowan University, Australia)
    Abstract: This paper features an analysis of the effectiveness of a range of portfolio diversication strategies, with a focus on down-side risk metrics, as a portfolio diversification strategy in a European market context. We apply these measures to a set of daily arithmetically compounded returns on a set of ten market indices representing the major European markets for a nine year period from the beginning of 2005 to the end of 2013. The sample period, which incorporates the periods of both the Global Financial Crisis (GFC) and subsequent European Debt Crisis (EDC), is challenging one for the application of portfolio investment strategies. The analysis is undertaken via the examination of multiple investment strategies and a variety of hold-out periods and back-tests. We commence by using four two year estimation periods and subsequent one year investment hold out period, to analyse a naive 1/N diversification strategy, and to contrast its effectiveness with Markowitz mean variance analysis with positive weights. Markowitz optimisation is then compared with various down-side investment optimisation strategies. We begin by comparing Markowitz with CVaR, and then proceed to evaluate the relative effectiveness of Markowitz with various draw-down strategies, utilising a series of backtests. Our results suggest that none of the more sophisticated optimisation strategies appear to dominate naive diversification.
    Keywords: Portfolio Diversification; Markowitz Analysis; Downside Risk; CVaR; Draw-down
    JEL: G11 C61
    Date: 2015–11–02
  3. By: Polanski, Arnold (University of East Anglia); Stoja, Evarist (University of Bristol)
    Abstract: Tail interdependence is defined as the situation where extreme outcomes for some variables are informative about such outcomes for other variables. We extend the concept of multi-information to quantify tail interdependence at different levels of extremity, decompose it into systemic and residual part and measure the contribution of a constituent to the interdependence of a system. Further, we devise statistical procedures to test: a) tail independence; b) whether an empirical interdependence structure is generated by a theoretical model; and c) symmetry of the interdependence structure in the tails. The application of this approach to multidimensional financial data confirms some known and uncovers new stylized facts on extreme returns.
    Keywords: Co-exceedance; Kullback-Leibler divergence; multi-information; relative entropy; risk contribution; risk interdependence.
    JEL: C12 C14 C52
    Date: 2015–11–06
  4. By: Ivan Granito; Paolo De Angelis
    Abstract: The aim of this paper is to introduce a method for computing the allocated Solvency II Capital Requirement (SCR) of each Risk which the company is exposed to, taking in account for the diversification effect among different risks. The method suggested is based on the Euler principle. We show that it has very suitable properties like coherence in the sense of Denault (2001) and RORAC compatibility, and practical implications for the companies that use the standard formula. Further, we show how this approach can be used to evaluate the underwriting and reinsurance policies and to define a measure of the Company's risk appetite, based on the capital at risk return.
    Date: 2015–11
  5. By: Viktor Tsyrennikov (IMF); Serguei Maliar (Santa Clara University); Lilia Maliar (Stanford University); Cristina Arellano (Federal Reserve Bank of Minneapolis)
    Abstract: We develop an envelope condition method (ECM) for dynamic programming problems -- a tractable alternative to expensive conventional value function iteration. ECM has two novel features: First, to reduce the cost, ECM replaces expensive backward iteration on Bellman equation with relatively cheap forward iteration on an envelope condition. Second, to increase the accuracy of solutions, ECM solves for derivatives of a value function jointly with a value function itself. We complement ECM with other computational techniques that are suitable for high-dimensional problems, such as simulation-based grids, monomial integration rules and derivative-free solvers. The resulting value-iterative ECM method can accurately solve models with at least up to 20 state variables and can successfully compete in accuracy and speed with state-of-the-art Euler equation methods. We also use ECM to solve a challenging default risk model with a kink in value and policy functions, and we find it to be fast, accurate and reliable.
    Date: 2015
  6. By: Mare, Davide Salvatore; Moreira, Fernando; Rossi, Roberto
    Abstract: In this work we develop advanced techniques for measuring bank insolvency risk. More specifically, we contribute to the existing body of research on the Z-Score. We develop bias reduction strategies for state-of-the-art Z-Score measures in the literature. We introduce novel estimators whose aim is to effectively capture nonstationary returns; for these estimators, as well as for existing ones in the literature, we discuss analytical confidence regions. We exploit moment-based error measures to assess the effectiveness of these estimators. We carry out an extensive empirical study that contrasts state-of-the-art estimators to our novel ones on over ten thousand banks. Finally, we contrast results obtained by using Z-score estimators against business news on the banking sector obtained from Factiva. Our work has important implications for researchers and practitioners. First, accounting for the degree of nonstationarity in returns yields a more accurate quantification of the degree of solvency. Second, our measure allows researchers to factor in the degree of uncertainty in the estimation due to the availability of data while estimating the overall risk of bank insolvency.
    Keywords: bank stability; prudential regulation; insolvency risk; financial distress; Z-Score
    JEL: C20 C60 G21
    Date: 2015–11–11
  7. By: Congressional Budget Office
    Abstract: The federal program that provides insurance against the risk of terrorism expired at the end of 2014. Without such a program, taxpayers will face less financial risk, but some businesses will lose or drop their terrorism coverage. Last year the Congress considered legislation to reauthorize the program but shift more risk to the private sector. Other options include limiting federal coverage to attacks using nonconventional weapons, and charging risk-based prices for federal coverage.
    JEL: G22 G28 H25 H42
    Date: 2015–01–06
  8. By: Elisa Cavezzali (Dept. of Management, Università Ca' Foscari Venice); Gloria Gardenal (Dept. of Management, Università Ca' Foscari Venice)
    Abstract: The paper investigates the relation between the adoption of good practices in risk management and the level of performance and riskiness of banks. In particular, we aim at understanding if the application of the Enterprise Risk Management approach to banks helps increasing their stability. We test the hypothesis that those banks using an integrated risk management approach have, ceteris paribus, a lower level of risk and a higher performance. Our analysis focuses on 21 Italian listed banking groups, in the time period 2005-2013. Our preliminary results show that the risk management function influences the risk and performance of the bank; however, it is not possible from our data to define an optimal model of risk governance.
    Keywords: Irisk management, risk governance, enterprise risk management, banking system
    Date: 2015–10
  9. By: Guillaume Arnould (CES - Centre d'économie de la Sorbonne - UP1 - Université Panthéon-Sorbonne - CNRS, LABEX Refi - ESCP Europe); Salim Dehmej (CES - Centre d'économie de la Sorbonne - UP1 - Université Panthéon-Sorbonne - CNRS, LABEX Refi - ESCP Europe)
    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: Basel III,Financial stability,stress tests,banking,financial regulation
    Date: 2015–07
  10. By: Simon Dietz
    JEL: G32
    Date: 2014–11
  11. By: Benedikt Hoechner (Faculty of Economics and Management, Otto-von-Guericke University Magdeburg); Peter Reichling (Faculty of Economics and Management, Otto-von-Guericke University Magdeburg); Gordon Schulze (Faculty of Economics and Management, Otto-von-Guericke University Magdeburg)
    Abstract: The Sharpe ratio has been criticized with regard to the assumptions of mean-volatility portfolio selection. Downside performance measures were developed to resolve this critique; they are consistent with expected utility under less restrictive assumptions. The most prominent family of downside performance measures is known as Kappa ratios and puts above target returns into relation to lower partial moments. While the Sharpe ratio of a mutual fund examines whether portfolios of mutual fund and risk-free asset dominate risk-adjusted passive portfolios of benchmark and risk-free asset, this characteristic cannot be transferred to downside performance measures with arbitrary targets. We show that Kappa ratios assign different values to passive strategies with varying fractions of benchmark and risk-free asset if the target differs from the risk-free rate. This effect can lead to reverse rankings of inferior and superior performing mutual funds. In addition, even the ratio of excess return and excess downside risk of passive portfolios is not constant in general. Therefore, downside performance measures turn out to be only applicable in asset management if the target is set equal to the risk-free rate.
    Keywords: Downside risk, Kappa ratios, lower partial moment, performance measurement, Sharpe ratio
    JEL: D81 G11
    Date: 2015–11
  12. By: Hertrich, Markus
    Abstract: During the recent financial crisis that erupted in mid-2007, credit default swap spreads increased by several hundred basis points, accompanied by a liquidity shortage in the U.S. financial sector. This period has both evidenced the importance that liquidity has for investors and underlined the need to understand the linkages between credit markets and liquidity. This paper sheds light on the dynamic interactions between credit and liquidity risk in the credit Default swap market. Contrary to the common belief that illiquidity leads to a credit risk deterioration in financial markets, it is found that in a sample of German and Swiss companies, credit risk is more likely to be weakly endogenous for liquidity risk than vice versa. The results suggest that a negative credit shock typically leads to a subsequent liquidity shortage in the credit default swap market, in the spirit of, for instance, the liquidity spiral posited by Brunnermaier (2009), and extends our knowledge about how credit markets work, as it helps to explain the amplification mechanisms that severely aggravated the recent crisis and also indicates which macro-prudential policies would be suitable for preventing a similar financial crisis in the future.
    Keywords: financial crisis, credit default swap, credit risk, liquidity risk, endogeneity, macroprudential policy
    JEL: E37 E61 G14 G32 G38
    Date: 2015–09
  13. By: Niushan Gao; Foivos Xanthos
    Abstract: We identify a large class of Orlicz spaces $X$ for which the topology $\sigma(X,X_n^\sim)$ fails the C-property. We also apply a variant of the C-property to establish a $w^*$-representation theorem for proper convex increasing functionals on dual Banach lattices that satisfy a suitable version of Delbaen's Fatou property.
    Date: 2015–11
  14. By: Dacorogna, Michel (SCOR SE); Kratz, Marie (ESSEC Business School)
    Abstract: If there is a concept that has gained awareness during the financial crisis of 2008/2009, it is certainly the concept of risk and its consequence in risk management. The failure of many financial institutions to grasp the risks they were taking appeared so clearly and was so costly that the subject became central both with the regulators and more generally within society. Even though risk is an old concept, its perception has changed over the ages. In this century, the increase of wealth and the advances of scientific techniques may give the illusion to mankind that it has full power over Nature. People are either risk adverse or risk prone, without accepting its possible negative consequences, reactions that could be qualified as extreme and silly. Looking at it in a binary way does not help us cope with it. There is indeed little rational behavior when risk is concerned. Instead we should consider its right definition to be able to manage it. Already in the XVIII th century, philosophers came to realize that risk could contain two aspects as summarized by the French thinker Etienne Bonnot de Condillac (1714-1780) who qualified risk as " The chance of incurring a bad outcome, coupled, with the hope, if we escape it, to achieve a good one. " We see here the birth of a notion that will become prevalent in finance and economics during the XX th century.
    Keywords: extreme risk; risk management
    JEL: C51 C53 C73 D81 G17 G22
    Date: 2015–10

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