nep-rmg New Economics Papers
on Risk Management
Issue of 2016‒02‒04
eighteen papers chosen by

  1. Choosing Expected Shortfall over VaR in Basel III Using Stochastic Dominance By Chang, C-L.; Jiménez-Martín, J.A.; Maasoumi, E.; McAleer, M.J.
  2. Contingent liabilities risk management : a credit risk analysis framework for sovereign guarantees and on-lending?country experiences from Colombia, Indonesia, Sweden, and Turkey By Bachmair,Fritz Florian
  3. Hedge Fund Tail Risk: An investigation in stressed markets, extended version with appendix By Monica Billio; Lorenzo Frattarolo; Loriana Pelizzon
  4. Bank capital regulation: are local or central regulators better? By Carole HARITCHABALET; Laetitia LEPETIT; Kévin SPINASSOU; Franck STROBEL
  5. Financial connectedness among European volatility risk premia By Andrea Cipollini; Iolanda Lo Cascio; Silvia Muzzioli
  6. Quantile hedging on markets with proportional transaction costs By Micha{\l} Barski
  7. Option-Implied Equity Premium Predictions via Entropic TiltinG By Davide Pettenuzzo; Konstantinos Metaxoglou; Aaron Smith
  8. Global commodities and African stocks: insights for hedging and diversification strategies By Gideon Boako and Paul Alagidede
  9. Taming macroeconomic instability: Monetary and macro prudential policy interactions in an agent-based model By Lilit Popoyan; Mauro Napoletano; Andrea Roventini
  10. Risk Shifting with Fuzzy Capital Constraints By Simon Dubecq; Xavier Ragot; Benoit Mojon
  11. On a law of large numbers for insurance risks By Yumiharu Nakano
  12. Credit risk: Taking fluctuating asset correlations into account By Thilo A. Schmitt; Rudi Sch\"afer; Thomas Guhr
  13. Survival Models for Credit Risk Estimation in the context of SME By Alberto BURCHI; Francesca PIERRI
  14. Stress events in the Hungarian stock market By Dömötör, Barbara; Váradi, Kata
  15. Dynamic Global Currency Hedging By Bent Jesper Christensen; Rasmus T. Varneskov
  16. The countercyclical capital buffer in spain: an analysis of key guiding indicators By Christian Castro; Ángel Estrada; Jorge Martínez
  17. Portfolio optimization under dynamic risk constraints By Imke H\"ofers; Ralf Wunderlich
  18. Pension Scheme Redesign and Wealth Redistribution Between the Members and Sponsor: The USS Rule Change in October 2011 By Emmanouil Platanakis; Charles Sutcliffe;

  1. By: Chang, C-L.; Jiménez-Martín, J.A.; Maasoumi, E.; McAleer, M.J.
    Abstract: Bank risk managers follow the Basel Committee on Banking Supervision (BCBS) recommendations that recently proposed shifting the quantitative risk metrics system from Value-at-Risk (VaR) to Expected Shortfall (ES). The Basel Committee on Banking Supervision (2013, p. 3) noted that: “a number of weaknesses have been identified with using VaR for determining regulatory capital requirements, including its inability to capture tail risk”. The proposed reform costs and impact on bank balances may be substantial, such that the size and distribution of daily capital charges under the new rules could be affected significantly. Regulators and bank risk managers agree that all else being equal, a “better” distribution of daily capital charges is to be preferred. The distribution of daily capital charges depends generally on two sets of factors: (1) the risk function that is adopted (ES versus VaR); and (2) their estimated counterparts. The latter is dependent on what models are used by bank risk managers to provide for forecasts of daily capital charges. That is to say, while ES is known to be a preferable “risk function” based on its fundamental properties and greater accounting for the tails of alternative distributions, that same sensitivity to tails can lead to greater daily capital charges, which is the relevant (that is, controlling) practical reference for risk management decisions and observations. In view of the generally agreed focus in this field on the tails of non-standard distributions and low probability outcomes, an assessment of relative merits of estimated ES and estimated VaR is ideally not limited to mean variance considerations. For this reason, robust comparisons between ES and VaR will be achieved in the paper by using a Stochastic Dominance (SD) approach to rank ES and VaR.
    Keywords: Stochastic dominance, Value-at-Risk, Expected Shortfall, Optimizing strategy, Basel III Accord
    JEL: G32 G11 G17 C53 C22
    Date: 2015–12–01
  2. By: Bachmair,Fritz Florian
    Abstract: Sovereign credit guarantees and government on-lending can catalyze private sector investment and fulfill specific policy objectives. However, contingent liabilities stemming from guarantees and contingent assets stemming from on-lending expose governments to risk. Prudent risk management, including risk analysis and measurement, can help identify and mitigate these risks. This paper proposes a four-step structure for analyzing and measuring credit risk: (i) defining key characteristics to determine the choice of a risk analysis approach; (ii) analyzing risk drivers; (iii) quantifying risks; and (iv) applying risk analyses and quantification to the design of risk management tools. This structure is based on an assessment of approaches discussed in academia and applied in practice. The paper demonstrates how the four steps of credit risk management are applied in Colombia, Sweden, and Turkey. It also discusses how the proposed framework is applied in Indonesia as it develops a credit risk management framework for sovereign guarantees. Country experiences show that although sovereign risk managers can draw on insights from credit risk management in the private sector, academic literature, and practices in other countries, approaches to risk management need to be highly context-specific. Key differentiating factors include characteristics of the guarantee and on-lending portfolio, the sovereign?s specific risk exposure, the availability of market information and data, and resources and capacity in the public sector. Developing a sound risk analysis and measurement framework requires significant investments in resources, capacity building, and time. Governments should view this process as iterative and long-term.
    Keywords: Debt Markets,Insurance&Risk Mitigation,Banks&Banking Reform,Access to Finance,Bankruptcy and Resolution of Financial Distress
    Date: 2016–01–22
  3. By: Monica Billio (Department of Economics, University Of Venice Cà Foscari); Lorenzo Frattarolo (Department of Economics, University Of Venice Cà Foscari); Loriana Pelizzon (SAFE-Goethe University Frankfurt and Department of Economics, University Of Venice Cà Foscari)
    Abstract: This paper develops several risk measures that captures the tail risk of single hedge fund strategies and the tail risk contribution of these hedge fund strategies to the overall portfolio tail risk, conditional on the level of market distress. We show that, during the recent global financial crisis, all the different hedge fund strategies are contributing to the tail risk of the portfolio of hedge funds, mostly because of the hedge fund strategies' exposure to liquidity and credit risk.
    Keywords: Hedge funds, Tail risk, Diversification, Marginal risk contribution
    JEL: G11 G29
    Date: 2016
    Abstract: Using a simple two-region model where local or central regulators set capital requirements as risk sensitive capital or leverage ratios, we demonstrate the importance of capital requirements being set centrally when cross-region spillovers are large and local regulators suffer from substantial regulatory capture. We show that local regulators may want to surrender regulatory power only when spillover effects are large but the degree of supervisory capture is relatively small, and that capital regulation at central rather than local levels is more beneficial the larger the impact of systemic risk and the more asymmetric is regulatory capture at the local level.
    Keywords: bank regulation; capital requirement; spillover; regulatory capture; financial architecture
    JEL: G21 G28
    Date: 2016–01
  5. By: Andrea Cipollini; Iolanda Lo Cascio; Silvia Muzzioli
    Abstract: In this paper we use the Diebold Yilmaz (2009 and 2012) methodology to estimate the contribution and the vulnerability to systemic risk of volatility risk premia for five European stock markets: France, Germany, UK, Switzerland and the Netherlands. The volatility risk premium, which is a proxy of risk aversion, is measured by the difference between the implied volatility and expected realized volatility of the stock market for next month. While Diebold and Yilmaz focus is on the forecast error variance decomposition of stock returns or range based volatilities employing a stationary VAR in levels, we account for the (locally) long memory stationary properties of the levels of volatility risk premia series. Therefore, we estimate and invert a Fractionally Integrated VAR model to compute the cross forecast error variance shares necessary to obtain the index of total and directional connectedness.
    Keywords: volatility risk premium, long memory, FIVAR, financial connectedness
    JEL: C32 C38 C58 G13
    Date: 2015–12
  6. By: Micha{\l} Barski
    Abstract: In the paper a problem of risk measures on a discrete-time market model with transaction costs is studied. Strategy effectiveness and shortfall risk is introduced. This paper is a generalization of quantile hedging presented in [4].
    Date: 2016–01
  7. By: Davide Pettenuzzo (Brandeis University); Konstantinos Metaxoglou (Carleton University); Aaron Smith (University of California, Davis)
    Abstract: We propose a new method to improve density forecasts of the equity premium us- ing information from options markets. We tilt the predictive densities from standard econometric models suggested in the stock return predictability literature towards the second moment of the risk-neutral distribution implied by options prices. In so do- ing, we use a simple regression-based approach to remove the variance risk premium. By combining the backward-looking information contained in the econometric models with the forward-looking information from the options prices, tilting yields sharper predictive densities. Using density forecasts of the U.S. equity premium in Rapach and Zhou (2012), we nd that tilting leads to more accurate predictions, both in terms of statistical and economic performance.
    JEL: C11 C22 G11 G12
    Date: 2016–01
  8. By: Gideon Boako and Paul Alagidede
    Abstract: Owing to frequent fluctuations in global markets, diversifying across emerging markets is increasingly becoming a necessity. Despite this, a cloud of uncertainty surrounds the relative capacities of emerging markets to provide the required shields for international investors, especially during extreme market conditions. In this paper, we explore the relative potentials of African equities to provide opportunities for hedging and diversification for global commodity investors by using data of daily periodicity on close-to-close basis from January 3, 2003 to December 29, 2014. The findings indicate the presence of non-linear relationships between some African stocks and returns on global commodities. Thus, global commodity market investors react differently towards investment potentials in African stocks during tranquil and crisis periods in the commodity markets. Additionally, from the mean-variance stand-point, including African equities in a diversified portfolio has the effect of lowering risk whiles simultaneously increasing expected returns. However, such investment strategies must be informed by volatility persistence, as well as past and present market conditions.
    Keywords: African stocks, global commodities, safe haven, mean-variance, hedging
    JEL: G10 G11 G15
    Date: 2015
  9. By: Lilit Popoyan (Laboratory of Economics and Management (Pisa) (LEM)); Mauro Napoletano (OFCE); Andrea Roventini (Department of economics)
    Abstract: We develop an agent-based model to study the macroeconomic impact of alternative macro prudential regulations and their possible interactions with different monetary policy rules.The aim is to shed light on the most appropriate policy mix to achieve the resilience of the banking sector and foster macroeconomic stability. Simulation results show that a triple-mandate Taylor rule, focused on output gap, inflation and credit growth, and a Basel III prudential regulation is the best policy mix to improve the stability of the banking sector and smooth output fluctuations. Moreover, we consider the dfferent levers of Basel III andtheir combinations. We find that minimum capital requirements and counter-cyclical capital buffers allow to achieve results close to the Basel III first-best with a much more simplifiedregulatory framework. Finally, the components of Basel III are non-additive: the inclusionof an additional lever does not always improve the performance of the macro prudentialregulation
    Keywords: Macro prudential policy; Basel III regulation; Financial stability; Monetary policy; Agent-based computational economics
    JEL: C63 E52 E6 G1 G21 G28
    Date: 2015–12
  10. By: Simon Dubecq (Banque centrale européenne); Xavier Ragot (OFCE); Benoit Mojon (Banque de France)
    Abstract: We construct a model where risk shifting can be moder-ated by capital requirements. Imperfect information about the level of capital per unit of risk, however, introduces uncertaintyabout the risk exposure of intermediaries. Over-estimation ofthe capital held by financial intermediaries, or the extent ofregulatory arbitrage, may induce households to wrongly infer from higher asset prices that the fundamentals of risky assets have improved. This mechanism can notably explain the lowrisk premia paid by U.S. financial intermediaries between 2000 and 2007 in spite of their increased exposure to risk through higher leverage. Moreover, the lower the level of the risk-free interest rate, the more risk is under-estimated
    Keywords: Risk shifting; Capital requirements
    JEL: G14 G21 E52
    Date: 2015–01
  11. By: Yumiharu Nakano
    Abstract: This note presents a kind of the strong law of large numbers for an insurance risk caused by a single catastrophic event rather than by an accumulation of independent and identically distributed risks. We derive this result by a large diversification effect resulting from optimal allocation of the risk to many reinsurers or investors.
    Date: 2016–01
  12. By: Thilo A. Schmitt; Rudi Sch\"afer; Thomas Guhr
    Abstract: In structural credit risk models, default events and the ensuing losses are both derived from the asset values at maturity. Hence it is of utmost importance to choose a distribution for these asset values which is in accordance with empirical data. At the same time, it is desirable to still preserve some analytical tractability. We achieve both goals by putting forward an ensemble approach for the asset correlations. Consistently with the data, we view them as fluctuating quantities, for which we may choose the average correlation as homogeneous. Thereby we can reduce the number of parameters to two, the average correlation between assets and the strength of the fluctuations around this average value. Yet, the resulting asset value distribution describes the empirical data well. This allows us to derive the distribution of credit portfolio losses. With Monte-Carlo simulations for the Value at Risk and Expected Tail Loss we validate the assumptions of our approach and demonstrate the necessity of taking fluctuating correlations into account.
    Date: 2016–01
  13. By: Alberto BURCHI; Francesca PIERRI
    Abstract: The credit risk is the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms. Using a large dataset of corporate balance sheets we develop a survival model to predict default. Unlike previous works, we consider forecasts of probability of default for small corporate, we take into account regional macroeconomic conditions as well as national macroeconomic indicators and we use a large sample of balance sheet. We define our model after a series of steps designed to select only the significant variables; we examine the scale of the continuous covariates in the preliminary main effect model and we apply, when required, appropriate transformations to respect the linearity in the log hazard. Last but not least, we check the proportionality hazard assumption.
    Date: 2015–12–01
  14. By: Dömötör, Barbara; Váradi, Kata
    Abstract: Central clearing and the role of central counterparties (CCP) has gained on importance in the financial sector, since counterparty risk of the trading is to be managed by them. The regulation has turned towards them lately, by defining several processes, how CCPs should measure and manage their risk. Stress situation is an important term of the regulation, however it is not specified clearly, how stress should be identified. This paper provides a possible definition of stress event based on the existing risk management methodology: the usage of risk measure oversteps, and investigates the potential stress periods of the last years on the Hungarian stock market. According to the results the definition needs further calibration based on the magnitude of the cross-sectional data. The paper examines furthermore whether stress is to be predicted from market liquidity. The connection of liquidity and market turmoil proved to be contrary to the expectations; liquidity shortage was rather a consequence, than a forecaster phenomenon in the tested period.
    Keywords: EMIR regulation, Value at Risk models, market liquidity measurement, stress definition
    JEL: G18 G28 G32
    Date: 2016–01–20
  15. By: Bent Jesper Christensen (Aarhus University and CREATES); Rasmus T. Varneskov (Northwestern University, CREATES and Nordea Asset Management)
    Abstract: This paper proposes a model for discrete-time hedging based on continuous-time movements in portfolio and foreign currency exchange rate returns. In particular, the vector of optimal currency exposures is shown to be given by the negative realized regression coefficients from a one-period conditional expectation of the intra-period quadratic covariation matrix for portfolio and foreign exchange rate returns. These are labelled the realized currency betas. The model, hence, facilitates dynamic hedging strategies that depend exclusively on the dynamic evolution of the ex-post quadratic covariation matrix. These hedging strategies are suggested implemented using modern, yet simple, non-parametric techniques to accurately measure and dynamically model historical quadratic covariation matrices. The empirical results from an extensive hedging exercise for equity investments illustrate that the realized currency betas exhibit important time variation, leading to substantial economic, as well as statistically significant, volatility reductions from the proposed hedging strategies, compared to existing benchmarks, without sacrificing returns. As a result, a risk-averse investor is shown to be willing to pay several hundred basis points to switch from existing hedging methods to the proposed realized currency beta approach. Interestingly, the empirical analysis strongly suggests that the superior performance of the latter during the most recent global financial crisis of 2008 is, at least partially, funded by carry traders.
    Keywords: Currency Hedging, Foreign Exchange Rates, High-frequency Data, Infill Asymptotics, Mean-Variance Analyis, Quadratic Covariation, Realized Currency Beta.
    JEL: C14 C32 C58 G11 G15
    Date: 2016–01–18
  16. By: Christian Castro (Banco de España); Ángel Estrada (Banco de España); Jorge Martínez (Banco de España)
    Abstract: This paper analyses a group of quantitative indicators to guide the Basel III countercyclical capital buffer (CCB) in Spain. Using data covering three stress events in the Spanish banking system since the early 1960s, we describe a number of conceptual and practical issues that may arise with the Basel benchmark buffer guide (i.e. the credit-to-GDP gap) and study alternative specifications plus a number of complementary indicators. In this connection, we explore ways to deal with structural changes that may lead to some shortcomings in the indicators. Overall, we find that indicators of credit ‘intensity’ (where we propose the ratio of changes in credit to GDP), private sector debt sustainability, real estate prices and external imbalances can usefully complement the credit-to-GDP gap when taking CCB decisions in Spain.
    Keywords: countercyclical capital buffer, credit-to-GDP gap, guiding indicators, build-up phase, credit intensity, real estate prices, external imbalances, private sector debt sustainability, macroprudential policy
    JEL: E58 G01 G21 G28 G32
    Date: 2016–01
  17. By: Imke H\"ofers; Ralf Wunderlich
    Abstract: We consider an investor faced with the classical portfolio problem of optimal investment in a log- Brownian stock and a fixed-interest bond, but constrained to choose portfolio and consumption strategies which reduce a dynamic shortfall risk measure. For continuous and discrete-time financial markets we investigate the loss in expected utility of intermediate consumption and terminal wealth caused by imposing a dynamic risk constraint. We derive the dynamic programming equations for the resulting stochastic optimal control problems and solve them numerically. Our numerical results indicate that the loss of portfolio performance is quite small while the risk is reduced considerably. We also investigate discretization effects and the loss in performance if trading is possible at discrete time points only.
    Date: 2016–02
  18. By: Emmanouil Platanakis (ICMA Centre, Henley Business School, University of Reading); Charles Sutcliffe (ICMA Centre, Henley Business School, University of Reading);
    Abstract: The redesign of defined benefit pension schemes usually results in a substantial redistribution of wealth between age cohorts of members, pensioners, and the sponsor. This is the first study to quantify the redistributive effects of a rule change by a real world scheme (the Universities Superannuation Scheme, USS) where the sponsor underwrites the pension promise. In October 2011 USS closed its final salary scheme to new members, opened a career average revalued earnings (CARE) section, and moved to ‘cap and share’ contribution rates. We find that the pre-October 2011 scheme was not viable in the long run, while the post-October 2011 scheme is probably viable in the long run, but faces medium term problems. In October 2011 future members of USS lost 65% of their pension wealth (or roughly £100,000 per head), equivalent to a reduction of roughly 11% in their total compensation, while those aged over 57 years lost almost nothing. The riskiness of the pension wealth of future members increased by a third, while the riskiness of the present value of the sponsor’s future contributions reduced by 10%. Finally, the sponsor’s wealth increased by about £32.5 billion, equivalent to a reduction of 26% in their pension costs.
    Keywords: Defined benefit, Pension scheme, Redistribution, USS, Scheme design, Risk shifting, Risk management
    JEL: G22 G23 J32
    Date: 2015–04

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