nep-rmg New Economics Papers
on Risk Management
Issue of 2016‒06‒14
fourteen papers chosen by
Stan Miles
Thompson Rivers University

  1. The effects of ratings-contingent regulation on international bank lending behavior: Evidence from the Basel 2 accord By Hasan, Iftekhar; Kim, Suk-Joong; Wu, Eliza
  2. On the Economics of Crisis Contracts By Elias, Aptus; Gersbach, Hans; Volker, Britz
  3. Risk Arbitrage and Hedging to Acceptability By Emmanuel Lepinette; Ilya Molchanov
  4. Can Higher-Order Risks Explain the Credit Spread Puzzle? By Okou, Cedric; Maalaoui Chun, Olfa; Dionne, Georges; Li, Jingyuan
  5. Financial Linkages, Portfolio Choice and Systemic Risk By Andrea Galeotti; Christian Ghiglinoy; Sanjeev Goyal
  6. Generalized additive modelling of the repayment performance of Korean borrowers By Young Ah Kim; Peter G. Moffatt
  7. Enterprise Risk Management Measurement Method By Juthamon Sithipolvanichgul
  8. The Effect of Investor Sentiment on Gold Market Dynamics By Mehmet Balcilar; Matteo Bonato; Riza Demirer; Rangan Gupta
  9. Natural Hedge Effects on Revenue Stability and Crop Insurance Decisions By Motamed, Mesbah; O'Donoghue, Erik
  10. Synchronization in human decision making By Yi-Fang Liu; Jørgen Vitting Andersen; Maxime Frolov; Philippe de Peretti
  11. The Potential to Use Futures and Options to Manage Crop Insurance Losses By Driedger, Jonathon; Porth, Lysa; Boyd, Milton
  12. Bubbles in US Regional House Prices: Evidence from House Price/Income Ratios at the State Level By Yang Hu; Les Oxley
  13. Moore's Law vs. Murphy's Law in the financial system: who's winning? By Andrew W Lo
  14. Assessing socioeconomic resilience to floods in 90 countries By Hallegatte,Stephane; Bangalore,Mook; Vogt-Schilb,Adrien Camille

  1. By: Hasan, Iftekhar; Kim, Suk-Joong; Wu, Eliza
    Abstract: We investigate the effects of credit ratings-contingent financial regulation on foreign bank lending behavior. We examine the sensitivity of international bank flows to debtor countries’ sovereign credit rating changes before and after the implementation of the Basel 2 risk-based capital regulatory rules. We study the quarterly bilateral flows from G-10 creditor banking systems to 77 recipient countries over the period Q4:1999 to Q2:2013. We find direct evidence that sovereign credit re-ratings that lead to changes in risk-weights for capital adequacy requirements have become more significant since the implementation of Basel 2 rules for assessing banks’ credit risk under the standardized approach. This evidence is consistent with global banks acting via their international lending decisions to minimize required capital charges associated with the use of ratings-contingent regulation. We find evidence that banking regulation induced foreign lending has also heightened the perceived sovereign risk levels of recipient countries, especially those with investment grade status. Keywords: cross-border banking, sovereign credit ratings, Basel 2, rating-contingent financial regulation
    JEL: E44 F34 G21 H63
    Date: 2014–11–17
  2. By: Elias, Aptus; Gersbach, Hans; Volker, Britz
    Abstract: We examine the impact of so-called "Crisis Contracts" on bank managers' risk-taking incentives and on the probability of banking crises. Under a Crisis Contract, managers are required to contribute a pre-specified share of their past earnings to finance public rescue funds when a crisis occurs. This can be viewed as a retroactive tax that is levied only when a crisis occurs and that leads to a form of collective liability for bank managers. We develop a game-theoretic model of a banking sector whose shareholders have limited liability, so that society at large will suffer losses if a crisis occurs. Without Crisis Contracts, the managers' and shareholders' interests are aligned, and managers take more than the socially optimal level of risk. We investigate how the introduction of Crisis Contracts changes the equilibrium level of risk-taking and the remuneration of bank managers. We establish conditions under which the introduction of Crisis Contracts will reduce the probability of a banking crisis and improve social welfare. We explore how Crisis Contracts and capital requirements can supplement each other and we show that the efficacy of Crisis Contracts is not undermined by attempts to hedge.
    JEL: C79 G21 G28
    Date: 2016–05
  3. By: Emmanuel Lepinette; Ilya Molchanov
    Abstract: The classical discrete time model of transaction costs relies on the assumption that the increments of the feasible portfolio process belong to the solvency set at each step. We extend this setting by assuming that any such increment belongs to the sum of an element of the solvency set and the family of acceptable positions, e.g. with respect to a dynamic risk measure. We formulate several no risk arbitrage conditions and explore connections between them. If the acceptance sets consist of non-negative random vectors, that is the underlying dynamic risk measure is the conditional essential infimum, we extend many classical no arbitrage conditions in markets with transaction costs and provide their natural geometric interpretation. The mathematical technique relies on results for unbounded and possibly non-closed random sets in the Euclidean space.
    Date: 2016–05
  4. By: Okou, Cedric (University of Quebec at Montreal); Maalaoui Chun, Olfa (KAIST); Dionne, Georges (HEC Montreal, Canada Research Chair in Risk Management); Li, Jingyuan (Lingnan University)
    Abstract: We tweak the conventional Merton model to account for the asymmetric properties of assets returns and investors asymmetric behavior toward the upside potential of gain versus the downside risk of loss. Using an asymmetric split normal distribution, we capture empirical asymmetries in the underlying return distribution, while we conserve the attractiveness of delivering closed-form pricing formulas that collapse to the basic Merton model in the symmetric Gaussian case. The asymmetric specification outperforms the symmetric one in matching high levels of historical credit spreads. We then link the residual (non-default-model-implied) spread to two illiquidity risk factors. The first factor is extracted from several measures of idiosyncratic illiquidity variables and the second factor is a systematic factor obtained from a general index common to all studied bonds. Our model explains 70% of the BBB-AAA spread and more than 72% of BBB and AAA credit spreads relative to the on-the-run Treasury rates.
    Keywords: Credit spread puzzle; Asymmetry; Illiquidity; Higher-order risks.
    JEL: D51 D80 G12
    Date: 2016–05–11
  5. By: Andrea Galeotti; Christian Ghiglinoy; Sanjeev Goyal
    Abstract: Financial linkages smooth the shocks faced by individual components of the system, but they also create a wedge between ownership and decision-making. The classical intuition on the role of pooling risk in raising welfare is valid when ownership is evenly dispersed. However, when the ownership of some agents is concentrated in the hands of a few others, greater integration and diversification can lead to excessive risk taking and volatility and result in lower welfare. We also show that individuals undertake too little (too much) risk relative to the first best if the network is homogeneous (heterogeneous), and study optimal networks.
    Date: 2016–02–19
  6. By: Young Ah Kim (University of Essex); Peter G. Moffatt (University of East Anglia)
    Abstract: Data from a sample of around 32,000 customers taking out personal loans from a Korean bank, are analysed. The focus of analysis is a binary variable indicating default, defined as any sort of failure to meet the obligations of the loan during a time period up to a fixed reference date. Around 1.5% of the sample defaulted. The Generalized Additive Modelling (GAM) framework is used to investigate the combined effect of a number of factors on the likelihood of default. The GAM framework allows flexibility in the effects of continuously- distributed predictors. The B-spline smoothing approach is used for each of these effects. An extensive model-selection process is implemented. It is found that the statistical fit improves if some, but not all, of the predictors are modelled with the B-spline. The two variables found to have non-linear effects are amount borrowed and age of borrower. The predicted probability curve obtained for the former shows that borrowers least likely to default are those that have borrowed at the 85th percentile of the amount-borrowed distribution. The prediction curve for the latter shows that the default probability declines in a stepwise fashion with age, falling abruptly at certain ages, but appearing to level off for significant periods within the life-cycle.
    Date: 2016–05–12
  7. By: Juthamon Sithipolvanichgul (University of Ediburgh)
    Abstract: Enterprise Risk Management (ERM) is seen as an holistic approach to ensure a good risk management strategy for companies to help minimise potential pitfalls and improve long term business sustainability. However questions still arise whether ERM implementation impacts on a firm's performance. Past studies have shown no consensus that ERM does increase firm performance as advocated by regulators and business advisors. So the issue exists as to whether ERM implementation has been adequately assessed. An alternative measurement of ERM implementation is proposed. The measurement is based on standardised integrative scoring. The relationship between the proposed measurement and firm performance is then considered taking account of appropriate control variables. Using data from the Thailand Stock Exchange it was found implementing ERM can improve firm performance in term of Tobin's Q, ROE and ROA.
    Keywords: Enterprise Risk Management, Risk Management, Risk Organisation, Holistic Strategic, Firm Performance
  8. By: Mehmet Balcilar (Department of Economics, Eastern Mediterranean University, Turkey; Department of Economics, University of Pretoria, South Africa ; IPAG Business School, France); Matteo Bonato (Department of Economics and Econometrics, University of Johannesburg, Auckland Park, South Africa); Riza Demirer (Department of Economics & Finance, Southern Illinois University Edwardsville, USA.); Rangan Gupta (Department of Economics, University of Pretoria)
    Abstract: This paper explores the effect of investor sentiment on the intraday dynamics in the gold market. Using a novel methodology to detect nonlinear causalities, we examine the effect of fear and excitement in the stock market on gold return and intraday volatility at alternative quantiles. While no significant sentiment effect is observed on daily gold returns, we find that sentiment drives intraday volatility in the gold market. Interestingly however, the sentiment effect is channeled via the discontinuous component of intraday volatility and more significantly at extreme quantiles, suggesting that extreme fear (excitement) contributes to positive (negative) volatility jumps in gold returns. The results suggest that measures of sentiment could be utilized to model volatility jumps in safe haven assets that are often hard to predict and have significant implications for risk management as well as the pricing of options.
    Keywords: Investor Sentiment, Gold Returns, Intraday Volatility
    JEL: C22 Q02
    Date: 2016–05
  9. By: Motamed, Mesbah; O'Donoghue, Erik
    Abstract: The natural hedge is a familiar concept in the agricultural risk literature, but little work has formally examined its size and effect on producer outcomes. In this paper, we systematically measure the impact of the natural hedge on revenue stability over the period 1960-2014. We also test its effect on present-day insurance uptake decisions. As part of the analysis, we propose an alternative measure of the natural hedge that is not subject to the simultaneity of price and yield outcomes. As an initial attempt, we correlate prices with rainfall to obtain a more "natural" natural hedge. From our results, the natural hedge exerts a stabilizing effect on long-run producer revenues, but its impact on insurance decisions is less consistent.
    Keywords: production, agricultural risk, natural hedge, Production Economics, Risk and Uncertainty,
    Date: 2016
  10. By: Yi-Fang Liu (College of Management and Economics - Tianjin University); Jørgen Vitting Andersen (Centre d'Economie de la Sorbonne); Maxime Frolov (Centre d'Economie de la Sorbonne); Philippe de Peretti (Centre d'Economie de la Sorbonne)
    Abstract: Just like soldiers crossing a bridge in sync can lead to a catastrophic failure, we show via experiments, theory, and simulations, how synchronization in human decision making can lead to extreme outcomes. Individual decision making and risk taking are well known to be gender dependent. Much less is however understood about gender's impact on the creation of collective risk through aggregate decision making, where the decision of one individual can affect the decision making of other individuals, eventually leading to synchronization in behavior. To study the formation of collective risk created due to synchronization in human decision making, we have devised a series of experiments that can be analyzed and understood within a game theoretical framework. In the experiments each individual in groups of either men or women decide to buy or sell a financial asset based on an information set containing past price behavior. Risk can be generated collectively through coordination in the aggregate decision making, which leads to a price formation far from the fundamental value of the asset. Here we show how collective risks can be generated in groups of both genders, but the pathway to formation of collective risks happens through an individual risk taking which are different for groups composed of men respectively women. A priori we find that it is impossible to know whether a given group will engage in the formation of collective risk, but via a fluctuation based game theoretical framework we are able to estimate the likelihood that it will happen. Our results highlight some of the foundations for creation of excessive collective risks relevant for example in the understanding of financial systemic risks
    Keywords: collective decision making; synchronization; agent based modeling
    JEL: G1 G12 G14
    Date: 2016–03
  11. By: Driedger, Jonathon; Porth, Lysa; Boyd, Milton
    Abstract: Crop insurers have limited ability to manage the risk of losses once premiums are set and farmers have taken out their policies. Any additional instruments that enhance the ability for insurers to reduce their risk between when premiums are set and final yields are determined can help manage potential losses. The relationship between crop insurance losses and changes in futures prices are examined, and whether there is the potential to hedge crop insurance losses with grain futures contracts.
    Keywords: crop insurance, hedging, futures contracts, Agricultural Finance, Risk and Uncertainty,
    Date: 2016
  12. By: Yang Hu (University of Waikato); Les Oxley (University of Waikato)
    Abstract: We investigate the presence of bubbles in the US house price-income ratio at the state level by applying the right-tailed unit root test of Phillips, Shi and Yu (2015, PSY) to data from January 1975 to December 2014. Based on a model specification with an intercept, we can identify ‘collapse’ episodes, ‘collapse and recovery’ episodes in addition to bubbles. The absence of an intercept in the null leads to identification of only potential bubbles. We find evidence of bubbles in several states in the 1980s (such as California, Hawaii, Massachusetts and New York), which coincides with some existing studies that investigate housing bubbles or booms and busts using a range of alternative approaches. Our results show the existence of a housing bubble that originates in the early 2000s and collapses in the mid-2000s in more than 20 States and the DC. We conclude that this housing bubble was localized and not a national phenomenon and that the bubbles of the 2000s were more widespread than the 1980s. We also found that the exclusion of an intercept in the unit root null hypothesis will affect the asymptotic theory and date-stamping outcomes for the PSY approach which translates empirically to evidence of ‘no exuberance’ in several of the states' house prices which otherwise would have suggested bubbles.
    Keywords: bubbles; generalized sup ADF test; US regional house prices; house price-income ratio
    JEL: C59 R19 R39
    Date: 2016–05–24
  13. By: Andrew W Lo
    Abstract: Breakthroughs in computing hardware, software, telecommunications and data analytics have transformed the financial industry, enabling a host of new products and services such as automated trading algorithms, crypto-currencies, mobile banking, crowdfunding and robo-advisors . However, the unintended consequences of technology-leveraged finance include firesales, flash crashes, botched initial public offerings, cybersecurity breaches, catastrophic algorithmic trading errors and a technological arms race that has created new winners, losers and systemic risk in the financial ecosystem. These challenges are an unavoidable aspect of the growing importance of finance in an increasingly digital society. Rather than fighting this trend or forswearing technology, the ultimate solution is to develop more robust technology capable of adapting to the foibles in human behaviour so users can employ these tools safely, effectively and effortlessly. Examples of such technology are provided.
    Keywords: Financial technology, systemic risk, macroprudential policy, risk management
    Date: 2016–05
  14. By: Hallegatte,Stephane; Bangalore,Mook; Vogt-Schilb,Adrien Camille
    Abstract: This paper presents a model to assess the socioeconomic resilience to natural disasters of an economy, defined as its capacity to mitigate the impact of disaster-related asset losses on welfare, and a tool to help decision makers identify the most promising policy options to reduce welfare losses due to floods. Calibrated with household surveys, the model suggests that welfare losses from the July 2005 floods in Mumbai were almost double the asset losses, because losses were concentrated on poor and vulnerable populations. Applied to river floods in 90 countries, the model provides estimates of country-level socioeconomic resilience. Because floods disproportionally affect poor people, each $1 of global flood asset loss is equivalent to a $1.6 reduction in the affected country's national income, on average. The model also assesses and ranks policy levers to reduce flood losses in each country. It shows that considering asset losses is insufficient to assess disaster risk management policies. The same reduction in asset losses results in different welfare gains depending on who benefits. And some policies, such as adaptive social protection, do not reduce asset losses, but still reduce welfare losses. Asset and welfare losses can even move in opposite directions: increasing by one percentage point the share of income of the bottom 20 percent in the 90 countries would increase asset losses by 0.6 percent, since more wealth would be at risk. But it would also reduce the impact of income losses on wellbeing, and ultimately reduce welfare losses by 3.4 percent.
    Keywords: Insurance&Risk Mitigation,Economic Theory&Research,Hazard Risk Management,Rural Poverty Reduction,Natural Disasters
    Date: 2016–05–09

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