
on Risk Management 
Issue of 2016‒08‒07
fifteen papers chosen by 
By:  Héctor Pérez Saiz; Gabriel Xerri 
Abstract:  The recent financial crisis has led to the development of new regulations to control risk in designated payment systems, and the implementation of new credit risk management standards is one of the key issues. In this paper, we study various credit risk management schemes for the Canadian retail payment system (ACSS) that are designed to cover the exposure of a defaulting member. We consider schemes that use a collateral pool calculated using a rolling time window. Our simulations show that the size of the window has a very significant effect on the average level of collateral and its variability day to day, creating an interesting tradeoff. Collateral levels and variability may be important for ACSS participants because they could affect the opportunity costs of pledging collateral, and also the costs of managing it over time. Our results contribute to understanding the practical implementation of risk management schemes in the current and future generations of payment systems in Canada. 
Keywords:  Econometric and statistical methods, Financial stability, Payment clearing and settlement systems 
JEL:  G21 G23 C58 
Date:  2016 
URL:  http://d.repec.org/n?u=RePEc:bca:bocadp:1616&r=rmg 
By:  Cornelis S. L. de Graaf; Drona Kandhai; Christoph Reisinger 
Abstract:  The focus of this paper is the efficient computation of counterparty credit risk exposure on portfolio level. Here, the large number of risk factors rules out traditional PDEbased techniques and allows only a relatively small number of paths for nested Monte Carlo simulations, resulting in large variances of estimators in practice. We propose a novel approach based on Kolmogorov forward and backward PDEs, where we counter the high dimensionality by a generalisation of anchoredANOVA decompositions. By computing only the most significant term in the decomposition, the dimensionality is reduced effectively, such that a significant computational speedup arises from the high accuracy of PDE schemes in low dimensions compared to Monte Carlo estimation. Moreover, we show how this truncated decomposition can be used as control variate for the full highdimensional model, such that any approximation errors can be corrected while a substantial variance reduction is achieved compared to the standard simulation approach. We investigate the accuracy for a realistic portfolio of exchange options, interest rate and crosscurrency swaps under a fully calibrated sevenfactor model. 
Date:  2016–08 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1608.01197&r=rmg 
By:  Fei Fang; Yiwei Sun; Konstantinos Spiliopoulos 
Abstract:  The goal of this paper is to study organized flocking behavior and systemic risk in heterogeneous meanfield interacting diffusions. We illustrate in a number of case studies the effect of heterogeneity in the behavior of systemic risk in the system. We also investigate the effect of heterogeneity on the "flocking behavior" of different agents, i.e., when agents with different dynamics end up behaving the same way in path space and follow closely the mean behavior of the system. Using Laplace asymptotics, we derive an asymptotic formula for the tail of the loss distribution as the number of agents grows to infinity. This characterizes the tail of the loss distribution and the effect of the heterogeneity of the network on the tail loss probability. 
Date:  2016–07 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1607.08287&r=rmg 
By:  Lorenzo CAMPONOVO (University of St. Gallen); Olivier SCAILLET (University of Geneva and Swiss Finance Institute); Fabio TROJANI (University of Geneva and Swiss Finance Institute) 
Abstract:  This paper contains comments on Nonparametric Tail Risk, Stock Returns and the Macroeconomy. 
Keywords:  Tail Risk, Risk Factor, RiskNeutral Probability, Prediction of Market Returns, Economic Predictability 
JEL:  G12 G13 G17 
URL:  http://d.repec.org/n?u=RePEc:chf:rpseri:rp1641&r=rmg 
By:  Ioannis Asimakopoulos (Bank of Greece); Panagiotis K. Avramidis (ALBA Graduate Business School at the American College of Greece); Dimitris Malliaropulos (Bank of Greece, University of Piraeus); Nickolaos G. Travlos 
Abstract:  Using a unique dataset of corporate loans of 13,070 Greek firms for the period 20082015 and an identification strategy based on the internal credit ratings of banks, we provide evidence that one out of six firms with nonperforming loans are strategic defaulters. Furthermore, we investigate potential determinants of firms’ behavior by relating the probability of strategic default to a number of firm characteristics such as size, age, liquidity, profitability and collateral value. We provide evidence of a positive relationship of strategic default with outstanding debt and economic uncertainty and a negative relationship with the value of collateral. Also, profitability and collateral can be used to distinguish the strategic defaulters from the financially distressed defaulters. Finally, we find evidence that the relationship of strategic default risk with firm size and age has an inverse Ushape, i.e. strategic default is more likely among mediumsized firms compared to small and large firms and it is also more likely among middleaged firms compared to newfounded and established firms. 
Keywords:  Strategic default; Nonperforming loans; Corporate loans; Leverage 
JEL:  G01 G21 G32 C23 
URL:  http://d.repec.org/n?u=RePEc:bog:wpaper:211&r=rmg 
By:  Quynh Anh VO (University of Zurich) 
Abstract:  This paper examines potential impacts of banks' leverage on their incentives to manage their liquidity. We analyse a model where banks control their liquidity risk by managing their liquid asset positions. In the basic framework, a model with a single bank, where the possibility of selling longterm assets when in need of liquidity is not taken into account, we find that the bank chooses to prudently manage its liquidity risk only when its leverage is low. In a model with multiple banks and a secondary market for longterm assets, we find that a banking system where banks are highly leveraged can be prone to liquidity crises. Our model predicts a typical pattern of liquidity crises that is consistent with what was observed during the 20072009 crisis. 
Keywords:  Leverage, Liquidity Risk, Moral Harzard, CashInTheMarket Pricing 
JEL:  G21 D82 
URL:  http://d.repec.org/n?u=RePEc:chf:rpseri:rp1551&r=rmg 
By:  Damien Ackerer (Ecole Polytechnique Fédérale de Lausanne; Ecole Polytechnique Fédérale de Lausanne  Swiss Finance Institute); Damir FilipoviÄ‡ (Ecole Polytechnique Fédérale de Lausanne; Ecole Polytechnique Fédérale de Lausanne  Swiss Finance Institute) 
Abstract:  We introduce a novel class of credit risk models in which the drift of the survival process of a firm is a linear function of the factors. These models outperform the standard affine default intensity models in terms of analytical tractability. The prices of defaultable bonds and credit default swaps (CDS) are linear in the factors. The price of a CDS option can be uniformly approximated by polynomials in the factors. An empirical study illustrates the versatility of these models by fitting CDS spread time series. 
Keywords:  Credit Default Swap, Credit Default Swap Option, Credit Risk, Credit Valuation Adjustment, Survival Process 
JEL:  G12 G13 
URL:  http://d.repec.org/n?u=RePEc:chf:rpseri:rp1634&r=rmg 
By:  Cañón Salazar Carlos Iván;Gallón Santiago;Olivar Santiago 
Abstract:  This paper proposes a systemic risk index based on Functional Data Analysis (FDA), overcoming salient shortcomings of standard methodologies related to data usage, data sparseness, and high dimensionality issues. Using Mexican data, a set of systemic risk indexes are constructed and we show that the proposed functional index captures new information, and through simulations, that it outperforms previous methods when the indicators become increasingly nonlinear. Finally, we show which indexes serve as complements, and which are the best early warning indicators. 
Keywords:  Systemic Risk; Functional Data Analysis; Dimensionality Reduction; Signal Informativeness 
JEL:  G01 G10 G17 G18 
Date:  2016–07 
URL:  http://d.repec.org/n?u=RePEc:bdm:wpaper:201612&r=rmg 
By:  Andrea M. Buffa (Boston University); Suleyman Basak (London Business School) 
Abstract:  We study the dynamic decision making of a financial institution in the presence of a novel implementation friction that gives rise to operational risk. We distinguish between internal and external operational risks depending on whether the institution has control over them. Internal operational risk naturally arises in the context of model risk, as the institution exposes itself to operational errors whenever it updates and improves its investment model. In this case, it is no longer optimal to implement the best model available, thus leaving scope for endogenous deviation from it, and hence model sophistication. We show that the optimal exposure to operational risk may well become decreasing in the level of internal operational risk, which in turn makes the exposure to market risk less volatile. We uncover that financial constraints interact with operational risk, whether internal or external, and prompt the institution to always adopt a more sophisticated model. While such constraints are always detrimental when operational risk is internal, they may be beneficial, despite inducing an excessive level of sophistication, when it is external. 
Date:  2016 
URL:  http://d.repec.org/n?u=RePEc:red:sed016:352&r=rmg 
By:  Mathieu Cambou (Ecole Polytechnique Fédérale de Lausanne); Damir FilipoviÄ‡ (Ecole Polytechnique Fédérale de Lausanne; Ecole Polytechnique Fédérale de Lausanne  Swiss Finance Institute) 
Abstract:  The replicating portfolio (RP) approach to the calculation of capital for life insurance portfolios is an industry standard. The RP is obtained from projecting the terminal loss of discounted asset liability cash flows on a set of factors generated by a family of financial instruments that can be efficiently simulated. We provide the mathematical foundations and a novel dynamic and pathdependent RP approach for realworld and riskneutral sampling. We show that the RP approach yields asymptotically consistent capital estimators. We illustrate the tractability of the RP approach by two numerical examples. 
Keywords:  assetliability portfolio, chaos expansion, replicating portfolio, solvency capital 
JEL:  C61 C63 D81 G22 
URL:  http://d.repec.org/n?u=RePEc:chf:rpseri:rp1625&r=rmg 
By:  Lubberink, Martien; Renders, Annelies 
Abstract:  Leading up to the implementation of Basel III, European banks repurchased belowpar debt securities. Banks are subjected to a prudential filter that excludes unrealized gains on liabilities from changes in own credit standing from the calculation of capital ratios. By repurchasing securities, unrealized gains become realized and increase Core Tier 1 capital. We show that poorly capitalized banks repurchased securities and lost about e9.1bn in premiums to compensate debt holders. Banks also repurchased the most lossabsorbing securities, for which they paid the highest premiums. These premiums increase with leverage and in times of stress. Hence debt repurchases are a cause for prudential concern. 
Keywords:  Banking, repurchases, subordinated debt. 
JEL:  E58 G21 G28 G32 G35 M41 
Date:  2016–06–15 
URL:  http://d.repec.org/n?u=RePEc:pra:mprapa:72814&r=rmg 
By:  Robert F. Engle; Olivier Ledoit; Michael Wolf 
Abstract:  Second moments of asset returns are important for risk management and portfolio selection. The problem of estimating second moments can be approached from two angles: time series and the crosssection. In time series, the key is to account for conditional heteroskedasticity; a favored model is Dynamic Conditional Correlation (DCC), derived from the ARCH/GARCH family started by Engle (1982). In the crosssection, the key is to correct insample biases of sample covariance matrix eigenvalues; a favored model is nonlinear shrinkage, derived from Random Matrix Theory (RMT). The present paper aims to marry these two strands of literature in order to deliver improved estimation of large dynamic covariance matrices. 
Keywords:  Composite likelihood, dynamic conditional correlations, GARCH, Markowitz portfolio selection, nonlinear shrinkage. 
JEL:  C13 C58 G11 
Date:  2016–07 
URL:  http://d.repec.org/n?u=RePEc:zur:econwp:231&r=rmg 
By:  Cakir, Murat 
Abstract:  During the last halfdecade, the 2007 global crisis has kept all interested parties busy and urged them to focus on the causes of this crisis, to find solutions for recovery, and to contrive to be capable of projecting potential ones that may happen in the future. As one of the precautionary toolsets devised for the authorities among others the classical macroprudential and systemic risk models focused on banks and sought for the systemically important ones (SIFIs). It had been argued by a handful of interest groups that this sort of approach to risk embedded in a network structure was both unbalanced condoning potential plausible sources of risk to monitor passively as well as take policy actions proactively and further was undue in remedying possible causes if, when and where seen indispensable. Therefore, a more macro stance towards the conventional macroprudential paradigms considering micro elements of the system was seen as vital. This work attempts to draw an extended framework that would span all potential incumbents forming part of the Circular Flow of Income (CFI), which is treated as a network or a bijective counterparty mapping of incumbent groups of different sources that each have claims against the funds granted to other groups or to members of the same group. Availability of data would be a focal point for the operability of a model as such. Though the significance of data availability being a central question is inarguable and the necessary data is really scarce, that doesn’t abstain one from devising usable designs, nor does it from standing in a proper position in such design efforts for public welfare. In reality, the data is available for a different variety of incumbent groups at different levels of congruity, but unfortunately sparsely distributed among different collectors and users . Still, there is data that can be used for empirical analysis purposes but needs a considerable extent of effort to collect and make use of. We propose a simple methodology on how to use the data on the extended framework, tipping on another study a data procural system shortly, and provide an inexhaustive list of potential features that can be used for our extended model at the end. There will be no issue of identification neither of risks from a particular source, nor of policy recommendations since they are a subject of another work and out of the scope of the current one. Still, one should bear in mind that though this other stream of work of ours employs any kind of analytical methodology that’d fit a particular context a general balance sheet, and the valuation of subportfolios at risk are the main architectural frame that shapes our analytical basis . 
Keywords:  Systemic Risk, Macro Prudential Policy, Circular Flow of Income 
JEL:  E58 G28 
Date:  2016–07–29 
URL:  http://d.repec.org/n?u=RePEc:pra:mprapa:72776&r=rmg 
By:  Peter Christoffersen; Bruno Feunou; Yoontae Jeon; Chayawat Ornthanalai 
Abstract:  We estimate a continuoustime model with stochastic volatility and dynamic crash probability for the S&P 500 index and find that market illiquidity dominates other factors in explaining the stock market crash risk. While the crash probability is timevarying, its dynamic depends only weakly on return variance once we include market illiquidity as an economic variable in the model. This finding suggests that the relationship between variance and jump risk found in the literature is largely due to their common exposure to market liquidity risk. Our study highlights the importance of equity market frictions in index return dynamics and explains why prior studies find that crash risk increases with market uncertainty level. 
Keywords:  Asset Pricing, Econometric and statistical methods, Financial stability 
JEL:  G01 G12 
Date:  2016 
URL:  http://d.repec.org/n?u=RePEc:bca:bocawp:1635&r=rmg 
By:  Barbara Rossi; Tatevik Sekhposyan; Matthieu Soupre 
Abstract:  We propose a decomposition to distinguish between Knightian uncertainty (ambiguity) and risk, where the ?rst measures the uncertainty about the probability distribution generating the data, while the second measures uncertainty about the odds of the outcomes when the probability distribution is known. We use the Survey of Professional Forecasters (SPF) density forecasts to quantify overall uncertainty as well as the evolution of the di¤erent components of uncertainty over time and investigate their importance for macroeconomic ?uctuations. We also study the behavior and evolution of the various components of our decomposition in a model that features ambiguity and risk. 
Keywords:  Uncertainty, Risk, Ambiguity, Knightian Uncertainty, Survey of Professional Forecasters, Predictive Densities. 
JEL:  C22 C52 C53 
Date:  2016–05 
URL:  http://d.repec.org/n?u=RePEc:upf:upfgen:1531&r=rmg 