nep-rmg New Economics Papers
on Risk Management
Issue of 2016‒08‒14
fifteen papers chosen by
Stan Miles
Thompson Rivers University

  1. Managing counterparty credit risk via BSDEs By Andrew Lesniewski; Anja Richter
  2. Option-Implied Equity Premium Predictions via Entropic TiltinG By Davide Pettenuzzo; Konstantinos Metaxoglou; Aaron Smith
  3. Modeling Rating Transition Matrices for Wholesale Loan Portfolios By Kit Baum; Soner Tunay; Alper Corlu
  4. Dynamic structure of stock communities: A comparative study between stock returns and turnover rates By Li-Ling Su; Xiong-Fei Jiang; Sai-Ping Li; Li-Xin Zhong; Fei Ren
  5. Allocation of risk capital in a cost cooperative game induced by a modified Expected Shortfall By Bernardi Mauro; Roy Cerqueti; Arsen Palestini
  6. Risk and Resilience Management in Social-Economic Systems By Tatyana Kovalenko; Didier Sornette
  7. Why Does Idiosyncratic Risk Increase with Market Risk? By Söhnke M. Bartram; Gregory Brown; René M. Stulz
  8. Versatile tests for comparing survival curves based on weighted logrank statistics By Theodore Karrison
  9. Long-Run Risk is the Worst-Case Scenario By Rhys Bidder; Ian Dew-Becker
  10. Key Borrowers Detection by Long-Range Interactions By Fuad Aleskerov; Natalia Meshcheryakova; Alisa Nikitina; Sergey Shvydun
  11. Dynamic portfolio strategy using clustering approach By Fei Ren; Ya-Nan Lu; Sai-Ping Li; Xiong-Fei Jiang; Li-Xin Zhong; Tian Qiu
  12. How Can We Realize the Value That Annuities Offer in a 401(k) World? By Steven A. Sass
  13. Finding Common Ground when Experts Disagree: Belief Dominance over Portfolios of Alternatives By Baker, Erin; Bosetti, Valentina; Salo, Ahti
  14. External Validity in a Stochastic World By Mark Rosenzweig; Christopher Udry
  15. Who would invest only in the risk-free asset? By Nuno Azevedo; Diogo Pinheiro; Stylianos Xanthopoulos; Athanasios Yannacopoulos

  1. By: Andrew Lesniewski; Anja Richter
    Abstract: We discuss a general dynamic replication approach to counterparty credit risk modeling. This leads to a fundamental jump-process backward stochastic differential equation (BSDE) for the credit risk adjusted portfolio value. We then reduce the fundamental BSDE to a continuous BSDE. Depending on the close out value convention, the reduced fundamental BSDE's solution can be represented explicitly or through an accurate approximate expression. Furthermore, we discuss practical aspects of the approach, important for the its industrial usage: (i) efficient numerical methodology for solving a BSDE driven by a moderate number of Brownian motions, and (ii) factor reduction methodology that allows one to approximately replace a portfolio driven by a large number of risk factors with a portfolio driven by a moderate number of risk factors.
    Date: 2016–08
  2. 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 obtain predictive densities from a stae-of-the-art stochastic volatility (SV) model, which we then tilt towards the second moment of the risk-neutral distribution implied by options prices, while imposing a non-negativity constraint on the equity premium. By combining the backward-looking information contained in the SV model with the forward-looking information from options prices, our procedure delivers sharper predictive densities. Using density forecasts of the U.S. equity premium from January 1990 to December 2014, we find that tilting leads to more accurate predictions, both in terms of statistical and economic criteria.
    Keywords: entropic tilting, density forecasts, variance risk premium, equity premium, options.
    JEL: C11 C22 G11 G12
    Date: 2016–01
  3. By: Kit Baum (Boston College; DIW Berlin); Soner Tunay (Citizens Financial Group); Alper Corlu (Citizens Financial Group)
    Abstract: Risk analysis of a commercial bank's wholesale loan portfolios involves modeling of the asset quality ratings of each borrower's obligations. This customarily involves transition matrices which capture the probability that a loan's AQ rating will migrate to a higher or lower rating, or transition to the default state. We compare and contrast three approaches for transition matrix modeling: the single factor approach commonly used in the financial industry, an approach based on time-series forecasts of default rates, and an approach based on modeling selected elements of the transition matrix which comprise the most likely outcomes. We find that these two unorthodox approaches both have excellent performance over a sample period encompassing the financial crisis.
    Date: 2016–08–10
  4. By: Li-Ling Su; Xiong-Fei Jiang; Sai-Ping Li; Li-Xin Zhong; Fei Ren
    Abstract: The detection of community structure in stock market is of theoretical and practical significance for the study of financial dynamics and portfolio risk estimation. We here study the community structures in Chinese stock markets from the aspects of both price returns and turnover rates, by using a combination of the PMFG and infomap methods based on a distance matrix. We find that a few of the largest communities are composed of certain specific industry or conceptional sectors and the correlation inside a sector is generally larger than the correlation between different sectors. In comparison with returns, the community structure for turnover rates is more complex and the sector effect is relatively weaker. The financial dynamics is further studied by analyzing the community structures over five sub-periods. Sectors like banks, real estate, health care and New Shanghai take turns to compose a few of the largest communities for both returns and turnover rates in different sub-periods. Several specific sectors appear in the communities with different rank orders for the two time series even in the same sub-period. A comparison between the evolution of prices and turnover rates of stocks from these sectors is conducted to better understand their differences. We find that stock prices only had large changes around some important events while turnover rates surged after each of these events relevant to specific sectors, which may offer a possible explanation for the complexity of stock communities for turnover rates.
    Date: 2016–08
  5. By: Bernardi Mauro; Roy Cerqueti; Arsen Palestini
    Abstract: The standard theory of coherent risk measures fails to consider individual institutions as part of a system which might itself experience instability and spread new sources of risk to the market participants. In compliance with an approach adopted by Shapley and Shubik (1969), this paper proposes a cooperative market game where agents and institutions play the same role can be developed. We take into account a multiple institutions framework where some of them jointly experience distress events in order to evaluate their individual and collective impact on the remaining institutions in the market. To carry out this analysis, we define a new risk measure (SCoES), generalising the Expected Shortfall of Acerbi (2002) and we characterise the riskiness profile as the outcome of a cost cooperative game played by institutions in distress (a similar approach was adopted by Denault 2001). Each institution's marginal contribution to the spread of riskiness towards the safe institutions in then evaluated by calculating suitable solution concepts of the game such as the Banzhaf--Coleman and the Shapley--Shubik values.
    Date: 2016–08
  6. By: Tatyana Kovalenko (ETH Zurich); Didier Sornette (Swiss Finance Institute; ETH Zürich - Department of Management, Technology, and Economics (D-MTEC))
    Abstract: We provide a roadmap to understand and develop resilience, based on the realisation that resilience is the complement of risk, both being associated to the stresses supported by the socio-economic system. We propose instruments for resilience build-up and management based on a novel classification of risk and resilience management regimes corresponding to the system’s degree of uncertainty/predictability and stress level within it. Four main quadrants are identified: Ad hoc management, Adaptive management, the Black swan regime and the Dragon-king regime. An annotated bibliography is also provided.
    Keywords: Resilience, risk, stress, uncertainty, predictability, dynamics, exogenous, endogenous, adaptive management, black swan, dragon-king
    JEL: D81 G32
  7. By: Söhnke M. Bartram; Gregory Brown; René M. Stulz
    Abstract: From 1963 through 2015, idiosyncratic risk (IR) is high when market risk (MR) is high. We show that the positive relation between IR and MR is highly stable through time and is robust across exchanges, firm size, liquidity, and market-to-book groupings. Though stock liquidity affects the strength of the relation, the relation is strong for the most liquid stocks. The relation has roots in fundamentals as higher market risk predicts greater idiosyncratic earnings volatility and as firm characteristics related to the ability of firms to adjust to higher uncertainty help explain the strength of the relation. Consistent with the view that growth options provide a hedge against macroeconomic uncertainty, we find evidence that the relation is weaker for firms with more growth options.
    JEL: G10 G11 G12
    Date: 2016–08
  8. By: Theodore Karrison (University of Chicago)
    Abstract: The logrank test is perhaps the most commonly used nonparametric method for comparing two survival curves and yields maximum power under proportional hazards (PH) alternatives. While PH is a reasonable assumption, it need not, of course, hold. Several authors have therefore developed versatile tests using combinations of weighted logrank statistics that are more sensitive to non-PH hazards. For example, Fleming and Harrington (1991) considered the family of G(rho) statistics, while JW Lee (1996) and S-H Lee (2007) proposed tests based on the more extended G(rho, gamma) family. In this talk we consider Zm=max(|Z1|,|Z2|,|Z3|), where Z1, Z2, and Z3 are z-statistics obtained from G(0,0), G(1,0), and G(0,1) tests, respectively. G(0,0) corresponds to the logrank test while G(1,0) and G(0,1) are more sensitive to early and late difference alternatives. Simulation results indicate that the method based on Zm maintains the type I error rate, provides increased power relative to the logrank test under early and late difference alternatives, and entails only a small to moderate power loss compared to the more optimally chosen test. The syntax for a Stata command to implement the method, verswlr, is described, and the user can specify other choices for rho and gamma.
    Date: 2016–08–10
  9. By: Rhys Bidder; Ian Dew-Becker
    Abstract: We study an investor who is unsure of the dynamics of the economy. Not only are parameters unknown, but the investor does not even know what order model to estimate. She estimates her consumption process nonparametrically – allowing potentially infinite-order dynamics – and prices assets using a pessimistic model that minimizes lifetime utility subject to a constraint on statistical plausibility. The equilibrium is exactly solvable and we show that the pricing model always includes long-run risks. With risk aversion of 4.7, the model matches major facts about asset prices, consumption, and dividends. The paper provides a novel link between ambiguity aversion and non-parametric estimation.
    JEL: C14 D83 D84 G12
    Date: 2016–07
  10. By: Fuad Aleskerov (National Research University Higher School); Natalia Meshcheryakova (National Research University Higher School); Alisa Nikitina (National Research University Higher School); Sergey Shvydun (National Research University Higher School)
    Abstract: We propose a new method for assessing agents' influence in financial network structures, which takes into consideration the intensity of interactions. A distinctive feature of this approach is that it considers not only direct interactions of agents of the first level and indirect interactions of the second level, but also long-range indirect interactions. At the same time we take into account the attributes of agents as well as the possibility of impact to a single agent from a group of other agents. This approach helps us to identify systemically important elements which cannot be detected by classical centrality measures or other indices. The proposed method was used to analyze the banking foreign claims for the end of 1Q 2015. Under the approach, two types of key borrowers were detected: a) major players with high ratings and positive credit history; b) intermediary players, which have a great scale of financial activities through the organization of favorable investment conditions and positive business climate.
    Keywords: systemic risk, key borrower, interconnectedness, centrality
    JEL: C7 G2
    Date: 2016
  11. By: Fei Ren; Ya-Nan Lu; Sai-Ping Li; Xiong-Fei Jiang; Li-Xin Zhong; Tian Qiu
    Abstract: The problem of portfolio optimization is one of the most important issues in asset management. This paper proposes a new dynamic portfolio strategy based on the time-varying structures of MST networks in Chinese stock markets, where the market condition is further considered when using the optimal portfolios for investment. A portfolio strategy comprises two stages: selecting the portfolios by choosing central and peripheral stocks in the selection horizon using five topological parameters, i.e., degree, betweenness centrality, distance on degree criterion, distance on correlation criterion and distance on distance criterion, then using the portfolios for investment in the investment horizon. The optimal portfolio is chosen by comparing central and peripheral portfolios under different combinations of market conditions in the selection and investment horizons. Market conditions in our paper are identified by the ratios of the number of trading days with rising index or the sum of the amplitudes of the trading days with rising index to the total number of trading days. We find that central portfolios outperform peripheral portfolios when the market is under a drawup condition, or when the market is stable or drawup in the selection horizon and is under a stable condition in the investment horizon. We also find that the peripheral portfolios gain more than central portfolios when the market is stable in the selection horizon and is drawdown in the investment horizon. Empirical tests are carried out based on the optimal portfolio strategy. Among all the possible optimal portfolio strategy based on different parameters to select portfolios and different criteria to identify market conditions, $65\%$ of our optimal portfolio strategies outperform the random strategy for the Shanghai A-Share market and the proportion is $70\%$ for the Shenzhen A-Share market.
    Date: 2016–08
  12. By: Steven A. Sass
    Abstract: Annuities have long been the basic building blocks of the U.S. retirement income system. Both Social Security and traditional employer pensions are annuities, paying retirees a specified sum each month for as long as they live. But due to the decline in Social Security replacement rates, for any given retirement age, and the shift in employer plans from defined benefit pensions to 401(k)s, a growing number of workers are entering retirement with more financial savings and less annuity income. Economists generally agree that many retirees would benefit if they annuitized at least some of their 401(k) savings. This brief reviews studies by the U.S. Social Security Administration’s Retirement Research Consortium that assess how best to meet this goal. The discussion proceeds as follows. The first section presents the value that annuities offer. The second section explains how this value is affected by medical expense risk and bequest motives. The third section identifies key behavioral impediments to annuitization. The fourth section reviews initiatives that address these impediments. The fifth section concludes that accustoming 401(k) participants to focus on retirement income rather than accumulations and developing an effective default distribution for 401(k) assets are promising initiatives to explore.
    Date: 2016–07
  13. By: Baker, Erin; Bosetti, Valentina; Salo, Ahti
    Abstract: We address the problem of choosing a portfolio of policies under “deep uncertainty.” We introduce the idea of belief dominance as a way to derive a set of non-dominated portfolios and robust individual alternatives. Our approach departs from the tradition of providing a single recommended portfolio; rather, it derives a group of good portfolios. The belief dominance concept allows us to synthesize multiple expert- or model- based beliefs by uncovering the range of alternatives that are intelligent responses to the range of beliefs. This goes beyond solutions that are optimal for any specific set of beliefs to uncover other defensible solutions that may not otherwise be revealed. We illustrate our approach using an important problem in the climate change and energy policy context: choosing among clean energy technology R&D portfolios. We demonstrate how the belief dominance concept can reveal portfolios and alternatives that would otherwise remain uncovered.
    Keywords: Deep Uncertainty, Decision Making under Uncertainty, Robust, Dominance, Risk and Uncertainty, D8, D78, D81,
    Date: 2016–07–31
  14. By: Mark Rosenzweig; Christopher Udry
    Abstract: We examine the generalizability of internally valid estimates of causal effects in a fixed population over time when that population is subject to aggregate shocks. This temporal external validity is shown to depend upon the distribution of the aggregate shocks and the interaction between these shocks and the casual effects. We show that returns to investment in agriculture, small and medium enterprises and human capital differ significantly from year to year. We also show how returns to investments interact with specific aggregate shocks, and estimate the parameters of the distributions of these shocks. We show how to use these estimates to appropriately widen estimated confidence intervals to account for aggregate shocks.
    JEL: C93 O1 O13 O14 O15
    Date: 2016–07
  15. By: Nuno Azevedo; Diogo Pinheiro; Stylianos Xanthopoulos; Athanasios Yannacopoulos
    Abstract: Within the setup of continuous-time semimartingale financial markets, we show that a multiprior Gilboa-Schmeidler minimax expected utility maximizer forms a portfolio consisting only of the riskless asset if and only if among the investor's priors there exists a probability measure under which all admissible wealth processes are supermartingales. Furthermore, we show that under a certain attainability condition (which is always valid in finite or complete markets) this is also equivalent to the existence of an equivalent (local) martingale measure among the investor's priors. As an example, we generalize a no betting result due to Dow and Werlang.
    Date: 2016–08

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