nep-rmg New Economics Papers
on Risk Management
Issue of 2016‒08‒28
ten papers chosen by
Stan Miles
Thompson Rivers University

  1. Elicitability and backtesting By Natalia Nolde; Johanna F. Ziegel
  2. The limits of model-based regulation By Behn, Markus; Haselmann, Rainer; Vig, Vikrant
  3. Pricing of Catastrophe Risk and the Implied Volatility Smile By Ben Ammar, Semir
  4. Shadow banking in the euro area: risks and vulnerabilities in the investment fund sector By Doyle, Nicola; Hermans, Lieven; Molitor, Philippe; Weistroffer, Christian
  5. On the hedging strategies for defaultable claims under incomplete information By Claudia Ceci; Katia Colaneri; Alessandra Cretarola
  6. Are Counterparty Arrangements in Reinsurance a Threat to Financial Stability? By Matt Davison; Darrell Leadbetter; Bin Lu; Jane Voll
  7. The randomised Heston model By Antoine Jacquier; Fangwei Shi
  8. Insurance and reinsurance risk management in Albania By Heralda, Jahollari
  9. Quantile Dependence between Stock Markets and its Application in Volatility Forecasting By Heejoon Han
  10. Bond risk premia, macroeconomic factors and financial crisis in the euro area By Garcí­a, Juan Angel; Werner, Sebastian E. V.

  1. By: Natalia Nolde; Johanna F. Ziegel
    Abstract: Conditional forecasts of risk measures play an important role in internal risk management of financial institutions as well as in regulatory capital calculations. In order to assess forecasting performance of a risk measurement procedure, risk measure forecasts are compared to the realized financial losses over a period of time and a statistical test of correctness of the procedure is conducted. This process is known as backtesting. Such traditional backtests are concerned with assessing some optimality property of a set of risk measure estimates. However, they are not suited to compare different risk estimation procedures. We investigate the proposal of comparative backtests, which are better suited for method comparisons on the basis of forecasting accuracy, but necessitate an elicitable risk measure. The discussion focuses on three risk measures, value-at-risk, expected shortfall and expectiles, and is supported by a simulation study and data analysis.
    Date: 2016–08
  2. By: Behn, Markus; Haselmann, Rainer; Vig, Vikrant
    Abstract: In this paper, we investigate how the introduction of sophisticated, model-based capital regulation affected the measurement of credit risk by financial institutions. Model-based regulation was meant to enhance the stability of the financial sector by making capital charges more sensitive to risk. Exploiting the introduction of the model-based approach in Germany and the richness of our loan-level data set, we show that (1) internal risk estimates employed for regulatory purposes systematically underpredict actual default rates by 0.5 to 1 percentage points; (2) both default rates and loss rates are higher for loans that were originated under the model-based approach, while corresponding risk-weights are significantly lower; and (3) interest rates are higher for loans originated under the model-based approach, suggesting that banks were aware of the higher risk associated with these loans and priced them accordingly. Counter to the stated objective of the reform, financial institutions have lower capital charges and at the same time experience higher loan losses. Further, we document that large banks benefited from the reform as they experienced a reduction in capital charges and consequently expanded their lending at the expense of smaller banks that did not introduce the model-based approach. Overall, our results highlight that if the challenges that accompanies complex regulation are too high simpler rules may increase the efficacy of financial regulation. JEL Classification: G01, G21, G28
    Keywords: Basel regulation, capital regulation, complexity of regulation, internal ratings
    Date: 2016–07
  3. By: Ben Ammar, Semir
    Abstract: Property-casualty (P&C) insurers are exposed to rare but severe natural disasters. This paper analyzes the relation between catastrophe risk and the implied volatility smile of insurance stock options. We find that the slope is significantly steeper compared to non-financials and other financial institutions. We show that this effect has increased over time, suggesting a higher risk compensation for catastrophic events. We are able to link the insurance-specific tail risk component derived from options with the risk spread from catastrophe bonds. Our results provide an accurate, high-frequency calculation for catastrophe risk linking the traditional derivatives market with insurance-linked securities (ILS).
    Keywords: Implied volatility, Options, Catastrophe risk, Tail risk, Natural disasters
    JEL: G12 G13 G14 G22
    Date: 2016–07
  4. By: Doyle, Nicola; Hermans, Lieven; Molitor, Philippe; Weistroffer, Christian
    Abstract: This paper first highlights the structural features of shadow banking in the euro area, focussing on investment funds. It then discusses the potential systemic risks that the recent expansion of the investment fund sector presents. While investment funds provide important intermediation services to the real sector, including market and liquidity risk-sharing and the bridging of information gaps, their rapid expansion may present systemic risks that need to be detected, monitored and managed. In particular, the risk of fund outflows and the possible negative impacts on the wider financial system have risen due to the rapid expansion of the investment fund sector, its growing involvement in capital markets, its use of synthetic leverage, and the inherent and growing maturity and liquidity mismatch arising from the demandable nature of fund share investments. While available data suggest that vulnerabilities within the investment fund sector are growing and links to the wider financial system and real economy have strengthened, data limitations prevent drawing a definitive conclusion on the sectors' contribution to systemic risk. JEL Classification: G01, G20, G23, G28
    Keywords: "shadow banking, asset management, financial stability, interconnectedness", investment funds, market liquidity, systemic risk
    Date: 2016–06
  5. By: Claudia Ceci; Katia Colaneri; Alessandra Cretarola
    Abstract: In this paper we investigate the hedging problem of a defaultable claim with recovery at default time via the local risk-minimization approach when investors have a restricted information on the market. We assume that the stock price process dynamics depends on an exogenous unobservable stochastic factor and that at any time, investors may observe the risky asset price and know if default has occurred or not. We characterize the optimal strategy in terms of the integrand in the Galtchouk-Kunita-Watanabe decomposition of the defaultable claim with respect to the minimal martingale measure and the available information flow. Finally, we provide an explicit formula by means of predictable projection of the corresponding hedging strategy under full information with respect to the natural filtration of the risky asset price and the minimal martingale measure in a Markovian setting via filtering.
    Date: 2016–08
  6. By: Matt Davison; Darrell Leadbetter; Bin Lu; Jane Voll
    Abstract: Interconnectedness among insurers and reinsurers at a global level is not well understood and may pose a significant risk to the sector, with implications for the macroeconomy. Models of the complex interactions among reinsurers and with other participants in the financial system and the real economy are at a very early stage of development. Parts of the market remain opaque to both regulators and market participants, particularly the counterparty arrangements among reinsurers through retrocession agreements. The authors create several plausible networks to model these relationships, each consistent with the financial statement data of the reinsurer. These networks are stress-tested under a series of severe but plausible catastrophic-loss scenarios. This analysis contributes to the literature by (i) applying a network-model approach common in the banking literature to the insurance industry; (ii) assessing the interconnections among reinsurers through potential claims rather than premiums; and (iii) investigating the most opaque part of the global insurance market, namely, counterparty arrangements among global reinsurers (retrocession). The authors find that contagion in the global reinsurance market is plausible and that the size of the potential market disruption is sensitive to (i) the distribution of risk among counterparties, (ii) the trigger for financial distress, (iii) the time horizon for claims resolution and (iv) the degree of loss netting. The findings suggest that further study of industry practices in these four areas would improve our ability to assess risk in the insurance sector and promote financial stability.
    Keywords: Financial stability; Financial system regulation and policies; Financial institutions; Financial services
    JEL: G10 G15 G18 G22 G28 C63
    Date: 2016
  7. By: Antoine Jacquier; Fangwei Shi
    Abstract: We propose a randomised version of the Heston model-a widely used stochastic volatility model in mathematical finance-assuming that the starting point of the variance process is a random variable. In such a system, we study the small- and large-time behaviours of the implied volatility, and show that the proposed randomisation generates a short-maturity smile much steeper (`with explosion') than in the standard Heston model, thereby palliating the deficiency of classical stochastic volatility models in short time. We precisely quantify the speed of explosion of the smile for short maturities in terms of the right tail of the initial distribution, and in particular show that an explosion rate of~$t^\gamma$ ($\gamma\in[0,1/2]$) for the squared implied volatility-as observed on market data-can be obtained by a suitable choice of randomisation. The proofs are based on large deviations techniques and the theory of regular variations.
    Date: 2016–08
  8. By: Heralda, Jahollari
    Abstract: Risk management in insurance and reinsurance companies is a very important element, which enables the organization to meet its obligations to customers and to survive in the market place. In order to be managed properly, the risk must be first identified correctly. The damage must be assessed carefully and using efficient methods, for the evaluation to be more realistic. This paper is the result of the use of several methods. Besides the theoretical and narration aspects, the paper also relies on the comparative method, as it addresses the practices followed by the Member States as well as Albania, a country that has recently adopted a new law, aiming to align its legislation with the acquis communautaire. The study shows that the Albanian legislation provides the necessary guarantees to ensure that companies will manage risk in the best way possible and will create all the necessary structures for this purpose. In this regard, we can say that the alignment with the acquis communautaire has been successfully accomplished.
    Keywords: risk, risk management, insurance, reinsurance, analysis, law, alignment
    JEL: K20
    Date: 2016–02
  9. By: Heejoon Han
    Abstract: This paper examines quantile dependence between international stock markets and evaluates its use for improving volatility forecasting. First, we analyze quantile dependence and directional predictability between the US stock market and stock markets in the UK, Germany, France and Japan. We use the cross-quantilogram, which is a correlation statistic of quantile hit processes. The detailed dependence between stock markets depends on specific quantile ranges and this dependence is generally asymmetric; the negative spillover effect is stronger than the positive spillover effect and there exists strong directional predictability from the US market to the UK, Germany, France and Japan markets. Second, we consider a simple quantile-augmented volatility model that accommodates the quantile dependence and directional predictability between the US market and these other markets. The quantile-augmented volatility model provides superior in-sample and out-of-sample volatility forecasts.
    Date: 2016–08
  10. By: Garcí­a, Juan Angel; Werner, Sebastian E. V.
    Abstract: This paper investigates the power of macroeconomic factors to explain euro area bond risk premia using (i) a large dataset that captures the nowadays data-rich environment (ii) the Elastic Net variable selection. We find that macroeconomic factors, in particular economic activity and sentiment indicators, explain 40% of the variability of risk premia before the crisis, and up to 55% during the financial crisis, and both for core countries (from 40% to 60%) and periphery countries (from 35% to 44%). Moreover, macroeconomic factor models clearly outperform financial indicators like the CP-factor and credit default swap (CDS) premia, even in periods of significant market turbulence. JEL Classification: E43, E44, G01, G12, C52, C55
    Keywords: bond risk premium, financial crisis, macro factors, model selection, variable selection
    Date: 2016–07

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