nep-rmg New Economics Papers
on Risk Management
Issue of 2016‒10‒09
twelve papers chosen by

  1. The Spectral Stress VaR (SSVaR) By Dominique Guegan; Bertrand K. Hassani; Kehan Li
  2. A hybrid approach to assess systemic risk in financial networks By Daniele Petrone; Vito Latora
  3. Hedging with regret By Korn, Olaf; Rieger, Marc Oliver
  4. The Missed Opportunity and Challenge of Capital Regulation By Admati, Anat R.
  5. When Is Distress Risk Priced? Evidence from Recessionary Failure Prediction By Ogneva, Maria; Piotroski, Joseph D.; Zakolyukina, Anastasia A.
  6. Risk or Regulatory Capital? Bringing distributions back in the foreground By Dominique Guegan; Bertrand Hassani
  7. The Bank Capital Regulation (BCR) Model By Hyejin Cho
  8. Mapping the exposure to natural disaster losses for Italian municipalities By Giovanni Marin; Marco Modica
  9. Sharpe portfolio using a cross-efficiency evaluation By Juan F. Monge; Mercedes Landete; Jos\'e L. Ruiz
  10. Continuous Time ARMA Processes: Discrete Time Representation and Likelihood Evaluation. By Andrew Clare; James Seaton; Peter N. Smith; Stephen Thomas
  11. On Measuring Uncertainty: Snakes and Ladders By Junankar, Pramod N. (Raja)
  12. Interest rate risk, longevity risk and the solvency of life insurers By Berdin, Elia

  1. By: Dominique Guegan (CES - Centre d'économie de la Sorbonne - UP1 - Université Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique); Bertrand K. Hassani (CES - Centre d'économie de la Sorbonne - UP1 - Université Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique); Kehan Li (CES - Centre d'économie de la Sorbonne - UP1 - Université Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique)
    Abstract: One of the key lessons of the crisis which began in 2007 has been the need to strengthen the risk coverage of the capital framework. In response, the Basel Committee in July 2009 completed a number of critical reforms to the Basel II framework which will raise capital requirements for the trading book and complex securitisation exposures, a major source of losses for many international active banks. One of the reforms is to introduce a stressed value-at-risk (VaR) capital requirement based on a continuous 12-month period of significant financial stress (Basel III (2011) [1]. However the Basel framework does not specify a model to calculate the stressed VaR and leaves it up to the banks to develop an appropriate internal model to capture material risks they face. Consequently we propose a forward stress risk measure “spectral stress VaR” (SSVaR) as an implementation model of stressed VaR, by exploiting the asymptotic normality property of the distribution of estimator of VaR p. In particular to allow SSVaR incorporating the tail structure information we perform the spectral analysis to build it. Using a data set composed of operational risk factors we fit a panel of distributions to construct the SSVaR in order to stress it. Additionally we show how the SSVaR can be an indicator regarding the inner model robustness for the bank.
    Keywords: risk measure,stress,value at risk,asymptotic theory,distribution,spectral analysis,regulation
    Date: 2015–06
  2. By: Daniele Petrone; Vito Latora
    Abstract: We propose a credit risk approach in which financial institutions, modelled as a portfolio of risky assets characterized by a probability of default and a correlation matrix, are the nodes of a network whose links are credit exposures that would be partially lost in case of neighbours' default. The systemic risk of the network is described in terms of the loss distribution over time obtained with a multi-period Montecarlo simulation process, during which the nodes can default, triggering a change in the probability of default in their neighbourhood as a contagion mechanism. In particular, we have considered the expected loss and introduced new measures of network stress called PDImpact and PDRank. They are expressed in monetary terms as the already known DebtRank and can be used to assess the importance of a node in the network. The model exhibits two regimes of 'weak' and 'strong' contagion, the latter characterized by the depletion of the loss distribution at intermediate losses in favour of fatter tails. Also, in systems with strong contagion, low average correlation between nodes corresponds to larger losses. This seems at odds with the diversification benefit obtained in standard credit risk models. Results suggest that the credit exposure network of the European global systemically important banks is in a weak contagion regime, but strong contagion could be approached in periods characterized by extreme volatility or in cases where the financial institutions are not adequately capitalized.
    Date: 2016–10
  3. By: Korn, Olaf; Rieger, Marc Oliver
    Abstract: This paper investigates corporate hedging under regret aversion. Regret-averse firms try to avoid deviations of their hedging policy from the ex post best policy, an intuitive consideration if one has to justify one's decisions afterward. The study presents a model of a firm that faces uncertain prices and seeks to hedge both profit risk and regret risk with derivatives. It characterizes optimal hedge positions and shows that regret aversion leads to stronger incentives to hedge downside price risk than standard expected utility theory. In the profit region of the price distribution, however, regret aversion reduces the hedging of price risk to avoid large regret in the case of increasing prices. The results show that regret aversion has a strong effect on the choice of the hedging instrument and provides a preference-based explanation for the use of options in corporate risk management.
    Keywords: regret aversion,risk management,hedging,derivatives
    JEL: D81 G02 G32 G30
    Date: 2016
  4. By: Admati, Anat R. (Stanford University)
    Abstract: Capital regulation is critical to address distortions and externalities from intense conflicts of interest in banking and from the failure of markets to counter incentives for recklessness. The approaches to capital regulation in Basel III and related proposals are based on flawed analyses of the relevant tradeoffs. The flaws in the regulations include dangerously low equity levels, complex and problematic system of risk weights that exacerbates systemic risk and adds distortions, and unnecessary reliance on poor equity substitutes. The underlying problem is a breakdown of governance and lack of accountability to the public throughout the system, including policymakers and economists.
    JEL: G21 G28 G32 G38 H81 K23
    Date: 2015–12
  5. By: Ogneva, Maria (University of Southern CA); Piotroski, Joseph D. (Stanford University); Zakolyukina, Anastasia A. (University of Chicago)
    Abstract: This paper introduces a new measure of firm's exposure to systematic distress risk--the probability of a recession at the time of a firm's failure. For stocks in the top quintile of the probability of failure, a median hedge portfolio based on our measure generates a positive risk premium of 10%-12% per annum. Our results differ from the previously documented distress-risk anomaly--a negative correlation between the probability of failure and stock returns. We argue that the probability of failure does not capture systematic distress risk well because it does not differentiate between failures occurring in recessions and expansions.
    JEL: G11 G12 G32 G33
    Date: 2015–05
  6. By: Dominique Guegan (CES - Centre d'économie de la Sorbonne - UP1 - Université Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique); Bertrand Hassani (CES - Centre d'économie de la Sorbonne - UP1 - Université Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique)
    Abstract: This paper discusses the regulatory requirement (Basel Committee, ECB-SSM and EBA) to measure financial institutions' major risks, for instance Market, Credit and Operational, regarding the choice of the risk measures, the choice of the distributions used to model them and the level of confidence. We highlight and illustrate the paradoxes and the issues observed implementing an approach over another and the inconsistencies between the methodologies suggested and the goal to achieve. This paper make some recommendations to the supervisor and proposes alternative procedures to measure the risks.
    Keywords: risk measures,sub-additivity,level of confidence,extreme value distributions,financial regulation
    Date: 2015–05
  7. By: Hyejin Cho (CES - Centre d'économie de la Sorbonne - UP1 - Université Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique)
    Abstract: The motivation of this article is to induce the bank capital management solution for banks and regulation bodies on commercial banks. The goal of the paper is intended to mitigate the risk of a banking area and also provide the right incentive for banks to support the real economy.
    Keywords: demand deposit,On-balance-sheet risks and off-balance-sheet risks,portfolio composition,minimum equity capital regulation
    Date: 2015–02
  8. By: Giovanni Marin (IRCrES-CNR, Milano, Italy; SEEDS, Italy); Marco Modica (IRCrES-CNR, Milano, Italy; SEEDS, Italy)
    Abstract: Even though the correct assessment of risks is a key aspect of the risk management analysis, we argue that limited effort has been devoted in the assessment of full measures of economic exposure at very low scale. For this reason, we aim at providing a complete and detailed map of the exposure of economic activities to natural disasters in the Italian context. We use Input-Output model and spatial autocorrelation (Moran's I) to provide information about several socio-economic variables, such as population density, employment density, firms’ turnover and capital stock, that can be seen as direct and indirect socio-economic exposure to natural disasters. These measures can be easily incorporated into risk assessment models to provide a clear picture of the disaster risk for Italian local areas.
    Keywords: Economic exposure, Disaster impact; Risk assessment; Risk management
    Date: 2016–10
  9. By: Juan F. Monge; Mercedes Landete; Jos\'e L. Ruiz
    Abstract: The Sharpe ratio is a way to compare the excess returns (over the risk free asset) of portfolios for each unit of volatility that is generated by a portfolio. In this paper we introduce a robust Sharpe ratio portfolio under the assumption that the risk free asset is unknown. We propose a robust portfolio that maximizes the Sharpe ratio when the risk free asset is unknown, but is within a given interval. To compute the best Sharpe ratio portfolio all the Sharpe ratios for any risk free asset are considered and compared by using the so-called cross-efficiency evaluation. An explicit expression of the Cross-Eficiency Sharpe ratio portfolio is presented when short selling is allowed.
    Date: 2016–10
  10. By: Andrew Clare; James Seaton; Peter N. Smith; Stephen Thomas
    Abstract: Sequence risk is a poorly understood, but crucial aspect of the risk faced by many investors. Using US equity data from 1872-2015 we apply the concept of Perfect Withdrawal Rates to show how this risk can be significantly reduced by applying simple, trend following investment strategies. We also show that knowing the CAPE ratio at the beginning of a decumulation period is useful for predicting and enhancing the sustainable withdrawal rate.
    Keywords: Sequence Risk; Perfect Withdrawal Rate; Decumulation; Trend-Following; CAPE
    JEL: G10 G11 G22
    Date: 2016–09
  11. By: Junankar, Pramod N. (Raja) (University of New South Wales)
    Abstract: The Global Crisis demonstrated to the world that Ratings Agencies had misled the public about the stability of financial institutions. The Finance literature had decided that it was impossible to have bubbles in financial markets and any surge in the stock market would be self-correcting. Recent papers have discussed the role of "uncertainty" and its measurement in influencing economic decisions. They attempt to measure uncertainty by indexes of volatility of the stock market, GDP, forecaster disagreement, mentions of uncertainty in news media, and the dispersion of productivity shocks to firms. Underlying their measures of uncertainty is the hypothesis that an increase in uncertainty leads to lower consumption by households and lower investment by firms, and hence leads to lower aggregate investment and growth. This paper argues that although risk can be measured, uncertainty cannot be measured. Even though risk can be measured, a simple symmetric measure (variance or standard deviation) is inappropriate because agents are loss averse and treat gains differently from losses. Although, it is clear that an increase in uncertainty worsens economic conditions, in this paper I shall also argue that this attempt at "measuring" risk or (fundamental) uncertainty is flawed.
    Keywords: uncertainty, risk, Keynes, variance measures, loss aversion, investment
    JEL: E12 E22 G01 G11
    Date: 2016–09
  12. By: Berdin, Elia
    Abstract: In this paper I assess the effect of interest rate risk and longevity risk on the solvency position of a life insurer selling policies with minimum guaranteed rate of return, profit participation and annuitization option at maturity. The life insurer is assumed to be based in Germany and therefore subject to German regulation as well as to Solvency II regulation. The model features an existing back book of policies and an existing asset allocation calibrated on observed data, which are then projected forward under stochastic financial markets and stochastic mortality developments. Different scenarios are proposed, with particular focus on a prolonged period of low interest rates and strong reduction in mortality rates. Results suggest that interest rate risk is by far the greatest threat for life insurers, whereas longevity risk can be more easily mitigated and thereby is less detrimental. Introducing a dynamic demand for new policies, i.e. assuming that lower offered guarantees are less attractive to savers, show that a decreasing demand may even be beneficial for the insurer in a protracted period of low interest rates. Introducing stochastic annuitization rates, i.e. allowing for deviations from the expected annuitization rate, the solvency position of the life insurer worsen substantially. Also profitability strongly declines over time, casting doubts on the sustainability of traditional life business going forward with the low interest rate environment. In general, in the proposed framework it is possible to study the evolution over time of an existing book of policies when underlying financial market conditions and mortality developments drastically change. This feature could be of particular interest for regulatory and supervisory authorities within their financial stability mandate, who could better evaluate micro- and macro-prudential policy interventions in light of the persistent low interest rate environment.
    Keywords: Interest Rate Risk,Longevity Risk,Life Insurance,Annuities,Solvency II
    JEL: G22 G23 G12 G17
    Date: 2016

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