
on Risk Management 
Issue of 2016‒11‒06
sixteen papers chosen by 
By:  Dangl, Thomas; Randl, Otto; Zechner, Josef 
Abstract:  In traditional portfolio theory, risk management is limited to the choice of the relative weights of the riskless asset and a diversified basket of risky securities, respectively. Yet in industry, risk management represents a central aspect of asset management, with distinct responsibilities and organizational structures. We identify frictions that lead to increased importance of risk management and describe three major challenges to be met by the risk manager. First, we derive a framework to determine a portfolio position's marginal risk contribution and to decide on optimal portfolio weights of active managers. Second, we survey methods to control downside risk and unwanted risks since investors frequently have nonstandard preferences which make them seek protection against excessive losses. Third, we point out that quantitative portfolio management usually requires the selection and parametrization of stylized models of financial markets. We therefore discuss risk management approaches to deal with parameter uncertainty, such as shrinkage procedures or resampling procedures, and techniques of dealing with model uncertainty via methods of Bayesian model averaging. 
Date:  2016 
URL:  http://d.repec.org/n?u=RePEc:zbw:cfswop:546&r=rmg 
By:  Wong, Woon K. (Cardiff Business School) 
Abstract:  This article extends the variance ratio test of Lo and MacKinlay (1988) to tests of skewness and kurtosis ratios. The proposed tests are based on generalized methods of moments. In particular, overlapping observations are used and their dependencies (under the IID assumption) are explicitly modelled so that more information can be used in order to make the tests more powerful with better size properties. The proposed tests are particularly relevant to the risk management industry where risk models are estimated using daily data, although multiperiod forecasts of tail risks are required for the determination of risk capital. Applications of the tests …nd signi…cant higherorder nonlinear dependencies in global major equity markets. Failure to correctly model such nonlinear relationships is likely to have a negative impact on the accuracy of forecasts of multiperiod tail risks. 
Keywords:  Skewness, kurtosis, overlapping observations, mutiperiod tail risk, ValueatRisk 
JEL:  C10 G11 
Date:  2016–08 
URL:  http://d.repec.org/n?u=RePEc:cdf:wpaper:2016/8&r=rmg 
By:  William R. Cline (Peterson Institute for International Economics) 
Abstract:  Deutsche Bank's recent troubles, including a fine by the US Department of Justice for allegedly misleading investors in the sale of mortgagebacked securities, have led to a decline in the bank's share price. The bank, however, is not insolvent and would not be even if the full $14 billion fine were levied. Its problems, nonetheless, should prompt policymakers to focus on whether banking sector reform after the financial crisis is on track. The new shocks from large legal fines add to concerns about capital adequacy. Low stock market prices may further reflect doubts about asset valuations, especially for derivatives, and about risk weightings using internal models. Cline notes that the decline in the bank's share price in both January–February and September was prompted by the specter of losses to additional tier 1 (AT1) bonds that count toward the bank's total lossabsorbing capacity (TLAC) imposed by the Basel III regulatory reforms. He concludes that the bank's difficulties provide further support for additional bank capital beyond Basel III targets. Higher equity capital provides a larger cushion against insolvency in the face of shocks. With equity a larger share of the TLAC target of 18 percent of riskweighted assets under Basel III, an additional benefit would be the resulting reduction in the need for contingent (AT1) capital, which has proven to be a source of market instability when investors fear writedowns on (or conversions of) such obligations. Low market valuations mean that banks would need to raise additional equity over time through retained earnings rather than immediately through new issuance when share prices are depressed. This problem is currently more severe for large banks in Europe than for those in the United States. Banks may also need to change their basic business models and downsize their balance sheets gradually until share prices rise toward book values. 
Date:  2016–10 
URL:  http://d.repec.org/n?u=RePEc:iie:pbrief:pb1619&r=rmg 
By:  Schneider, Paul; Wagner, Christian; Zechner, Josef 
Abstract:  This paper shows theoretically and empirically that beta and volatilitybased low risk anomalies are driven by return skewness. The empirical patterns con cisely match the predictions of our model which generates skewness of stock returns via default risk. With increasing downside risk, the standard capital as set pricing model increasingly overestimates required equity returns relative to firms' true (skewadjusted) market risk. Empirically, the profitability of betting against beta/volatility increases with firms' downside risk. Our results suggest that the returns to betting against beta/volatility do not necessarily pose asset pricing puzzles but rather that such strategies collect premia that compensate for skew risk. 
Keywords:  low risk anomaly,skewness,credit risk,risk premia,equity options 
Date:  2016 
URL:  http://d.repec.org/n?u=RePEc:zbw:cfswop:550&r=rmg 
By:  Thibaut Lux; Antonis Papapantoleon 
Abstract:  We derive bounds on the distribution function, therefore also on the ValueatRisk, of $\varphi(\mathbf X)$ where $\varphi$ is an aggregation function and $\mathbf X = (X_1,...,X_d)$ is a random vector with known marginal distributions and partially known dependence structure. More specifically, we analyze three types of available information on the dependence structure: First, we consider the case where extreme value information, such as distributions of partial minima and maxima of $\mathbf X$ are known. In order to include this information in the computation of ValueatRisk bounds, we establish a reduction principle that relates this problem to an optimization problem over a standard Fr\'echet class. Second, we assume that the copula of $\mathbf X$ is known only on a subset of its domain, and finally we consider the case where the copula of $\mathbf X$ lies in the vicinity of a reference copula as measured by a statistical distance. In order to derive ValueatRisk bounds in the latter situations, we first improve the Fr\'echetHoeffding bounds on copulas so as to include the additional information. Then, we relate the improved Fr\'echetHoeffding bounds to ValueatRisk using the improved standard bounds of Embrechts et al. In numerical examples we illustrate that the additional information may lead to a considerable improvement of the bounds compared to the marginalsonly case. 
Date:  2016–10 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1610.09734&r=rmg 
By:  Takuji Arai; Yuto Imai 
Abstract:  We discuss the difference between locally riskminimizing and delta hedging strategies for exponential L\'evy models, where delta hedging strategies in this paper are defined under the minimal martingale measure. We give firstly modelindependent upper estimations for the difference. In addition we show numerical examples for two typical exponential L\'evy models: Merton models and variance gamma models. 
Date:  2016–10 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1610.09085&r=rmg 
By:  Ines Wilms; Jeroen Rombouts; Christophe Croux 
Abstract:  Volatility forecasts are key inputs in financial analysis. While lasso based forecasts have shown to perform well in many applications, their use to obtain volatility forecasts has not yet received much attention in the literature. Lasso estimators produce parsimonious forecast models. Our forecast combination approach hedges against the risk of selecting a wrong degree of model parsimony. Apart from the standard lasso, we consider several lasso extensions that account for the dynamic nature of the forecast model. We apply forecast combined lasso estimators in a comprehensive forecasting exercise using realized variance time series of ten major international stock market indices. We find the lasso extended 'ordered lasso' to give the most accurate realized variance forecasts. Multivariate forecast models, accounting for volatility spillovers between different stock markets, outperform univariate forecast models for longer forecast horizons. 
Keywords:  Forecast combination, Hierarchical lasso, Lasso, Ordered Lasso, Realized variance, Volatility forecasting 
Date:  2016–10 
URL:  http://d.repec.org/n?u=RePEc:ete:kbiper:553087&r=rmg 
By:  Nils Detering; Thilo MeyerBrandis; Konstantinos Panagiotou; Daniel Ritter 
Abstract:  To quantify and manage systemic risk in the interbank market, we propose a weighted, directed random network model. The vertices in the network are financial institutions and the weighted edges represent monetary exposures between them. Our model resembles the strong degree of heterogeneity observed in empirical data and the parameters of the model can easily be fitted to market data. We derive asymptotic results that, based on these parameters, allow to determine the impact of local shocks to the entire system and the wider economy. Furthermore, we characterize resilient and nonresilient cases. For networks with degree sequences without second moment, a small number of initially defaulted banks can trigger a substantial default cascade even under the absence of so called contagious links. Paralleling regulatory discussions we determine minimal capital requirements for financial institutions sufficient to make the network resilient to small shocks. 
Date:  2016–10 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1610.09542&r=rmg 
By:  Stijn Ferrari (National Bank of Belgium); Mara Pirovano (National Bank of Belgium); Pablo Rovira Kaltwasser (National Bank of Belgium) 
Abstract:  In December 2013 the National Bank of Belgium introduced a sectoral capital requirement aimed at strengthening the resilience of Belgian banks against adverse developments in the real estate market. This paper assesses the impact of this macroprudential measure on mortgage lending spreads. Our results indicate that affected banks reacted heterogeneously to the introduction of the measure. Specifically, mortgagespecialised and capitalconstrained banks increase mortgage lending spreads by a greater amount. As expected, the impact of the measure on mortgage loan pricing has been rather modest in economic terms. 
Keywords:  Regions, productivity, labour costs, linked panel data 
JEL:  E44 E58 G21 G28 
Date:  2016–10 
URL:  http://d.repec.org/n?u=RePEc:nbb:reswpp:201610306&r=rmg 
By:  Cociuba, Simona (University of Western Ontario); Shukayev, Malik (University of Alberta, Department of Economics); Ueberfeldt, Alexander (Bank of Canada) 
Abstract:  We develop a model in which a financial intermediarys investment in risky assets risk taking is excessive due to limited liability and deposit insurance, and characterize the policy tools that implement efficient risk taking. In the calibrated model, coordinating interest rate policy with statecontingent macroprudential regulations either capital or leverage regulation, and a tax on pro ts achieves efficiency. Interest rate policy mitigates excessive risk taking, by altering the return and the supply of collateralizable safe assets. In contrast to commonlyused capital regulation, leverage regulation has stronger effects on risk taking and calls for higher interest rates. 
Keywords:  Financial intermediation; risk taking; interest rate policy; macroprudential regulations; capital requirements; leverage ratio 
JEL:  E44 E52 G11 G18 
Date:  2016–11–01 
URL:  http://d.repec.org/n?u=RePEc:ris:albaec:2016_017&r=rmg 
By:  Moshe A. Milevsky; Thomas S. Salisbury 
Abstract:  Tontines were once a popular type of mortalitylinked investment pool. They promised enormous rewards to the last survivors at the expense of those died early. And, while this design appealed to the gambling instinc}, it is a suboptimal way to generate retirement income. Indeed, actuariallyfair life annuities making constant payments  where the insurance company is exposed to longevity risk  induce greater lifetime utility. However, tontines do not have to be structured the historical way, i.e. with a constant cash flow shared amongst a shrinking group of survivors. Moreover, insurance companies do not sell actuariallyfair life annuities, in part due to aggregate longevity risk. We derive the tontine structure that maximizes lifetime utility. Technically speaking we solve the EulerLagrange equation and examine its sensitivity to (i.) the size of the tontine pool $n$, and (ii.) individual longevity risk aversion $\gamma$. We examine how the optimal tontine varies with $\gamma$ and $n$, and prove some qualitative theorems about the optimal payout. Interestingly, Lorenzo de Tonti's original structure is optimal in the limit as longevity risk aversion $\gamma \to \infty$. We define the natural tontine as the function for which the payout declines in exact proportion to the survival probabilities, which we show is nearoptimal for all $\gamma$ and $n$. We conclude by comparing the utility of optimal tontines to the utility of loaded life annuities under reasonable demographic and economic conditions and find that the life annuity's advantage over the optimal tontine is minimal. In sum, this paper's contribution is to (i.) rekindle a discussion about a retirement income product that has been long neglected, and (ii.) leverage economic theory as well as tools from mathematical finance to design the next generation of tontine annuities. 
Date:  2016–10 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1610.10078&r=rmg 
By:  Simona Cociuba; Malik Shukayev; Alexander Ueberfeldt 
Abstract:  We develop a model in which a financial intermediary’s investment in risky assets—risk taking—is excessive due to limited liability and deposit insurance and characterize the policy tools that implement efficient risk taking. In the calibrated model, coordinating interest rate policy with statecontingent macroprudential regulations, either capital or leverage regulation, and a tax on profits achieves efficiency. Interest rate policy mitigates excessive risk taking by altering both the return and the supply of collateralizable safe assets. In contrast to commonly used capital regulation, leverage regulation has stronger effects on risk taking and calls for higher interest rates. 
Keywords:  Financial system regulation and policies, Monetary policy framework 
JEL:  E44 E52 G11 G18 
Date:  2016 
URL:  http://d.repec.org/n?u=RePEc:bca:bocawp:1647&r=rmg 
By:  Amrita Dhillon; Andrew Pickering; Tomas Sjöström 
Abstract:  We examine default decisions under different political systems. If democratically elected politicians are unable to make credible commitments to repay externally held debt, default rates are inefficiently high because politicians internalize voter utility loss from repayment. Politicians who are motivated by electoral concerns are more likely to default in order to avoid voter utility losses, and, since lenders recognize this, interest rates and risk premiarise. Therefore, democracy potentially confers a credit market disadvantage. However, farsighted institutions that take into account how interest rates respond to default risk can ameliorate the disadvantage. Using a numerical measure of institutional farsightedness obtained from the Government Insight Business Risk and Conditions database, we …find that the observed relationship between creditratings and democratic status is indeed strongly conditional on farsightedness. With myopic institutions, democracy is estimated to cost on average about 2.5 investment grades. With farsighte institutions there is, if anything, a democratic advantage. 
Keywords:  Sovereign debt, Default, Risk premia, Autocracy, Democracy, Institutions 
JEL:  H63 F55 D72 D82 H75 O43 C72 
Date:  2016–11 
URL:  http://d.repec.org/n?u=RePEc:yor:yorken:16/13&r=rmg 
By:  Dangl, Thomas; Zechner, Josef 
Abstract:  This paper shows that long debt maturities eliminate equityholders' incentives to reduce leverage when the firm performs poorly. By contrast, short debt maturities commit equityholders to such leverage reductions. However, shorter debt maturities also lead to higher transactions costs when maturing bonds must be refinanced. We show that this tradeoff between higher expected transactions costs against the commitment to reduce leverage when the firm is doing poorly motivates an optimal maturity structure of corporate debt. Since firms with high costs of financial distress benefit most from committing to leverage reductions, they have a stronger motive to issue shortterm debt. 
Keywords:  debt maturity,optimal capital structure choice 
JEL:  G3 G32 
Date:  2016 
URL:  http://d.repec.org/n?u=RePEc:zbw:cfswop:547&r=rmg 
By:  Horneff, Vanya; Maurer, Raimond; Mitchell, Olivia S. 
Abstract:  Most defined contribution pension plans pay benefits as lump sums, yet the US Treasury has recently encouraged firms to protect retirees from outliving their assets by converting a portion of their plan balances into longevity income annuities (LIA). These are deferred annuities which initiate payouts not later than age 85 and continue for life, and they provide an effective way to hedge systematic (individual) longevity risk for a relatively low price. Using a life cycle portfolio framework, we measure the welfare improvements from including LIAs in the menu of plan payout choices, accounting for mortality heterogeneity by education and sex. We find that introducing a longevity income annuity to the plan menu is attractive for most DC plan participants who optimally commit 815% of their plan balances at age 65 to a LIA that starts paying out at age 85. Optimal annuitization boosts welfare by 520% of average retirement plan accruals at age 66 (assuming average mortality rates), compared to not having access to the LIA. We also compare the optimal LIA allocation versus two default options that plan sponsors could implement. We conclude that an approach where a fixed fraction over a dollar threshold is invested in LIAs will be preferred by most to the status quo, while enhancing welfare for the majority of workers. 
Keywords:  dynamic portfolio choice,longevity risk,variable annuity,retirement income 
JEL:  G11 G22 D14 D91 
Date:  2016 
URL:  http://d.repec.org/n?u=RePEc:zbw:safewp:150&r=rmg 
By:  Britz, Wolfgang; Linda, Arata 
Abstract:  We present a dual cost function estimation for total farm cost in a programming model setup, with individual crop shares and expected yields as arguments, estimated simultaneously with risk behaviour. Using large unbalanced samples of specialized arable farms from Northern Italy, the French Grandes Culture Region and CologneAachen in Germany that are observed for at least three consecutive years over the time period 19952008, we find a quite satisfactory fit for crop shares and total costs. We implement two model variants where zero crop observations are considered only in the second variant. Our results indicate that the specialized arable crop farmers in the samples use crop shares only to a limited degree as an instrument of risk management. We find moderate technical progress and large efficiency differences between farms. 
Keywords:  Risk, dual cost function estimation, programming model, Production Economics, Research Methods/ Statistical Methods, Risk and Uncertainty, 
URL:  http://d.repec.org/n?u=RePEc:ags:gewi16:244801&r=rmg 