nep-rmg New Economics Papers
on Risk Management
Issue of 2016‒12‒18
fourteen papers chosen by

  1. Multivariate extreme value statistics for risk assessment By He, Yi
  2. Liquidity and Risk Management: Coordinating Investment and Compensation Policies By Patrick Bolton; Neng Wang; Jinqiang Yang
  3. Clustering in Dynamic Causal Networks as a Measure of Systemic Risk on the Euro Zone By Monica Billio; Lorenzo Frattarolo; Hayette Gatfaoui; Philippe de Peretti
  4. Equity Option-Implied Probability of Default and Equity Recovery Rate By Bo Young Chang; Greg Orosi
  5. European insurance union and how to get there By Dirk Schoenmaker
  6. The risk asymmetry index By Elyas Elyasani; Luca Gambarelli; Silvia Muzzioli
  7. Market Discipline Working for and Against Financial Stability: The Two Faces of Equity Capital in U.S. Commercial Banking By Joseph P. Hughes; Loretta J. Mester; Choon-Geol Moon
  8. Bank capital requirements and balance sheet management practices: has the relationship changed after the crisis? By de-Ramon, Sebastian J A; Francis, William; Harris, Qun
  9. The hierarchical generalized linear model and the bootstrap estimator of the error of prediction of loss reserves in a non-life insurance company By Alicja Wolny-Dominiak
  10. Volatility spillovers across European stock markets around the Brexit referendum By Hong Li; Shamim Ahmed; Thanaset Chevapatrakul
  11. A large deviations approach to the statistics of extreme events By de Valk, Cees
  12. Parameter uncertainty and reserve risk under Solvency II By Andreas Fr\"ohlich; Annegret Weng
  13. Risk averse fractional trading using the current drawdown By Stanislaus Maier-Paape
  14. Alternative Strategies to Manage Weather Risk in Perennial Fruit Crop Production By Ho, Shuay-Tsyr; Ifft, Jennifer E.; Rickard, Bradley J.; Turvey, Calum G.

  1. By: He, Yi (Tilburg University, School of Economics and Management)
    Abstract: This dissertation consists of three essays about statistical estimation and inference methods concerning extremal events and tail risks. The first essay establishes a natural, semi-parametric estimation procedure for the multivariate half-space depth-based extreme quantile region in arbitrary dimensions. In contrast to the failure of fully non-parametric approaches due to the scarcity of extremal observations, the good finite-sample performance of our extreme estimator is clearly demonstrated in simulation studies. The second essay extends this method to various depth functions, and, furthermore, establishes an asymptotic approximation theory of what-we-called (directed) logarithmic distance between our estimated and true quantile region. Confidence sets that asymptotically cover the quantile region or its complement, or both simultaneously, with a pre-specified probability can be therefore constructed under weak regular variation conditions. The finite-sample coverage probabilities of our asymptotic confidence sets are evaluated in a simulation study for the half-space depth and the projection depth. We use the procedures in both chapters for risk management by applying them to stock market returns. The third essay develops a statistical inference theory of a recently proposed tail risk measure. For regulators who are interested in monitoring these what-we-called relative risks of individual banks, we provide a jackknife empirical likelihood inference procedure based on the smoothed nonparametric estimation and a Wilks type of result. A simulation study and real-life data analysis show that the proposed relative risk measure is useful in monitoring systemic risk.
    Date: 2016
  2. By: Patrick Bolton (Columbia University); Neng Wang (Columbia Business School); Jinqiang Yang (School of Finance, Shanghai University of Finance and Economics)
    Abstract: We formulate a dynamic financial contracting problem with risky inalienable human capital. We show that the inalienability of the entrepreneur’s risky human capital not only gives rise to endogenous liquidity limits but also calls for dynamic liquidity and risk management policies via standard securities that firms routinely pursue in practice, such as retained earnings, possible line of credit draw-downs, and hedging via futures and insurance contracts.
    Date: 2016
  3. By: Monica Billio (University Ca' Foscari of Venice - Department of Economics); Lorenzo Frattarolo (University Ca' Foscari of Venice - Department of Economics); Hayette Gatfaoui (IESEG School of Management (LEM) et Centre d'Economie de la Sorbonne); Philippe de Peretti (Centre d'Economie de la Sorbonne)
    Abstract: In this paper, we analyze the dynamic relationships between ten stock exchanges of the euro zone using Granger causal networks. Considering returns for which we allow the variance to follow a Markov-Switching GARCH or a Changing-Point GARCH process, we first show that over different periods, the topology of the network is highly unstable. In particular dynamic relationships vanish over very recent years. Then, expanding on this idea, we analyze patterns of information transmission within the network. Using rolling windows to study networks' topology in terms of information clustering, we find that the nodes' state changes continually. Moreover, the system exhibits periods of flickering in information tranmission. During these periods of flickering, the system also exhibits desynchronization in the information transmission process. These periods do precede tipping points or phase transitions on the market, especially before the global financial crisis, and can thus be used as early warnings. To our knowledge, this is the first time that flickering in information transmission is identified on financial markets, and that flickering is related to phase transitions
    Keywords: Causal Network; Topology; Flickering; Desynchronisation; Phase transitions
    JEL: C1 C4 G1
    Date: 2016–05
  4. By: Bo Young Chang; Greg Orosi
    Abstract: There is a close link between prices of equity options and the default probability of a firm. We show that in the presence of positive expected equity recovery, standard methods that assume zero equity recovery at default misestimate the option-implied default probability. We introduce a simple method to detect stocks with positive expected equity recovery by examining option prices and propose a method to extract the default probability from option prices that allows for positive equity recovery. We demonstrate possible applications of our methodology with examples that include large financial institutions in the United States during the 2007–09 subprime crisis.
    Keywords: Asset Pricing, Financial markets, Market structure and pricing
    JEL: G13 G33
    Date: 2016
  5. By: Dirk Schoenmaker
    Abstract: The issue The full entry into force at the start of 2016 of the European Union’s Solvency II risk-based capital framework for insurance poses new challenges for supervisory cooperation in Europe. Supervisory challenges are present in terms of both management of systemic risk and day-to-day supervision. The common vulnerability of insurers to market risks, in particular the current low interest rate, is a source of systemic risk, and while supervisors might cooperate in day-to-day supervision, cooperation, such as exchange of information and coordinated action, can run less smoothly in times of crisis. Furthermore, risks are present in the context of a European insurance sector that is highly integrated, with a large and rising share of cross-border business. The policy challenge The European Insurance and Occupational Pensions Supervisory Authority (EIOPA) currently plays a coordinating role in supervision, with final authority remaining with the national supervisors. A more centralised role for EIOPA in a European insurance union would overcome the fragmentation in supervision and ensure a joined-up view of the large cross-border insurance groups, enhancing the effectiveness of supervision. However, a staggered approach can be followed in a move towards insurance union. In the first stage, EIOPA can be given the authority to foster supervisory convergence. Ultimately, EIOPA would be given direct powers to supervise significant insurance groups, within a network of national insurance supervisors.
    Date: 2016–12
  6. By: Elyas Elyasani; Luca Gambarelli; Silvia Muzzioli
    Abstract: The aim of this paper is to propose a simple and unique measure of risk, that subsumes the conflicting information in volatility and skewness indices and overcomes the limits of these indices in correctly measuring future fear or greed in the market. To this end, we exploit the concept of upside and downside corridor implied volatility, which accounts for the asymmetry in risk-neutral distribution, i.e. the fact that investors like positive spikes in returns, while they dislike negative ones. We combine upside and downside implied volatilities in a single asymmetry index called the risk-asymmetry index (RAX). The risk-asymmetry index (RAX) plays a crucial role in predicting future returns, since it subsumes all the information embedded in both the Italian skewness index ITSKEW and the Italian volatility index (ITVIX). The RAX index is the only index that is able to indicate (when reaching very high values) a clearly risky situation for the aggregate stock market, which is detected neither by the ITVIX ?index nor by the ITSKEW index
    Keywords: risk-neutral moments, model-free implied volatility, corridor implied volatility, skewness, skewness risk premium.
    JEL: G13 G14
    Date: 2016–12
  7. By: Joseph P. Hughes (Rutgers University); Loretta J. Mester (Federal Reserve Bank of Cleveland and the Wharton School, University of Pennsylvania); Choon-Geol Moon (Hanyang University)
    Abstract: The second Basel Capital Accord points to market discipline as a tool to reinforce capital standards and supervision in promoting bank safety and soundness. The Bank for International Settlements contends that market discipline imposes strong incentives on banks to operate in a safe and efficient manner – in particular, to maintain an adequate capital base to absorb potential losses from their risk exposures. Using 2007 and 2013 data on top-tier, publicly traded U.S. bank holding companies, we find that market discipline rewards risk-taking at some of the largest U.S. financial institutions. In particular, we find evidence of two faces of equity investment – dichotomous capital strategies for maximizing value. At banks with higher-valued investment opportunities, a marginal increase in their equity capital ratio is associated with better financial performance, while at banks with lower-valued investment opportunities, a marginal decrease in their equity capital ratio is associated with better financial performance. Because the largest U.S. financial institutions tend to have lower-valued investment opportunities, our results suggest that they may have a market-based incentive to reduce their capital ratio. To the extent that market discipline rewards reducing the capital ratio among the largest banks, it would tend to undermine financial stability. Our results support the need for regulatory capital requirements.
    Keywords: banking, efficiency, capital structure, charter value
    JEL: C58 G21 G28
    Date: 2016–12–14
  8. By: de-Ramon, Sebastian J A (Bank of England); Francis, William (Bank of England); Harris, Qun (Bank of England)
    Abstract: We use a proprietary database of individual UK capital requirements spanning 1989 to 2013 and panel regression techniques to evaluate whether the effects of capital requirements on banks’ balance sheet adjustments changed after the 2008–09 financial crisis. We find that after the crisis banks placed more emphasis on overall asset de-leveraging. A 1 percentage point increase in capital requirements lowered total asset growth by 14 basis points before the crisis and 20 basis points after the crisis. We also find evidence of a structural change in banks’ capital management practices, with banks increasing better-quality, Tier 1 capital significantly more in response to higher requirements after the crisis than they did before the crisis. However, the effects of capital requirements on lending and risk-weighted asset growth both before and after the crisis are similar. Our results suggest that both before and after the crisis, a 1 percentage point increase in capital requirements lowered annual loan (risk-weighted asset) growth by 8 (12) basis points.
    Keywords: Banking; regulatory capital requirements; bank capital ratios; bank credit supply; macroprudential tools
    JEL: D21 G21 G28
    Date: 2016–12–09
  9. By: Alicja Wolny-Dominiak
    Abstract: This paper presents the hierarchical generalized linear model (HGLM) for loss reserving in a non-life insurance company. Because in this case the error of prediction is expressed by a complex analytical formula, the error bootstrap estimator is proposed instead. Moreover, the bootstrap procedure is used to obtain full information about the error by applying quantiles of the absolute prediction error. The full R code is available on the Github serveHGLM.
    Date: 2016–12
  10. By: Hong Li; Shamim Ahmed; Thanaset Chevapatrakul
    Abstract: The vote of the people of the United Kingdom to leave the European Union following the referendum on June 23, 2016, created tremendous uncertainty in the financial markets. This paper documents the stock market interdependence across four major European markets around this rare and unique event. We uncover the characteristics of the volatility spillover dynamics across France, Germany, Switzerland and the United Kingdom using intraday data at 15-minute intervals. Specifically, we quantify four types of volatility spillover measures: total (non-directional) spillovers, gross directional spillovers, net directional spillovers, and net pairwise spillovers. Our results point to considerable interdependence among the four stock markets. We find that France and Germany were in general the net volatility transmitters to others, while Switzerland and the United Kingdom the net receivers from others during January 4, 2016 to September 30, 2016. Around the day of the Brexit referendum, France and the United Kingdom appear to be net transmitters, while Germany and Switzerland net receivers. Our empirical analysis uncovers important information regarding stock market interdependence, which will be beneneficial to both policymakers and practitioners.
    Keywords: Market risk, Stock market, Spillover effect, Vector autoregression, and Variance decomposition.
    Date: 2016
  11. By: de Valk, Cees (Tilburg University, School of Economics and Management)
    Abstract: A large deviations approach to the statistics of extreme events addresses the statistical analysis of extreme events with very low probabilities: given a random sample of data of size n, the probability is much smaller than 1/n. In particular, it takes a close look at the regularity assumptions on the tail of the (univariate or multivariate) distribution function. The classical assumptions, cast in the form of limits of ratios of probabilities of extreme events, are not directly applicable in this setting. Therefore, additional assumptions are commonly imposed. Because these may be very restrictive, this thesis proposes an alternative regularity assumption, taking the form of asymptotic bounds on ratios of logarithms of probabilities of extreme events, i.e., a large deviation principle (LDP). In the univariate case, this tail LDP is equivalent to the log-Generalised Weibull (log-GW) tail limit, which generalises the Weibull tail limit and the classical Pareto tail limit, amongst others. Its application to the estimation of high quantiles is discussed. In the multivariate case, the tail LDP implies marginal log-GW tail limits together with a standardised tail LDP describing tail dependence. Its application to the estimation of very low probabilities of multivariate extreme events is discussed, and a connection is established to hidden regular variation (residual tail dependence) and similar models.
    Date: 2016
  12. By: Andreas Fr\"ohlich; Annegret Weng
    Abstract: In this article we consider the parameter risk in the context of internal modelling of the reserve risk under Solvency II. We discuss two opposed perspectives on parameter uncertainty and point out that standard methods of classical reserving focusing on the estimation error of claims reserves are in general not appropriate to model the impact of parameter uncertainty upon the actual risk of economic losses from the undertakings's perspective. Referring to the requirements of Solvency II we assess methods to model parameter uncertainty for the reserve risk by comparing the probability of solvency actually attained when modelling the solvency risk capital requirement based on the respective method to the required confidence level. Using the simple example of a normal model we show that the bootstrapping approach is not appropriate to model parameter uncertainty according to this criterion. We then present an adaptation of the approach proposed in [Modelling parameter uncertainty for risk capital calculation, Andreas Fr\"ohlich, Annegret Weng, European Actuarial Journal, Vol. 5, Issue No. 1 (2015), pp. 79-112]. Experimental results demonstrate that this new method yields a risk capital model for the reserve risk achieving the required confidence level in good approximation.
    Date: 2016–12
  13. By: Stanislaus Maier-Paape
    Abstract: In this paper the fractional trading ansatz of money management is reconsidered with special attention to chance and risk parts in the goal function of the related optimization problem. By changing the goal function with due regards to other risk measures like current drawdowns, the optimal fraction solutions reflect the needs of risk averse investors better than the original optimal f solution of Ralph Vince. Keywords: fractional trading, optimal f, current drawdown, terminal wealth relative, risk aversion
    Date: 2016–12
  14. By: Ho, Shuay-Tsyr; Ifft, Jennifer E.; Rickard, Bradley J.; Turvey, Calum G.
    Abstract: Fruit producers in the Eastern United States face a wide range of weather-related risks during the growing season, and many of these events have the capacity to largely impact yields and profitability. This research examines the economic implications associated with responding to these risks for sweet cherry production in three different systems: using high tunnels to protect the crop, purchasing revenue insurance products, and employing weather insurance schemes. The analysis considers a distribution of revenue flows and costs using detailed price, yield, and weather data between 1984 and 2013. Our results show that the high tunnel system generates the largest net return if significant price premiums exist for earlier and larger fruit. Under most conditions, the results also indicate that net returns for the system that uses revenue-based crop insurance exceed those for the system that uses weather insurance products.
    Keywords: Specialty crops, risk management, crop insurance, weather insurance, high tunnels, Crop Production/Industries, Farm Management, Risk and Uncertainty, J43, K37, Q13,
    Date: 2016–11

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