nep-rmg New Economics Papers
on Risk Management
Issue of 2017‒03‒05
fifteen papers chosen by

  1. Solvency II, or How to Swipe the Downside Risk Under the Carpet By Stefan Weber
  2. Did the Basel Process of Capital Regulation Enhance the Resiliency of European Banks? By Gehrig, Thomas Paul; Iannino, Maria Chiara
  3. Robust and Consistent Estimation of Generators in Credit Risk By Greig Smith; Goncalo dos Reis
  4. Reverse stress testing interbank networks By Daniel Grigat; Fabio Caccioli
  5. Asset Encumbrance, Bank Funding, and Financial Fragility By Ahnert, Toni; Anand, Kartik; Gai, Prasanna; Chapman, James
  6. Optimal Investment and Pricing in the Presence of Defaults By Tetsuya Ishikawa; Scott Robertson
  7. Are Trump and Bitcoin Good Partners? By Jamal Bouoiyour; Refk Selmi
  8. Tail co-movement in inflation expectations as an indicator of anchoring By Natoli, Filippo; Sigalotti, Laura
  9. A closed-form representation of mean-variance hedging for additive processes via Malliavin calculus By Takuji Arai; Yuto Imai
  10. On the bimodality of the distribution of the S&P 500's distortion: Empirical evidence and theoretical explanations By Schmitt, Noemi; Westerhoff, Frank
  11. A Unified Approach for Drawdown (Drawup) of Time-Homogeneous Markov Processes By David Landriault; Bin Li; Hongzhong Zhang
  12. Choosing two business degrees versus choosing one: What does it tell about mutual fund managers' investment behavior? By Andreu, Laura; Pütz, Alexander
  13. Are Basel's Capital Surcharges for Global Systemically Important Banks Too Small? By Wayne Passmore; Alexander H. von Hafften
  14. Natural disaster and bank stability: Evidence from the U.S. financial system By Noth, Felix; Schüwer, Ulrich
  15. Bubbles for Fama By Robin Greenwood; Andrei Shleifer; Yang You

  1. By: Stefan Weber
    Abstract: Under Solvency II the computation of capital requirements is based on value at risk (V@R). V@R is a quantile-based risk measure and neglects extreme risks in the tail. V@R belongs to the family of distortion risk measures. A serious deficiency of V@R is that firms can hide their total downside risk in corporate groups. They can largely reduce their total capital requirements via appropriate transfer agreements within a group structure consisting of sufficiently many entities and thereby circumvent capital regulation. We prove several versions of such a result for general distortion risk measures of V@R-type, explicitly construct suitable allocations of the group portfolio, and finally demonstrate how these findings can be extended beyond distortion risk measures.
    Date: 2017–02
  2. By: Gehrig, Thomas Paul; Iannino, Maria Chiara
    Abstract: This paper analyses the evolution of the resiliency of the European banking sector after the implementation of the Basel Capital Accord. In particular, by analysing SRISK and CoVaR we trace systemic risk and measures of systematic risk as the Basel process unfolds. We observe that, though systematic risk for European banks have been decreasing over the last three decades, systemic risk has heightened especially for the largest systemic banks. While the Basel process has succeeded in containing systemic risk of small banks, it has been less successful for the larger institutions. The latter ones opportunistically exploited the option of self-regulation by employing internal models and effectively increasing SRISK. Hence, the sub-prime crisis found the largest and more systemic banks ill-prepared and lacking resiliency. This condition was even aggravated during the European sovereign crisis.
    JEL: G21 G01 B26
    Date: 2016
  3. By: Greig Smith; Goncalo dos Reis
    Abstract: Bond rating Transition Probability Matrices (TPMs) are built over a one-year time-frame and for many practical purposes, like the assessment of risk in portfolios, one needs to compute the TPM for a smaller time interval. In the context of continuous time Markov chains (CTMC) several deterministic and statistical algorithms have been proposed to estimate the generator matrix. We focus on the Expectation-Maximization (EM) algorithm by \cite{BladtSorensen2005} for a CTMC with an absorbing state for such estimation. This work's contribution is fourfold. Firstly, we provide directly computable closed form expressions for quantities appearing in the EM algorithm. Previously, these quantities had to be estimated numerically and considerable computational speedups have been gained. Secondly, we prove convergence to a single set of parameters under reasonable conditions. Thirdly, we derive a closed-form expression for the error estimate in the EM algorithm allowing to approximate confidence intervals for the estimation. Finally, we provide a numerical benchmark of our results against other known algorithms, in particular, on several problems related to credit risk. The EM algorithm we propose, padded with the new formulas (and error criteria), is very competitive and outperforms other known algorithms in several metrics.
    Date: 2017–02
  4. By: Daniel Grigat; Fabio Caccioli
    Abstract: We reverse engineer dynamics of financial contagion to find the scenario of smallest exogenous shock that, should it occur, would lead to a given final systemic loss. This reverse stress test can be used to identify the potential triggers of systemic events, and it removes the arbitrariness in the selection of shock scenarios in stress testing. We consider in particular the case of distress propagation in an interbank market, and we study a network of 44 European banks, which we reconstruct using data collected from Bloomberg. By looking at the distribution across banks of the size of smallest exogenous shocks we rank banks in terms of their systemic importance, and we show the effectiveness of a policy with capital requirements based on this ranking. We also study the properties of smallest exogenous shocks as a function of the largest eigenvalue $\lambda_{\rm max}$ of the matrix of interbank leverages, which determines the endogenous amplification of shocks. We find that the size of smallest exogenous shocks reduces and that the distribution across banks becomes more localized as $\lambda_{\rm max}$ increases.
    Date: 2017–02
  5. By: Ahnert, Toni; Anand, Kartik; Gai, Prasanna; Chapman, James
    Abstract: How does asset encumbrance affect the fragility of intermediaries subject to rollover risk? We offer a model of covered bonds that features the bankruptcy remoteness and replenishment of the asset pool that backs secured funding. Encumbering assets allows a bank to raise cheap secured debt and expand profitable investment, but it also concentrates risk on unsecured debt and thus exacerbates fragility. Deposit insurance or guarantees induce excessive encumbrance, shifting risks to the deposit insurance fund or the guarantor. Prudential regulation to correct this negative externality are limits on encumbrance, capital requirements, and surcharges on deposit insurance premia.
    JEL: G01 G21 G28
    Date: 2016
  6. By: Tetsuya Ishikawa; Scott Robertson
    Abstract: We consider the optimal investment problem when the traded asset may default, causing a jump in its price. For an investor with constant absolute risk aversion, we compute indifference prices for defaultable bonds, as well as a price for dynamic protection against default. For the latter problem, our work complements Sircar & Zariphopoulou (2007), where it is implicitly assumed the investor is protected against default. We consider a factor model where the asset's instantaneous return, variance, correlation and default intensity are driven by a time-homogenous diffusion X taking values in an arbitrary region E. We identify the certainty equivalent with a semi-linear degenerate elliptic partial differential equation with quadratic growth in both function and gradient. Under a minimal integrability assumption on the market price of risk, we show the certainty equivalent is a classical solution. In particular, our results cover when X is a one-dimensional affine diffusion and when returns, variances and default intensities are also affine. Numerical examples highlight the relationship between the factor process and both the indifference price and default insurance. Lastly, we show the insurance protection price is not the default intensity under the dual optimal measure.
    Date: 2017–02
  7. By: Jamal Bouoiyour (CATT); Refk Selmi (CATT)
    Abstract: During times of extreme market turmoil, it is acknowledged that there is a tendency towards "flight to safety". A strong (weak) safe haven is defined as an asset that has a significant positive (negative) return in periods where another asset is in distress, while hedge has to be negatively correlated (uncorrelated) on average. The Bitcoin's surge alongside the aftermath of Trump's win in the 2016 U.S. presidential elections has strengthened its status as the modern safe haven. This paper uses a truly noise-assisted data analysis method, termed as Ensemble Empirical Mode Decomposition-based approach, to examine whether Bitcoin can act as a hedge and safe haven for U.S. stock price index. The results document that the Bitcoin's safe-haven property is time-varying and that it has primarily been a weak safe haven in the short term and the long-term. We also demonstrate that precious metals lost their safe haven properties over time as the correlation between gold/silver and U.S. stock price declines from short-to long-run horizons.
    Date: 2017–03
  8. By: Natoli, Filippo; Sigalotti, Laura
    Abstract: We analyze the degree of anchoring of inflation expectations in the euro area during the post-crisis period, with a focus on the time span from 2014 onwards when long-term beliefs have substantially drifted away from the policy target. Using a new estimation technique, we look at tail co-movements between short- and long-term distributions of inflation expectations, estimated from daily quotes of inflation derivatives. We find that, during 2014, average correlations between short- and long-term inflation expectations rose sharply; moreover, negative tail events impacting short-term beliefs have been increasingly channeled to long-term views, triggering both downward revisions in expectations and upward changes in uncertainty. Overall, our results signal a risk of downside de-anchoring of long-term inflation expectations. JEL Classification: C14, C58, E31, E44, G13
    Keywords: anchoring, inflation expectations, inflation swaps, inflations options, option-implied density, tail co-movement
    Date: 2017–01
  9. By: Takuji Arai; Yuto Imai
    Abstract: We derive an explicit closed-form representation of mean-variance hedging strategies for models whose asset price follows an exponential additive process. Our representation is given in terms of Malliavin calculus for L\'evy processes. In addition, we develop an approximation method to compute mean-variance hedging strategies for exponential L\'evy models, and illustrate numerical results.
    Date: 2017–02
  10. By: Schmitt, Noemi; Westerhoff, Frank
    Abstract: After showing that the distribution of the S&P 500's distortion, i.e. the log difference between its real stock market index and its real fundamental value, is bimodal, we demonstrate that agentbased financial market models may explain this puzzling observation. Within these models, speculators apply technical and fundamental analysis to predict asset prices. Since destabilizing technical trading dominates the market near the fundamental value, asset prices tend to be either overvalued or undervalued. Interestingly, the bimodality of the distribution of the S&P 500's distortion confirms an implicit prediction of a number of seminal agent-based financial market models.
    Keywords: stock market dynamics,bubbles and crashes,chartists and fundamentalists,nonlinear dynamics,bimodality tests,time series analysis
    JEL: G12 G14 G17
    Date: 2017
  11. By: David Landriault; Bin Li; Hongzhong Zhang
    Abstract: Drawdown (resp. drawup) of a stochastic process, also referred as the reflected process at its supremum (resp. infimum), has wide applications in many areas including financial risk management, actuarial mathematics and statistics. In this paper, for general time-homogeneous Markov processes, we study the joint law of the first passage time of the drawdown (resp. drawup) process, its overshoot, and the maximum of the underlying process at this first passage time. By using short-time pathwise analysis, under some mild regularity conditions, the joint law of the three drawdown quantities is shown to be the unique solution to an integral equation which is expressed in terms of fundamental two-sided exit quantities of the underlying process. Explicit forms for this joint law are found when the Markov process has only one-sided jumps or is a L\'{e}vy process (possibly with two-sided jumps). The proposed methodology provides a unified approach to study various drawdown quantities for the general class of time-homogeneous Markov processes.
    Date: 2017–02
  12. By: Andreu, Laura; Pütz, Alexander
    Abstract: We analyze what a second business degree reveals about the investment behavior of mutual fund managers. Specifically, we compare investment risk and style of managers with both a CFA designation and an MBA degree to managers with only one of these qualifications. We document that managers with both degrees take less risk, follow less extreme investment styles, and achieve less extreme performance outcomes. Our results are consistent with the explanation that managers with a certain personal attitude that makes them take less risk and invest more conventionally choose to gather both qualifications. We rule out several alternative explanations: our results are not driven by the respective contents of the MBA and the CFA program, by the manager's skill, or by the fund family's investment policy.
    Keywords: Mutual funds,Investment behavior,Manager education,MBA,CFA
    JEL: G23
    Date: 2016
  13. By: Wayne Passmore; Alexander H. von Hafften
    Abstract: The Basel Committee promulgates bank regulatory standards that many major economies enact to a significant extent. One element of the Basel III capital standards is a system of capital surcharges for global systemically important banks (G-SIBs). If the purpose of the surcharges is to ensure the survival of G-SIBs through serious crises (like the 2007-09 financial crisis) without extraordinary public assistance, our analysis suggests that current surcharges are too low because of three shortcomings: (1) the Basel system underestimates the probability that a G-SIB can fail, (2) the Basel system fails to account for short-term funding, and (3) the Basel system excludes too many banks from current surcharges. Our best estimate suggests that the current surcharges should be between 225 and 525 basis points higher for G-SIBs that are not reliant on short-term funding; G-SIBs that are reliant on short-term funding should have even higher surcharges. Furthermore, we find that, even with significant confidence in the effectiveness of other Basel III reforms, modest increases in surcharges appear needed.
    Keywords: Basel III ; G-SIBs ; G-SIFIs ; Bank capital ; Bank equity ; Bank regulation ; Banks
    JEL: G01 G18 G21
    Date: 2017–02–21
  14. By: Noth, Felix; Schüwer, Ulrich
    Abstract: We document that natural disasters significantly weaken the stability of banks with business activities in affected regions, as reflected in lower z-scores, higher probabilities of default, higher non-performing assets ratios, higher foreclosure ratios, lower returns on assets and lower bank equity ratios. The effects are economically relevant and suggest that insurance payments and public aid programs do not sufficiently protect bank borrowers against financial difficulties. We also find that the adverse effects on bank stability dissolve after some years if no further disasters occur in the meantime.
    Keywords: natural disasters,bank stability,non-performing assets,bank performance
    JEL: G21 Q54
    Date: 2017
  15. By: Robin Greenwood; Andrei Shleifer; Yang You
    Abstract: We evaluate Eugene Fama’s claim that stock prices do not exhibit price bubbles. Based on US industry returns 1926-2014 and international sector returns 1985-2014, we present four findings: (1) Fama is correct in that a sharp price increase of an industry portfolio does not, on average, predict unusually low returns going forward; (2) such sharp price increases predict a substantially heightened probability of a crash; (3) attributes of the price run-up, including volatility, turnover, issuance, and the price path of the run-up can all help forecast an eventual crash and future returns; and (4) some of these characteristics can help investors earn superior returns by timing the bubble. Results hold similarly in US and international samples.
    JEL: G02 G1 G12 G14
    Date: 2017–02

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