
on Risk Management 
Issue of 2017‒07‒09
seventeen papers chosen by 
By:  Tente, Natalia; von Westernhagen, Natalja; Slopek, Ulf 
Abstract:  MPRESSCreditRisk is a new topdown macro stress testing framework that can help supervisors gauge banks' capital adequacy related to credit risk. For the first time, it combines calibration of microprudential capital requirements and macroprudential buffers in a unified, coherent framework. Its core element is an advanced credit portfolio model  SystemicCreditRisk  built upon a rich, nonlinear dependence structure for interconnected bank portfolios. Incorporating numerous sector/countryspecific systematic factors, the model focuses on credit default concentration risk as a major source of large losses that may have systemic impact. A test run using a sample of 12 systemically important German banks provides measures for systemic credit risk and the banks' contributions to it in both baseline and stress scenarios. Capital requirements calibrated to the results combine elements of Pillar 1 and Pillar 2, whereas macroprudential buffers can internalize the system's tail risk. The maximum modelbased combined requirements range between 6.3% and 27.2% of credit RWA depending on the bank. A comparison with the reported capital figures suggests that there appears to be enough capital in the banking system, but its distribution might be suboptimal from a systemic point of view as the capital level of a number of banks might need improvement. 
Keywords:  Systemic Credit Risk,Tail Risk,Stress Testing,Microprudential Capital Requirements,Systemic Risk Buffer,OSII Buffer,Hierarchical Archimedean Copula 
JEL:  C15 C23 C63 G21 G28 
Date:  2017 
URL:  http://d.repec.org/n?u=RePEc:zbw:bubdps:152017&r=rmg 
By:  Yang, Bill Huajian 
Abstract:  Common ordinal models, including the ordered logit model and the continuation ratio model, are structured by a common score (i.e., a linear combination of a list of given explanatory variables) plus rank specific intercepts. Sensitivity with respect to the common score is generally not differentiated between rank outcomes. In this paper, we propose an ordinal model based on forward ordinal probabilities for rank outcomes. The forward ordinal probabilities are structured by, in addition to the common score and intercepts, the rank and rating (for a riskrated portfolio) specific sensitivity. This rank specific sensitivity allows a risk rating to respond to its migrations to default, downgrade, stay, and upgrade accordingly. An approach for parameter estimation is proposed based on maximum likelihood for observing rank outcome frequencies. Applications of the proposed model include modeling rating migration probability for pointintime probability of default term structure for IFRS9 expected credit loss estimation and CCAR stress testing. Unlike the rating transition model based on Merton model, which allows only one sensitivity parameter for all rank outcomes for a rating, and uses only systematic risk drivers, the proposed forward ordinal model allows sensitivity to be differentiated between outcomes and include entity specific risk drivers (e.g., downgrade history or credit quality changes for an entity in last two quarters can be included). No estimation of the asset correlation is required. As an example, the proposed model, benchmarked with the rating transition model based on Merton model, is used to estimate the rating migration probability and probability of default term structure for a commercial portfolio, where for each rating the sensitivity is differentiated between migrations to default, downgrade, stay, and upgrade. Results show that the proposed model is more robust. 
Keywords:  PD term structure, forward ordinal probability, common score, rank specific sensitivity, rating migration probability 
JEL:  C0 C01 C02 C13 C18 C4 C5 C51 C52 C53 C54 C58 C61 C63 E61 G3 G31 G32 G38 O3 
Date:  2017–09 
URL:  http://d.repec.org/n?u=RePEc:pra:mprapa:79934&r=rmg 
By:  Daniel Bartl; Samuel Drapeau; Ludovic Tangpi 
Abstract:  Accounting for model uncertainty in risk management leads to infinite dimensional optimization problems which are both analytically and numerically untractable. In this article we study when this fact can be overcome for the socalled optimized certainty equivalent risk measure (OCE)  including the average valueatrisk as a special case. First we focus on the case where the set of possible distributions of a financial loss is given by the neighborhood of a given baseline distribution in the Wasserstein distance, or more generally, an optimaltransport distance. Here it turns out that the computation of the robust OCE reduces to a finite dimensional problem, which in some cases can even be solved explicitly. Further, we derive convex dual representations of the robust OCE for measurable claims without any assumptions on the set of distributions and finally give conditions on the latter set under which the robust average valueatrisk is a tail risk measure. 
Date:  2017–06 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1706.10186&r=rmg 
By:  Bardoscia, Marco (Bank of England); Barucca, Paolo (University of Zurich, London Institute for Mathematical Science, IMT Lucca); Brinley Codd, Adam (Bank of England); Hill, John (Bank of England) 
Abstract:  We study solvency contagion risk in the UK banking system from 2008 to 2015. We develop a model that not only accounts for losses transmitted after banks default, but also for losses due to the fact that creditors revalue their exposures when probabilities of default of their counterparties change. We apply our model to a unique data set of real UK interbank exposures. We show that risks due to solvency contagion decrease markedly from the peak of the crisis to the present, to the point of becoming negligible. By decomposing the change in losses into two main contributions — the increase in banks’ capital and the decrease in interbank exposures — we are able to pinpoint the main driver in each year. In some cases we observe that an increase in aggregate capital is associated with a positive contribution to losses. This suggests that the distribution of capital among banks is also important. 
Keywords:  Financial networks; systemic risk; financial contagion; macroprudential policy; stress testing 
JEL:  D85 G01 G12 G21 G28 G33 G38 
Date:  2017–06–30 
URL:  http://d.repec.org/n?u=RePEc:boe:boeewp:0662&r=rmg 
By:  ; Georg Junge; Peter Kugler (University of Basel) 
Abstract:  This paper extends the analysis of Junge and Kugler (2013) on the effects of increased capital requirements on Swiss GDP and obtains the following main results: First the ModiglianiMiller effect is robust with respect to a substantial extension of the data base and yields an offset of capital cost of 46 percent. Second, the Translog production function estimate results in a timevarying elasticity of production with respect to the price of capital between 0.34 and 0.27, which is substantially lower than the value of 0.43 found in the earlier CES framework. Third the unweighted capital (leverage) ratio for Swiss GSIBs is approximately 6 percent for Basel III Tier1 and 4.3 percent for CET1. This corresponds to riskweighted capital ratios of 17 to 20 percent and 13 to 15 percent, respectively. The estimates show that the recently revised Swiss TooBigToFail capital ratios for GSIBs are about 30 percent smaller than the optimal levels. However, the oftdebated proposal to raise the equitytoasset ratio to 20 to 30 percent is not warranted by our analysis. 
Keywords:  Financial regulation, Bank equity capital requirements, Capital structure, Elasticity of substitution, Translog production function 
JEL:  G21 G28 E20 E22 
Date:  2017 
URL:  http://d.repec.org/n?u=RePEc:bsl:wpaper:2017/11&r=rmg 
By:  Vikram Nanda; Wei Wu; Xing Zhou 
Abstract:  Insurance companies often follow highly correlated investment strategies. As major investors in corporate bonds, their investment commonalities subject investors to firesale risk when regulatory restrictions prompt widespread divestment of a bond following a rating downgrade. Reflective of firesale risk, clustering of insurance companies in a bond has significant explanatory power for yield spreads, controlling for liquidity, credit risk and other factors. The effect of firesale risk on bond yield spreads is more evident for bonds held to a greater extent by capitalconstrained insurance companies, those with ratings closer to NAIC riskcategories with larger capital requirements, and during the financial crisis. 
Keywords:  Capital constraints ; Corporate bonds ; Credit rating ; Fire sales ; Insurance companies ; Regulation ; Yield spread 
JEL:  G11 G12 G18 G22 
Date:  2017–06–28 
URL:  http://d.repec.org/n?u=RePEc:fip:fedgfe:201769&r=rmg 
By:  Jinglun Yao; Maxime LevyChapira; Mamikon Margaryan 
Abstract:  The existence of asymmetric information has always been a major concern for financial institutions. Financial intermediaries such as commercial banks need to study the quality of potential borrowers in order to make their decision on corporate loans. Classical methods model the default probability by financial ratios using the logistic regression. As one of the major commercial banks in France, we have access to the the account activities of corporate clients. We show that this transactional data outperforms classical financial ratios in predicting the default event. As the new data reflects the real time status of cash flow, this result confirms our intuition that liquidity plays an important role in the phenomenon of default. Moreover, the two data sets are supplementary to each other to a certain extent: the merged data has a better prediction power than each individual data. We have adopted some advanced machine learning methods and analyzed their characteristics. The correct use of these methods helps us to acquire a deeper understanding of the role of central factors in the phenomenon of default, such as credit line violations and cash inflows. 
Date:  2017–07 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1707.00757&r=rmg 
By:  Arunangshu Biswas; Anindya Goswami 
Abstract:  In the classical model of stock prices which is assumed to be Geometric Brownian motion, the drift and the volatility of the prices are held constant. However, in reality, the volatility does vary. In quantitative finance, the Heston model has been successfully used where the volatility is expressed as a stochastic differential equation. In addition, we consider a regime switching model where the stock volatility dynamics depends on an underlying process which is possibly a nonMarkov pure jump process. Under this model assumption, we find the locally risk minimizing pricing of European type vanilla options. The price function is shown to satisfy a Heston type PDE. 
Date:  2017–07 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1707.01237&r=rmg 
By:  Dominique Guegan (CES  Centre d'économie de la Sorbonne  UP1  Université PanthéonSorbonne  CNRS  Centre National de la Recherche Scientifique, Labex ReFi  Université Paris1  PanthéonSorbonne); Bertrand Hassani (CES  Centre d'économie de la Sorbonne  UP1  Université PanthéonSorbonne  CNRS  Centre National de la Recherche Scientifique, Labex ReFi  Université Paris1  PanthéonSorbonne); Kehan Li (CES  Centre d'économie de la Sorbonne  UP1  Université PanthéonSorbonne  CNRS  Centre National de la Recherche Scientifique, Labex ReFi  Université Paris1  PanthéonSorbonne) 
Abstract:  The distortion operator proposed by Wang (2000) has been developed in the actuarial literature and that are now part of the risk measurement tools inventory available for practitioners in finance and insurance. In this article, we propose an alternative class of distortion operators with explicit analytical inverse mapping. The distortion operators are based on tangent function allowing to transform a symmetrical unimodal distribution to an asymmetrical multimodal distribution. 
Keywords:  Distortion operator,Multimodal distribution,Asymmetry,Invertibility 
Date:  2017–06 
URL:  http://d.repec.org/n?u=RePEc:hal:cesptp:halshs01543251&r=rmg 
By:  DeRamon, sebastian (Bank of England); Straughan, Michael (Bank of England) 
Abstract:  The Basel III/CRD IV reforms to the banking system following the financial crisis of 2008–09 required banks to raise significantly both the quality and quantity of capital on their balance sheets. This econometric study provides evidence of both the long and shortterm implications for ongoing activity in the UK economy of a change in the aggregate proportion of bank capital funding. We find that, in response to changes in their capital funding, banks change credit spreads applied to private nonfinancial corporate borrowers to a greater extent than for household borrowers in the short term, but equalise these changes in the longer term. The shortterm impact reflects banks’ desire to adjust their capital ratios through changes to the value of their riskweighted assets by restricting the flow of lending to higherrisk sectors to a greater extent than to lowerrisk sectors. We also find that after recent regulatory reforms banks may have modified their pricesetting behaviour somewhat. We develop a vector error correction model of these effects with an innovative nonstandard estimation of the shortterm coefficients. Using this approach, we are able to: (i) test hypotheses about the shortterm and longterm responses to changes in the aggregate mix of bank capital funding; (ii) test hypotheses about the responses of the nonfinancial corporate and household sectors; and (iii) enhance the accuracy of the shortterm dynamics and the accuracy of the macroeconomic simulations of the effect of increasing bank capital. 
Keywords:  Capital requirements; DSGE models; UK economy; bank competition 
JEL:  D22 D53 E27 G21 
Date:  2017–06–30 
URL:  http://d.repec.org/n?u=RePEc:boe:boeewp:0663&r=rmg 
By:  David Puelz; P. Richard Hahn; Carlos Carvalho 
Abstract:  This paper considers portfolio construction in a dynamic setting. We specify a loss function comprised of utility and complexity components with an unknown tradeoff parameter. We develop a novel regretbased criterion for selecting the tradeoff parameter to construct optimal sparse portfolios over time. 
Date:  2017–06 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1706.10180&r=rmg 
By:  Liu, Lily Y. (Federal Reserve Bank of Boston) 
Abstract:  This paper combines a term structure model of credit default swaps (CDS) with weakidentification robust methods to jointly estimate the probability of default and the loss given default of the underlying firm. The model is not globally identified because it forgoes parametric time series restrictions that have aided identification in previous studies, but that are also difficult to verify in the data. The empirical results show that informative (small) confidence sets for loss given default are estimated for half of the firmmonths in the sample, and most of these are much lower than and do not include the conventional value of 0.60. This also implies that riskneutral default probabilities, and hence risk premia on default probabilities, are underestimated when loss given default is exogenously fixed at the conventional value instead of estimated from the data. 
JEL:  C13 C14 C58 G12 G13 
Date:  2017–05–08 
URL:  http://d.repec.org/n?u=RePEc:fip:fedbqu:rpa171&r=rmg 
By:  Dan Pirjol; Lingjiong Zhu 
Abstract:  We consider the stochastic volatility model $dS_t = \sigma_t S_t dW_t,d\sigma_t = \omega \sigma_t dZ_t$, with $(W_t,Z_t)$ uncorrelated standard Brownian motions. This is a special case of the HullWhite and the $\beta=1$ (lognormal) SABR model, which are widely used in financial practice. We study the properties of this model, discretized in time under several applications of the EulerMaruyama scheme, and point out that the resulting model has certain properties which are different from those of the continuous time model. We study the asymptotics of the timediscretized model in the $n\to \infty$ limit of a very large number of time steps of size $\tau$, at fixed $\beta=\frac12\omega^2\tau n^2$ and $\rho=\sigma_0^2\tau$, and derive three results: i) almost sure limits, ii) fluctuation results, and iii) explicit expressions for growth rates (Lyapunov exponents) of the positive integer moments of $S_t$. Under the EulerMaruyama discretization for $(S_t,\log \sigma_t)$, the Lyapunov exponents have a phase transition, which appears in numerical simulations of the model as a numerical explosion of the asset price moments. We derive criteria for the appearance of these explosions. 
Date:  2017–07 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1707.00899&r=rmg 
By:  Adams, Zeno; Kartsakli, Maria 
Abstract:  The financialization of crude oil markets over the last decade has changed the behavior of oil prices in fundamental ways. In this paper, we uncover the gradual transformation of crude oil from a physical to a financial asset. Although economic demand and supply factors continue to play an important role, recent indicators associated with financialization have emerged since 2008. We show that financial variables have become the main driving factors explaining the variation in crude oil returns and volatility today. Our findings have important implications for portfolio analysis and for the effectiveness of hedging in crude oil markets. 
Keywords:  Crude Ois, Financialization, Rsquared Decomposition 
JEL:  Q40 Q41 G14 
Date:  2017–06 
URL:  http://d.repec.org/n?u=RePEc:usg:sfwpfi:2017:10&r=rmg 
By:  Eraslan, Sercan; Ali, Faek Menla 
Abstract:  This paper investigates the dynamic linkages in terms of the first and second moments between stock and bond returns, within a wide range of advanced economies, over the different phases of the recent financial crisis. The adopted empirical framework is a bivariate volatility model, where volatility spillovers of either positive or negative sign are allowed for. Our results lend support to the existence of a substantial timevariation in the dynamic linkages between these financial assets over the different stages of the recent crisis. In particular, our results of the return spillovers show that such spillovers mostly run from stocks to bonds and exhibit a timevarying pattern over all three stages of the crisis in most countries. Regarding the volatility spillovers, such spillovers from bond returns to those of stocks are stronger than the other way round and also exhibit a timevarying pattern in most countries. Furthermore, the portfolio performance comparison results show that by considering timevarying return and volatility spillovers when calculating the riskminimising portfolio weights of the selected assets, the portfolio volatility can be reduced despite limited diversification opportunities within national markets in times of financial crises. 
Keywords:  Bond prices,Financial crisis,Stock prices,Timevarying GARCH models,Volatility spillovers 
JEL:  C32 C58 G15 
Date:  2017 
URL:  http://d.repec.org/n?u=RePEc:zbw:bubdps:172017&r=rmg 
By:  Guglielmo D'Amico; Montserrat Guillen; Raimondo Manca; Filippo Petroni 
Abstract:  In this paper we propose a multistate model for the evaluation of the conversion option contract. The multistate model is based on ageindexed semiMarkov chains that are able to reproduce many important aspects that influence the valuation of the option such as the duration problem, the time nonhomogeneity and the ageing effect. The value of the conversion option is evaluated after the formal description of this contract. 
Date:  2017–07 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1707.01028&r=rmg 
By:  Larry G. Epstein (Boston University); Yoram Halevy (University of British Columbia) 
Abstract:  Many decisions are made in environments where outcomes are determined by the realization of multiple random events. A decision maker may be uncertain how these events are related. We identify and experimentally substantiate behavior that intuitively reflects a lack of confidence in their joint distribution. Our findings suggest a dimension of ambiguity which is different from that in the classical distinction between risk and "Knightian uncertainty." 
Date:  2017–02 
URL:  http://d.repec.org/n?u=RePEc:bos:wpaper:wp2017006&r=rmg 