nep-rmg New Economics Papers
on Risk Management
Issue of 2017‒09‒10
thirteen papers chosen by
Stan Miles
Thompson Rivers University

  1. Borderline: judging the adequacy of return distribution estimation techniques in initial margin models By Houllier, Melanie; Murphy, David
  2. Counterparty Credit Risk in OTC Derivatives under Basel III By Mabelle Sayah
  3. Risk-Minimizing Hedging of Counterparty Risk By Lijun Bo; Agostino Capponi; Claudia Ceci
  4. Backtesting Expected Shortfall: is it really that hard? By Felix Moldenhauer; Marcin Pitera
  5. Diversification benefits under multivariate second order regular variation By Bikramjit Das; Marie Kratz
  6. Volatility spillovers and heavy tails: a large t-Vector AutoRegressive approach By Luca Barbaglia; Christophe Croux; Ines Wilms
  7. Too complex to work: A critical assessment of the bail-in tool under the European bank recovery and resolution regime By Tröger, Tobias H.
  8. Capital Requirements and Bailouts By Perri, Fabrizio; Stefanidis, Georgios
  9. Market entry waves and volatility outbursts in stock markets By Blaurock, Ivonne; Schmitt, Noemi; Westerhoff, Frank
  10. Modeling Time-Varying Uncertainty of Multiple-Horizon Forecast Errors By Clark, Todd E.; McCracken, Michael W.; Mertens, Elmar
  11. How Have Banks Been Managing the Composition of High-Quality Liquid Assets? By Jane E. Ihrig; Edward Kim; Ashish Kumbhat; Cindy M. Vojtech; Gretchen C. Weinbach
  12. Econophysics of Business Cycles: Aggregate Economic Fluctuations, Mean Risks and Mean Square Risks By Victor Olkhov
  13. On the hedging of liabilities with an endogenous profit sharing mechanism By Frédéric Sart

  1. By: Houllier, Melanie (The London Institute for Banking and Finance); Murphy, David (Bank of England)
    Abstract: The advent of mandatory central clearing for certain types of over-the-counter derivatives and margin requirements for others means that margin is the most important mitigation mechanism for many counterparty credit risks. Initial margin requirements are typically calculated using risk-based margin models, and these models must be tested to ensure that they are prudent. However, two different margin models can calculate substantially different levels of margin yet both pass the usual tests. This paper presents a new approach to parameter selection based on the statistical properties of the worst loss over a margin period of risk estimated by the margin model under test. This measure is related to risk estimated at a fixed confidence interval yet leads to a more powerful test which is better able to justify the choice of parameters used in margin models. The test proposed is used on a variety of volatility estimation techniques applied to a long history of returns of the S&P 500 index. Well known techniques, including exponentially weighted moving average volatility estimation and generalised autoregressive conditional heteroskedasticity approaches are considered, and novel approaches derived from signal processing are also analysed. In each case a range of model parameters which give rise to acceptable risk estimates is identified.
    Keywords: Conditional volatility; filtered volatility; GARCH(1; 1); initial margin model; model backtesting; volatility estimation
    JEL: C12 C52 G13
    Date: 2017–09–01
  2. By: Mabelle Sayah (Université Claude Bernard Lyon 1, UCBL, Faculte des Sciences - Universite Saint Joseph - USJ - Université Saint-Joseph de Beyrouth)
    Abstract: Recent financial crises were the root of many changes in regulatory implementations in the banking sector. Basel previously covered the default capital charge for counterparty exposures however, the crisis showed that more than two third of the losses related to this risk emerged from the exposure to the movement of the counterparty's credit quality and not its actual default therefore, Basel III divided the required counterparty risk capital into two categories: The traditional default capital charge and an additional counter-party credit valuation adjustment (CVA) capital charge. In this article, we explain the new methodologies to compute these capital charges on the OTC market: The standardized approach for default capital charge (SA-CCR) and the basic approach for CVA (BA-CVA). Based on historical calibration and future estimations, we built internal models in order to compare them with the amended standardized approach. Up till June 2015, interest rate and FX derivatives constituted more than 90% of the traded total OTC notional amount; we constructed our application on such portfolios containing and computed their total counterparty capital charge. The analysis reflected different impacts of the netting and collateral agreements on the regulatory capital depending on the instruments' typologies. Moreover, results showed an important increase in the capital charge due to the CVA addition doubling it in some cases.
    Keywords: Basel III,Counterparty Credit Risk,SA-CCR,CVA,OTC Derivatives
    Date: 2016–12–30
  3. By: Lijun Bo; Agostino Capponi; Claudia Ceci
    Abstract: We study dynamic hedging of counterparty risk for a portfolio of credit derivatives. Our empirically driven credit model consists of interacting default intensities which ramp up and then decay after the occurrence of credit events. Using the Galtchouk-Kunita-Watanabe decomposition of the counterparty risk price payment stream, we recover a closed-form representation for the risk minimizing strategy in terms of classical solutions to nonlinear recursive systems of Cauchy problems. We discuss applications of our framework to the most prominent class of credit derivatives, including credit swap and risky bond portfolios, as well as first-to-default claims.
    Date: 2017–09
  4. By: Felix Moldenhauer; Marcin Pitera
    Abstract: In this short note we propose a new backtesting framework for Expected Shortfall that could be used by the regulator. Instead of looking at the estimated capital reserve and the realized cash-flow separately, one could bind them into the secured position, for which the risk measurement process is much easier. Using this simple concept combined with monotonicity of Expected Shortfall with respect to its target confidence level, one can provide an unconditional coverage backtesting framework for Expected Shortfall that is a natural extension of the current Value-at-Risk regulatory traffic-light approach.
    Date: 2017–09
  5. By: Bikramjit Das (Singapore University of Technology and Design - parent); Marie Kratz (ESSEC Business School - Essec Business School)
    Abstract: We analyze risk diversifi cation in a portfolio of heavy-tailed risk factors under the assumption of second order multivariate regular variation. Asymptotic limits for a measure of diversifi cation benefi t are obtained when considering, for instance, the value-at-risk . The asymptotic limits are computed in a few examples exhibiting a variety of different assumptions made on marginal or joint distributions. This study ties up existing related results available in the literature under a broader umbrella.
    Keywords: asymptotic theory,diversi cation bene t,heavy tail,risk concentration,second order regular variation,value-at-risk
    Date: 2017–04
  6. By: Luca Barbaglia; Christophe Croux; Ines Wilms
    Abstract: Volatility is a key measure of risk in financial analysis. The high volatility of one financial asset today could affect the volatility of another asset tomorrow. These lagged effects among volatilities - which we call volatility spillovers - are studied using the Vector AutoRegressive (VAR) model. We account for the possible fat-tailed distribution of the VAR model errors using a VAR model with errors following a multivariate Student t-distribution with unknown degrees of freedom. Moreover, we study volatility spillovers among a large number of assets. To this end, we use penalized estimation of the VAR model with t-distributed errors. We study volatility spillovers among energy, biofuel and agricultural commodities and reveal bidirectional volatility spillovers between energy and biofuel, and between energy and agricultural commodities.
    Keywords: Commodities, Forecasting, Multivariate t-distribution, Vector AutoRegressive model, Volatility spillover
    Date: 2017–08
  7. By: Tröger, Tobias H.
    Abstract: This paper analyses the bail-in tool under the BRRD and predicts that it will not reach its policy objective. To make this argument, this paper first describes the policy rationale that calls for mandatory private sector involvement (PSI). From this analysis the key features for an effective bail-in tool can be derived. These insights serve as the background to make the case that the European resolution framework is likely ineffective in establishing adequate market discipline through risk-reflecting prices for bank capital. The main reason for this lies in the avoidable embeddedness of the BRRD's bail-in tool in the much broader resolution process which entails ample discretion of the authorities also in forcing private sector involvement. Finally, this paper synthesized the prior analysis by putting forward an alternative regulatory approach that seeks to disentangle private sector involvement as a precondition for effective bank-resolution as much as possible from the resolution process as such.
    Keywords: bail-in,private sector involvement,precautionary recapitalization,cross-border insolvency,market discipline
    JEL: G01 G18 G21 G28 K22 K23
    Date: 2017
  8. By: Perri, Fabrizio (Federal Reserve Bank of Minneapolis); Stefanidis, Georgios (Federal Reserve Bank of Minneapolis)
    Abstract: We use balance sheet data and stock market data for the major U.S. banking institutions during and after the 2007-8 financial crisis to estimate the magnitude of the losses experienced by these institutions because of the crisis. We then use these estimates to assess the impact of the crisis under alternative, and higher, capital requirements. We find that substantially higher capital requirements (in the 20% to 30% range) would have substantially reduced the vulnerability of these financial institutions, and consequently they would have significantly reduced the need of a public bailout.
    Keywords: Financial crises; Too big to fail
    JEL: G01 G21
    Date: 2017–08–31
  9. By: Blaurock, Ivonne; Schmitt, Noemi; Westerhoff, Frank
    Abstract: We develop a simple agent-based financial market model in which speculators' market entry decisions are subject to herding behavior and market risk. Moreover, speculators' orders depend on price trends, market misalignments and fundamental news. Using a mix of analytical and numerical tools, we show that a herding-induced market entry wave may amplify excess demand, triggering lasting volatility outbursts. Eventually, however, higher stock market risk reduces stock market participation and volatility decreases again. Simulations furthermore reveal that our approach is also able to produce bubbles and crashes, excess volatility, fat-tailed return distributions and serially uncorrelated price changes.
    Keywords: stock markets,heterogeneous speculators,exponential replicator dynamics,herding behavior,stylized facts
    JEL: C63 D84 G15
    Date: 2017
  10. By: Clark, Todd E. (Federal Reserve Bank of Cleveland); McCracken, Michael W. (Federal Reserve Bank of St. Louis); Mertens, Elmar (Bank for International Settlements)
    Abstract: We develop uncertainty measures for point forecasts from surveys such as the Survey of Professional Forecasters, Blue Chip, or the Federal Open Market Committee's Summary of Economic Projections. At a given point of time, these surveys provide forecasts for macroeconomic variables at multiple horizons. To track time-varying uncertainty in the associated forecast errors, we derive a multiple-horizon specification of stochastic volatility. Compared to constant-variance approaches, our stochastic-volatility model improves the accuracy of uncertainty measures for survey forecasts.
    Keywords: Stochastic volatility; survey forecasts; prediction
    JEL: C32 C53 E47
    Date: 2017–08–28
  11. By: Jane E. Ihrig; Edward Kim; Ashish Kumbhat; Cindy M. Vojtech; Gretchen C. Weinbach
    Abstract: Leading up to 2014, banks generally increased their holdings of excess reserves as they moved to become compliant with the liquidity coverage ratio (LCR) requirement. However, once the LCR requirement was met, some banks shifted the compositions of their high-quality liquid assets (HQLA), reducing shares of reserves and increasing shares of Treasury securities and certain mortgage-backed securities (MBS). This raises the question: For a given stock of HQLA, what is its optimal composition? We use standard optimal portfolio theory to benchmark the ideal composition of a given stock of HQLA and find that a range of "optimal" HQLA portfolios is plausible depending on banks' tolerance for risk. A bank that is highly risk averse (inclined) prefers a relatively large share of reserves (MBS). Of course, the LCR is not the only constraint on banks' operations. We discuss how other factors interact with the LCR, and then examine the data for individual BHCs to show that they are currently employing a range of approaches to managing the compositions of their HQLA. In addition, we find that the pattern of dispersion in the daily variance of banks' HQLA shares supports the view that such factors are important drivers of banks' management of HQLA. Finally, we discuss possible policy implications of our results regarding the Federal Reserve's longer-run implementation of monetary policy.
    Keywords: CAPM ; HQLA ; LCR ; Bank balance sheets ; Liquid assets ; Liquidity management ; Reserve balances
    JEL: E51 E58 G21 G28
    Date: 2017–08–30
  12. By: Victor Olkhov
    Abstract: This paper presents hydrodynamic-like model of business cycles aggregate fluctuations of economic and financial variables. We model macroeconomics as ensemble of economic agents on economic space and agent's risk ratings play role of their coordinates. Sum of economic variables of agents with coordinate x define macroeconomic variables as functions of time and coordinates x. We describe evolution and interactions between macro variables on economic space by hydrodynamic-like equations. Integral of macro variables over economic space defines aggregate economic or financial variables as functions of time t only. Hydrodynamic-like equations define fluctuations of aggregate variables. Motion of agents from low risk to high risk area and back define the origin for repeated fluctuations of aggregate variables. Economic or financial variables on economic space may define statistical moments like mean risk, mean square risk and higher. Fluctuations of statistical moments describe phases of financial and economic cycles. As example we present a simple model relations between Assets and Revenue-on-Assets and derive hydrodynamic-like equations that describe evolution and interaction between these variables. Hydrodynamic-like equations permit derive systems of ordinary differential equations that describe fluctuations of aggregate Assets, Assets mean risks and Assets mean square risks. Our approach allows describe business cycle aggregate fluctuations induced by interactions between any number of economic or financial variables.
    Date: 2017–08
  13. By: Frédéric Sart (Risk Management - Delta Lloyd Life)
    Abstract: The fair replication method is a method designed to value liabilities with an endogenous profit sharing mechanism, i.e. based on the book yield of the backing assets. The basic idea is to construct a hypothetical portfolio, the fair replicating portfolio (FRP), whose cash flows are scenario-invariant. The method is a computationally efficient alternative to traditional stochastic modeling. It may be particularly useful in applications where extensive calculations of best estimate of liabilities are required.
    Keywords: Solvency II,Best estimate of liabilities,Life insurance,Profit sharing mechanism,Replicating portfolio
    Date: 2016

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