nep-rmg New Economics Papers
on Risk Management
Issue of 2017‒12‒03
23 papers chosen by
Stan Miles
Thompson Rivers University

  1. Risk Management and Regulation By Adrian, Tobias
  2. Optimizing S-shaped utility and implications for risk management By John Armstrong; Damiano Brigo
  3. Level and slope of volatility smiles in Long-Run Risk Models By Branger, Nicole; Rodrigues, Paulo; Schlag, Christian
  4. Network models of financial systemic risk: A review By Fabio Caccioli; Paolo Barucca; Teruyoshi Kobayashi
  5. Dynamics of islamic stock market returns and exchange rate movements in the ASEAN Countries in a regime-switching environment: Implications for the islamic investors and risk hedgers By Mustapha, Ishaq Muhammad; Masih, Mansur
  6. Model risk of risk models By Danielsson, Jon; James, Kevin R.; Valenzuela, Marcela; Zer, Ilknur
  7. Research on ruin probability of risk model based on AR(1) series By Wenhao Li; Bolong Wang; Tianxiang Shen; Ronghua Zhu; Dehui Wang
  8. On Fair Reinsurance Premiums; Capital Injections in a Perturbed Risk Model By Zied Ben Salah; Jos\'e Garrido
  9. A Bayesian methodology for systemic risk assessment in financial networks By Gandy, Axel; Veraart, Luitgard A. M.
  10. A continuous selection for optimal portfolios under convex risk measures does not always exist By Michel Baes; Cosimo Munari
  11. Cyber Risk, Market Failures, and Financial Stability By Emanuel Kopp; Lincoln Kaffenberger; Christopher Wilson
  12. On Game-Theoretic Risk Management (Part Three) - Modeling and Applications By Stefan Rass
  13. Empirical Investigation on Price Risk Hedging of Emerging Countries Airline Companies By Dzhamaev, Donat Sh.; Okulov, Vitaliy L.
  14. The Corporate Risk-Management Strategy on Emerging Markets: Diving Through the Crisis By Loukianova, Anna E.; Smirnova, Ekaterina
  15. Interconnectedness of Global Systemically-Important Banks and Insurers By Sheheryar Malik; TengTeng Xu
  16. Back to the Future: The Nature of Regulatory Capital Requirements By Ralph Chami; Thomas F. Cosimano; Emanuel Kopp; Celine Rochon
  17. SYSMO I: A Systemic Stress Model for the Colombian Financial System By Santiago Gamba; Oscar Jaulín; Angélica Lizarazo; Juan Carlos Mendoza; Paola Morales; Daniel Osorio; Eduardo Yanquen
  18. Quantum attacks on Bitcoin, and how to protect against them By Divesh Aggarwal; Gavin K. Brennen; Troy Lee; Miklos Santha; Marco Tomamichel
  19. Macroprudential Policies in Peru: The effects of Dynamic Provisioning and Conditional Reserve Requirements By Elias Minaya; Miguel Cabello
  20. Why are some banks recapitalized and others taken over? By Beccalli, Elena; Frantz, Pascal
  21. Comparison of Small Bank Failures and FDIC Losses in the 1986–92 and 2007–13 Banking Crises By Prescott, Edward Simpson; Balla, Eliana; Mazur, Laurel; Walter, John R.
  22. The implied volatility of Forward-Start options: ATM short-time level, skew and curvature By Elisa Alos; Antoine Jacquier; Jorge Leon
  23. Career Risk and Market Discipline in Asset Management By Andrew Ellul; Marco Pagano; Annalisa Scognamiglio

  1. By: Adrian, Tobias
    Abstract: The evolution of risk management has resulted from the interplay of financial crises, risk management practices, and regulatory actions. In the 1970s, research lay the intellectual foundations for the risk management practices that were systematically implemented in the 1980s as bond trading revolutionized Wall Street. Quants developed dynamic hedging, Value-at-Risk, and credit risk models based on the insights of financial economics. In parallel, the Basel I framework created a level playing field among banks across countries. Following the 1987 stock market crash, the near failure of Salomon Brothers, and the failure of Drexel Burnham Lambert, in 1996 the Basel Committee on Banking Supervision published the Market Risk Amendment to the Basel I Capital Accord; the amendment went into effect in 1998. It led to a migration of bank risk management practices toward market risk regulations. The framework was further developed in the Basel II Accord, which, however, from the very beginning, was labeled as being procyclical due to the reliance of capital requirements on contemporaneous volatility estimates. Indeed, the failure to measure and manage risk adequately can be viewed as a key contributor to the 2008 global financial crisis. Subsequent innovations in risk management practices have been dominated by regulatory innovations, including capital and liquidity stress testing, macroprudential surcharges, resolution regimes, and countercyclical capital requirements.
    Keywords: Banking; Financial crises; regulation; Risk management
    JEL: G00 G01 G21 G24 G28
    Date: 2017–11
  2. By: John Armstrong; Damiano Brigo
    Abstract: We consider market players with tail-risk-seeking behaviour as exemplified by the S-shaped utility introduced by Kahneman and Tversky. We argue that risk measures such as value at risk (VaR) and expected shortfall (ES) are ineffective in constraining such players. We show that, in many standard market models, product design aimed at utility maximization is not constrained at all by VaR or ES bounds: the maximized utility corresponding to the optimal payoff is the same with or without ES constraints. By contrast we show that, in reasonable markets, risk management constraints based on a second more conventional concave utility function can reduce the maximum S-shaped utility that can be achieved by the investor, even if the constraining utility function is only rather modestly concave. It follows that product designs leading to unbounded S-shaped utilities will lead to unbounded negative expected constraining utilities when measured with such conventional utility functions. To prove these latter results we solve a general problem of optimizing an investor expected utility under risk management constraints where both investor and risk manager have conventional concave utility functions, but the investor has limited liability. We illustrate our results throughout with the example of the Black--Scholes option market. These results are particularly important given the historical role of VaR and that ES was endorsed by the Basel committee in 2012--2013.
    Date: 2017–11
  3. By: Branger, Nicole; Rodrigues, Paulo; Schlag, Christian
    Abstract: We propose a long-run risk model with stochastic volatility, a time-varying mean reversion level of volatility, and jumps in the state variables. The special feature of our model is that the jump intensity is not affine in the conditional variance but driven by a separate process. We show that this separation of jump risk from volatility risk is needed to match the empirically weak link between the level and the slope of the implied volatility smile for S&P 500 options.
    Keywords: asset pricing,Epstein-Zin preferences,jump risk,stochastic volatility,level and slope of implied volatility smile
    JEL: G12
    Date: 2017
  4. By: Fabio Caccioli; Paolo Barucca; Teruyoshi Kobayashi
    Abstract: The global financial system can be represented as a large complex network in which banks, hedge funds and other financial institutions are interconnected to each other through visible and invisible financial linkages. Recently, a lot of attention has been paid to the understanding of the mechanisms that can lead to a breakdown of this network. This can happen when the existing financial links turn from being a means of risk diversification to channels for the propagation of risk across financial institutions. In this review article, we summarize recent developments in the modeling of financial systemic risk. We focus in particular on network approaches, such as models of default cascades due to bilateral exposures or to overlapping portfolios, and we also report on recent findings on the empirical structure of interbank networks. The current review provides a landscape of the newly arising interdisciplinary field lying at the intersection of several disciplines, such as network science, physics, engineering, economics, and ecology.
    Date: 2017–10
  5. By: Mustapha, Ishaq Muhammad; Masih, Mansur
    Abstract: This research is motivated by the increasing systemic relevance of Islamic finance and Islamic stock markets beyond the borders of Arabia and other Muslim majority territories. It makes the initial attempt to consider the degree to which the five Islamic stock markets in the original ASEAN-5 and their foreign exchange markets are correlated with a view to assessing the feasibility of policy initiatives to enhance ASEAN Islamic stock market integration and the implications for portfolio investors and risk hedgers. We applied a combination of Wavelet transformation model with appropriate regime-switching models to investigate the dynamic linkages between the foreign exchange and Islamic stock market returns for these ASEAN countries (Malaysia, Indonesia, Thailand, Philippines, Singapore). The analysis tends to indicate that stock returns of the ASEAN countries evolve according to two different regimes: a low volatility regime and a high volatility regime, which explains the bearish and bullish market periods. Furthermore, we investigated what evidence Markov switching analysis unfolds in regard to the dynamic linkage between the Islamic stock markets and exchange rate volatility of the ASEAN countries during both the calm and turbulent periods. This seeks to provide a valuable insight for the Islamic Investors, fund and portfolio managers, and policymakers whether to pay heed to these regime-specific dynamic interactions or not, particularly when they make capital budgeting decisions and implement regulation policies.
    Keywords: ASEAN, Exchange Rates, Islamic Stock Markets, Continuous Wavelet Transformation (CWT), Markov Switching
    JEL: C22 C58 G15
    Date: 2017–08–10
  6. By: Danielsson, Jon; James, Kevin R.; Valenzuela, Marcela; Zer, Ilknur
    Abstract: This paper evaluates the model risk of models used for forecasting systemic and market risk. Model risk, which is the potential for different models to provide inconsistent outcomes, is shown to be increasing with market uncertainty. During calm periods, the underlying risk forecast models produce similar risk readings; hence, model risk is typically negligible. However, the disagreement between the various candidate models increases significantly during market distress, further frustrating the reliability of risk readings. Finally, particular conclusions on the underlying reasons for the high model risk and the implications for practitioners and policy makers are discussed.
    Keywords: model risk; systemic risk; value-at-risk; expected shortfall; Basel III
    JEL: G10 G18 G20 G28 G38
    Date: 2016–02–23
  7. By: Wenhao Li; Bolong Wang; Tianxiang Shen; Ronghua Zhu; Dehui Wang
    Abstract: In this text, we establish the risk model based on AR(1) series and propose the basic model which has a dependent structure under intensity of claim number. Considering some properties of the risk model, we take advantage of newton iteration method to figure out the adjustment coefficient and estimate the exponential upper bound of ruin probability. This is significant to refine the research of ruin theory. As a result, our theory will help develop insurance industry stably.
    Date: 2017–10
  8. By: Zied Ben Salah; Jos\'e Garrido
    Abstract: We consider a risk model in which deficits after ruin are covered by a new type of reinsurance contract that provides capital injections which depend on a chosen level of retention. To allow the insurance company's survival after ruin, the reinsurer would have to inject capital. Assuming that these capital injections are not from the shareholders, but rather obtained through such new reinsurance agreements, the problem here is to determine adequate reinsurance premiums. It seems fair to base the net reinsurance premium on the discounted expected value of any future capital injections. Inspired by the results of Huzak et al. (2004) and Ben Salah (2014) on successive ruin events, we show that an explicit formula for this reinsurance premium exists in a setting where aggregate claims are modeled by a subordinator and a Brownian perturbation. This result is illustrated explicitly for two specific risk models and some numerical examples.
    Date: 2017–10
  9. By: Gandy, Axel; Veraart, Luitgard A. M.
    Abstract: We develop a Bayesian methodology for systemic risk assessment in financial networks such as the interbank market. Nodes represent participants in the network and weighted directed edges represent liabilities. Often, for every participant, only the total liabilities and total assets within this network are observable. However, systemic risk assessment needs the individual liabilities. We propose a model for the individual liabilities, which, following a Bayesian approach, we then condition on the observed total liabilities and assets and, potentially, on certain observed individual liabilities. We construct a Gibbs sampler to generate samples from this conditional distribution. These samples can be used in stress testing, giving probabilities for the outcomes of interest. As one application we derive default probabilities of individual banks and discuss their sensitivity with respect to prior information included to model the network. An R-package implementing the methodology is provided.
    Keywords: Financial network; unknown interbank liabilities; systemic risk; Bayes; MCMC; Gibbs sampler; power law
    JEL: F3 G3
    Date: 2016–10–06
  10. By: Michel Baes; Cosimo Munari
    Abstract: One of the crucial problems in mathematical finance is to mitigate the risk of a financial position by setting up hedging positions of eligible financial securities. This leads to focusing on set-valued maps associating to any financial position the set of those eligible payoffs that reduce the risk of the position to a target acceptable level at the lowest possible cost. Among other properties of such maps, the ability to ensure lower semicontinuity and continuous selections is key from an operational perspective. It is known that lower semicontinuity generally fails in an infinite-dimensional setting. In this note we show that neither lower semicontinuity nor, more surprisingly, the existence of continuous selections can be a priori guaranteed even in a finite-dimensional setting. In particular, this failure is possible under arbitrage-free markets and convex risk measures.
    Date: 2017–10
  11. By: Emanuel Kopp; Lincoln Kaffenberger; Christopher Wilson
    Abstract: Cyber-attacks on financial institutions and financial market infrastructures are becoming more common and more sophisticated. Risk awareness has been increasing, firms actively manage cyber risk and invest in cybersecurity, and to some extent transfer and pool their risks through cyber liability insurance policies. This paper considers the properties of cyber risk, discusses why the private market can fail to provide the socially optimal level of cybersecurity, and explore how systemic cyber risk interacts with other financial stability risks. Furthermore, this study examines the current regulatory frameworks and supervisory approaches, and identifies information asymmetries and other inefficiencies that hamper the detection and management of systemic cyber risk. The paper concludes discussing policy measures that can increase the resilience of the financial system to systemic cyber risk.
    Keywords: Systemic risk;Public goods;Cyber risk, cyber insurance, cyber regulation, risk management, information asymmetries, market failure, General, Externalities, Asymmetric and Private Information, General, General
    Date: 2017–08–07
  12. By: Stefan Rass
    Abstract: The game-theoretic risk management framework put forth in the precursor reports "Towards a Theory of Games with Payoffs that are Probability-Distributions" (arXiv:1506.07368 [q-fin.EC]) and "Algorithms to Compute Nash-Equilibria in Games with Distributions as Payoffs" (arXiv:1511.08591v1 [q-fin.EC]) is herein concluded by discussing how to integrate the previously developed theory into risk management processes. To this end, we discuss how loss models (primarily but not exclusively non-parametric) can be constructed from data. Furthermore, hints are given on how a meaningful game theoretic model can be set up, and how it can be used in various stages of the ISO 27000 risk management process. Examples related to advanced persistent threats and social engineering are given. We conclude by a discussion on the meaning and practical use of (mixed) Nash equilibria equilibria for risk management.
    Date: 2017–11
  13. By: Dzhamaev, Donat Sh.; Okulov, Vitaliy L.
    Abstract: The paper is an empirical investigation which goal is estimation of premiums to the market values of the companies that use price hedging instruments. The sample is comprised of the publicly traded airline companies of BRIC countries in 2000-2014. The results of the investigation suggest that the value premium for price risk hedging on the BRIC airlines market can be as large as 15%and the source of the premium can be attributed to the interaction of hedging with investment.
    Keywords: risk management, hedging, price risk, airline companies, BRIC,
    Date: 2016
  14. By: Loukianova, Anna E.; Smirnova, Ekaterina
    Abstract: The history of financial crises is considered and the attempt is made to analyse the parallels in emerging markets crises in the working paper. The historical conditions of crises on the markets are contemplated on the base of the literature review and the examples from the analysed markets are presented with the use of the network analysis. The conclusion made is that the financial contagion indicator can be used for the market risk assessment for practical and theoretical purposes. The corporate risk-management strategy building algorithm is proposed with the use of the financial contagion indicators and the market risk factors revealed.
    Keywords: emerging markets, financial contagion indicators, financial crises, market risk, assessment, risk-management, strategy, corporate finance, risk factors,
    Date: 2016
  15. By: Sheheryar Malik; TengTeng Xu
    Abstract: Interconnectedness among global systemically important banks (GSIBs) and global systemically important insurers (GSIIs) has important financial stability implications. This paper examines connectedness among United States, European and Asian GSIBs and GSIIs, using publicly-available daily equity returns and intra-day volatility data from October 2007 to August 2016. Results reveal strong regional clusters of return and volatility connectedness amongst GSIBs and GSIIs. Compared to Asia, selected GSIBs and GSIIs headquartered in the United States and Europe appear to be main sources of market-based connectedness. Total system connectedness—i.e., among all GSIBs and GSIIs—tends to rise during financial stress, which is corroborated by a balance sheet oriented systemic risk measure. Lastly, the paper demonstrates significant influence of economic policy uncertainty and U.S. long-term interest rates on total connectedness among systemically important institutions, and the important role of bank profitability and asset quality in driving bank-specific return connectedness.
    Keywords: Equity prices;JEL Classification Numbers: G21, G22 and C32 Keywords: Global systemically important banks and insurers, connectedness, volatility, vector autoregression, Global systemically important banks and insurers, Time-Series Models, JEL Classification Numbers: G21 G22 and C32, Keywords: Global systemically important banks and insurers
    Date: 2017–09–29
  16. By: Ralph Chami; Thomas F. Cosimano; Emanuel Kopp; Celine Rochon
    Abstract: This paper compares the current regulatory capital requirements under the Dodd-Frank Act (DFA) and the 10-percent leverage ratio, as proposed by the U.S. Treasury and the U.S. House of Representatives' Financial CHOICE Act (FCA). We find that the majority of U.S. banks would not qualify for an "off-ramp"option—where regulatory relief is offered to FCA qualifying banks (QBOs)—unless considerable amounts of capital are added, and that large banks are much closer to the proposed leverage threshold and, therefore, are more likely to stand to gain from regulatory relief. The paper identifies an important moral hazard problem that arises due to the QBO optionality, where banks are likely to increase the riskiness of their asset portfolio and qualify for the FCA “off-ramp” relief with unintended effects on financial stability.
    Date: 2017–08–04
  17. By: Santiago Gamba (Banco de la República de Colombia); Oscar Jaulín (Banco de la República de Colombia); Angélica Lizarazo (Banco de la República de Colombia); Juan Carlos Mendoza (Banco de la República de Colombia); Paola Morales (Banco de la República de Colombia); Daniel Osorio (Banco de la República de Colombia); Eduardo Yanquen (Banco de la República de Colombia)
    Abstract: This paper presents the first version of SYSMO, the analytical framework employed by the Financial Stability Department at the Banco de la República (the Central Bank of Colombia) to perform its biannual, top-down, stress testing exercise. The framework comprises: (i) a module to produce internally consistent macroeconomic scenarios; (ii) a set of satellite risk models that capture the materialization of credit and market risks in times of stress, and (iii) a bank model that simulates the endogenous response of banks to an adverse scenario. The framework also incorporates endogenous contagion and funding risks, key regulatory constraints (solvency and liquidity), and the feedback effects between the endogenous response of banks and the macroeconomic scenario. The use of SYSMO is illustrated with the example of the stress testing exercise published in the Banco de la República’s Financial Stability Report of the second semester of 2017. Classification JEL: E44, E58, G01, G17, G20.
    Keywords: Stress Testing, DSGE Models, VAR models, Credit Risk, Market Risk, Liquidity Risk, Funding Risk, Contagion Risk.
    Date: 2017–11
  18. By: Divesh Aggarwal; Gavin K. Brennen; Troy Lee; Miklos Santha; Marco Tomamichel
    Abstract: The key cryptographic protocols used to secure the internet and financial transactions of today are all susceptible to attack by the development of a sufficiently large quantum computer. One particular area at risk are cryptocurrencies, a market currently worth over 150 billion USD. We investigate the risk of Bitcoin, and other cryptocurrencies, to attacks by quantum computers. We find that the proof-of-work used by Bitcoin is relatively resistant to substantial speedup by quantum computers in the next 10 years, mainly because specialized ASIC miners are extremely fast compared to the estimated clock speed of near-term quantum computers. On the other hand, the elliptic curve signature scheme used by Bitcoin is much more at risk, and could be completely broken by a quantum computer as early as 2027, by the most optimistic estimates. We analyze an alternative proof-of-work called Momentum, based on finding collisions in a hash function, that is even more resistant to speedup by a quantum computer. We also review the available post-quantum signature schemes to see which one would best meet the security and efficiency requirements of blockchain applications.
    Date: 2017–10
  19. By: Elias Minaya; Miguel Cabello
    Abstract: Over the past decade, credit has grown significantly in Peru, a small and partially dollarised economy, and the mounting credit risk attached to foreign currency credit created severe challenges for financial regulators. This paper assesses the effectiveness of two macroprudential measures implemented by regulators: dynamic provisioning, to reduce the procyclicality of credit and conditional reserve requirements, to diminish the degree of dollarisation of the economy. Using credit register data that covers the period of 2004-2014, we find evidence that dynamic provisioning has decelerated the rapid growth of commercial bank lending. Moreover, mortgage dollarisation declined significantly after the implementation of the conditional reserve requirement scheme.
    Keywords: reserve requirement, dynamic provisioning, credit supply, macroprudential policy, dollarisation
    JEL: E51 E52 E58 G21 G28
    Date: 2017–11
  20. By: Beccalli, Elena; Frantz, Pascal
    Abstract: This study investigates the likelihood of takeovers or recapitalizations for EU listed banks before and during the financial, using both static and sequential multinomial logistic models. Takeovers and recapitalizations are potential alternatives used to shore up financial institutions. We find that takeovers occur when the bank has low net interest margins. Instead, private recapitalizations occur for banks with lower equity, higher net interest margins, and positive growth at the bank level. Public recapitalizations occur for larger, less liquid banks with positive prospects that operate in bigger banking systems. Both types of recapitalizations occur in countries with lower growth. The determinants for takeovers and recapitalization differ between the pre-crisis and crisis periods. Overall, a need for corporate control exists when traditional banking suffers lower performance, whereas the search for stability explains recapitalizations.
    Keywords: banking; recapitalizations; takeovers; EU
    JEL: G21 G34
    Date: 2016–11–01
  21. By: Prescott, Edward Simpson (Federal Reserve Bank of Cleveland); Balla, Eliana (Federal Reserve Bank of Richmond); Mazur, Laurel (University of Maryland); Walter, John R. (Federal Reserve Bank of Richmond)
    Abstract: Failure rates of small commercial banks during the banking crisis of the late 1980s were about 7.6%, which is significantly higher than the 5.7% failure rate during the recent crisis. The higher rate is surprising because small banks had significantly increased their commercial real estate (CRE) lending by the second crisis, which is riskier than other types of lending, and economic shocks were more severe in the recent crisis. We compare failure rates in the two periods using a statistical model that allows us to decompose the effect of changes in bank characteristics and economic shocks on failure rates. We find that the severe economic shocks of the recent crisis had a larger impact on high bank failure rates than bank characteristics. Increases in risk from CRE lending were offset by higher capital levels and other changes in bank characteristics. The failure rate would have been much lower in the later crisis if banks were subject to the less severe economic shocks of the earlier crisis. To the extent that higher capital levels were due to Basel I and the prompt corrective action (PCA) provisions of the Federal Deposit Insurance Corporation Improvement Act of 1991, we find that these reforms were beneficial. We also compare Federal Deposit Insurance Corporation (FDIC) losses on failed banks between the two periods. Here, despite the PCA reforms, losses on failed banks were higher in the recent crisis than in the earlier one. These differences are not accounted for by changes in CRE concentrations or the relative size of economic shocks. On this dimension, the reforms of the early 1990s did not seem to help. Finally, we find that a discretionary accounting variable, interest accrued but not yet received, is predictive of both failure and higher FDIC losses in both crises.
    Keywords: Bank failures; Regulations;
    JEL: G21 G28
    Date: 2017–11–13
  22. By: Elisa Alos; Antoine Jacquier; Jorge Leon
    Abstract: Using Malliavin Calculus techniques, we derive closed-form expressions for the at-the-money behaviour of the forward implied volatility, its skew and its curvature, in general Markovian stochastic volatility models with continuous paths.
    Date: 2017–10
  23. By: Andrew Ellul (Indiana University and CSEF); Marco Pagano (Università di Napoli Federico II, CSEF, EEIF, CEPR and ECGI); Annalisa Scognamiglio (Università di Napoli Federico II and CSEF)
    Abstract: Using hand-collected data on 1,627 hedge fund employees, we investigate the role of talent and luck in their careers. Upon entry in the hedge fund industry, careers accelerate, especially for employees with high-quality education and asset management experience. However, those who achieve high-ranking positions tend to face significant and permanent career setbacks if their fund is liquidated after persistently under-performing its benchmark. Hence, the “scarring effects” of fund liquidation appear to reflect a loss of reputation rather than the materialization of career risk. Our results reveal a new facet of market discipline in asset management, operating via the labor market.
    Keywords: careers, hedge funds, asset managers, market discipline, scarring effects.
    JEL: G20 G23 J24 J62 J63
    Date: 2017–11–21

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