nep-rmg New Economics Papers
on Risk Management
Issue of 2017‒12‒11
24 papers chosen by
Stan Miles
Thompson Rivers University

  1. Model Risk of Expected Shortfall By Emese Lazar; Ning Zhang;
  2. Bank Failures, Capital Buffers, and Exposure to the Housing Market Bubble By Gazi Kara; Cindy M. Vojtech
  3. Systemic risk in insurance: Towards a new approach By Berdin, Elia; Sottocornola, Matteo
  4. Likelihood-based Risk Estimation for Variance-Gamma Models By Marco Bee; Maria Michela Dickson; Flavio Santi
  5. On the Tail Risk Premium in the Oil Market By Reinhard Ellwanger
  6. Banks' Capital Surplus and the Impact of Additional Capital Requirements By Simona Malovana
  7. Japan; Financial Sector Assessment Program-Detailed Assessment of Observance on Basel Core Principles for Effective Banking Supervision By International Monetary Fund
  8. Portfolio Homogenization and Systemic Risk of Financial Network By Huang, Yajing; Liu, Taoxiong; Lien, Donald
  9. Japan; Financial Sector Assessment Program-Technical Note-Systemic Risk Analysis and Stress Testing the Financial Sector By International Monetary Fund
  10. Get the Balance Right: A Simultaneous Equation Model to Analyze Growth, Profitability, and Safety By Eling, Martin; Jia, Ruo; Schaper, Philipp
  11. Geometrically stopped Markovian random growth processes and Pareto tails By Brendan K. Beare; Alexis Akira Toda
  12. Luxembourg: Financial Sector Assessment Program; Technical Note-Fund Management: Regulation, Supervision, and Systemic Risk Monitoring By International Monetary Fund
  13. Multi-currency reserving for coherent risk measures By Saul Jacka; Seb Armstrong; Abdel Berkaoui
  14. Non-bank Financial Institutions at the Ground Zero of Next Crisis By Xing, Victor
  15. Capital requirements for government bonds: Implications for bank behaviour and financial stability By Neyer, Ulrike; Sterzel, André
  16. Should Portfolio Model Inputs Be Estimated Using One or Two Economic Regimes? By Emmanouil Platanakis; Athanasios Sakkas; Charles Sutcliffe
  17. Contagion in Derivatives Markets By H Peyton Young; Mark Paddrik; Sriram Rajan
  18. Variance Risk Premia on Stocks and Bonds By Petar Sabtchevsky; Paul Whelan; Andrea Vedolin; Philippe Mueller
  19. Household Credit, Global Financial Cycle, and Macroprudential Policies: Credit Register Evidence from an Emerging Country By Mircea Epure; Irina Mihai; Camelia Minoiu; José-Luis Peydró
  20. Individual and group preferences over risk: Does group size matter? By Andrea Morone; Francesco Nemore; Tiziana Temerario
  21. Does corporate control matter to financial volatility? By Laura Gianfagna; Armando Rungi
  22. A Neural Stochastic Volatility Model By Rui Luo; Weinan Zhang; Xiaojun Xu; Jun Wang
  23. Quantum Bounds for Option Prices By Paul McCloud
  24. US stocks in the presence of oil price risk: Large cap vs. Small cap By Afees A. Salisu; Raymond Swaray; Tirimisyu F. Oloko

  1. By: Emese Lazar (ICMA Centre, Henley Business School, University of Reading); Ning Zhang (ICMA Centre, Henley Business School, University of Reading);
    Abstract: In this paper we study the model risk of Expected Shortfall (ES), extending the results of Boucher et al. (2014) on model risk of Value-at-Risk (VaR). We propose a correction formula for ES based on passing three backtests. Our results show that for the DJIA index, the smallest corrections are required for the ES estimates built using GARCH models. Furthermore, the 2.5% ES requires smaller corrections for model risk than the 1% VaR, which advocates the replacement of VaR with ES as recommended by the Basel Committee. Also, if the model risk of VaR is taken into account, then the correction made to ES estimates reduces by 50% on average.
    Keywords: model risk, Expected Shortfall, backtesting
    Date: 2017–11
  2. By: Gazi Kara; Cindy M. Vojtech
    Abstract: We empirically document that banks with greater exposure to high home price-to-income ratio regions in 2005 and 2006 have higher mortgage delinquency and charge-off rates and significantly higher probabilities of failure during the last financial crisis even after controlling for capital, liquidity, and other standard bank performance measures. While high price-to-income ratios present a greater likelihood of house price correction, we find no evidence that banks managed this risk by building stronger capital buffers. Our results suggest that there is scope for improved measures of mortgage loan risk that could be considered for regulatory and risk management applications.
    Keywords: Bank failure ; Credit risk ; Mortgage risk ; Residential real estate
    JEL: G01 G21 G28 R31
    Date: 2017–11–29
  3. By: Berdin, Elia; Sottocornola, Matteo
    Abstract: Financial stability can be intended as the state whereby the build-up of systemic risk is prevented along with consequent major disruptions in financial markets that could have potential negative effects on the real economy. It follows that financial stability is considered a prerequisite for a sustainable economic growth (Dudley, 2011) and the empirical evidence suggests that an instable financial system can have indeed a negative impact on economic growth (Creel et al., 2015). A growing body of literature provides evidence that among financial institutions, insurers do pose systemic risk although less than banks. Thus, it follows that insurers can also be a source of financial instability that in turn can create significant dislocation on the economic activity. Against this background, it is important to have in place a set of regulatory and supervisory tools that aim to enhance and preserve financial stability across the entire financial system. Such regulatory and supervisory tools might be adopted following a twofold approach: on the one hand, the completion of existing microprudential frameworks with tools that embed macroprudential features, i.e. the current Solvency II regime as an example (Christophersen and Zschiesche, 2015); on the other hand, the adoption of a macroprudential framework designed to take into account the characteristics of the insurance business, complemented by a set of additional measures designed to take into account the specific characteristics of other financial institutions, primarily banks. In this short letter, we mainly focus on the latter aspect, although the design of a macroprudential framework inevitably foresees macroprudential features into microprudential frameworks, thereby blurring the separating line between the two approaches.
    Keywords: systemic risk,macroprudential franework,insurance,financial stability
    Date: 2017
  4. By: Marco Bee; Maria Michela Dickson; Flavio Santi
    Abstract: Although the variance-gamma distribution is a flexible model for log-returns of financial assets, so far it has found rather limited applications in finance and risk management. One of the reasons is that maximum likelihood estimation of its parameters is not straightforward. We develop an EM-type algorithm that bypasses the evaluation of the full likelihood, which may be dicult because the density is not in closed form and is unbounded for small values of the shape parameter. Moreover, we study the relative eciency of our approach with respect to the maximum likelihood estimation procedures implemented in the VarianceGamma and ghyp R packages. Extensive simulation experiments and real-data analyses suggest that the multicycle ECM algorithm and the routines in the ghyp R package give the best results in terms of root-mean-squared-error, for both parameter and Value-at-Risk estimation
    Keywords: Multicycle EM algorithm, maximum likelihood, numerical optimization, risk estimation
    Date: 2017
  5. By: Reinhard Ellwanger
    Abstract: This paper shows that changes in market participants’ fear of rare events implied by crude oil options contribute to oil price volatility and oil return predictability. Using 25 years of historical data, we document economically large tail risk premia that vary substantially over time and significantly forecast crude oil futures and spot returns. Oil futures prices increase (decrease) in the presence of upside (downside) fears in order to allow for smaller (larger) returns thereafter. This increase (decrease) is amplified for the spot price because of time varying-benefits from holding physical oil inventories that work in the same direction. We also provide support for view that that time variation in the relative importance of oil demand and supply shocks is an important determinant of oil price fluctuations and their interaction with aggregate outcomes. However, the option-implied tail risk premia are not spanned by traditional macroeconomic and oil market uncertainty measures, suggesting that time-varying oil price fears are an additional source of oil price volatility and predictability.
    Keywords: Asset Pricing, Econometric and statistical methods, Financial markets
    JEL: C53 C58 D84 E44 G12 G13 Q43
    Date: 2017
  6. By: Simona Malovana
    Abstract: Banks in the Czech Republic maintain their regulatory capital ratios well above the level required by their regulator. This paper discusses the main reasons for this capital surplus and analyses the impact of additional capital requirements stemming from capital buffers and Pillar 2 add-ons on the capital ratios of banks holding such extra capital. The results provide evidence that banks shrink their capital surplus in response to higher capital requirements. A substantial portion of this adjustment seems to be delivered through changes in average risk weights. For this and other reasons, it is desirable to regularly assess whether the evolution and current level of risk weights give rise to any risk of underestimating the necessary level of capital.
    Keywords: Banks, capital requirements, capital surplus, panel data, partial adjustment model
    JEL: G21 G28 G32
    Date: 2017–11
  7. By: International Monetary Fund
    Abstract: Banking regulations and supervisory processes have undergone significant improvements since the last Financial Sector Assessment Program (FSAP). The Japan Financial Services Agency (JFSA) is in the process of reforming its supervisory practices and has been shifting its focus from assessing compliance with prudential requirements to a more sophisticated and forward-looking risk-based approach to supervising banks and bank holding companies. Its prudential requirements have also continued to evolve in line with international trends. Capital, liquidity and disclosure requirements have been updated to incorporate the Basel III reforms agreed by the Basel Committee in accordance with the internationally agreed timelines. Corporate governance expectations have also been strengthened with the implementation of Japan’s Stewardship Code and Corporate Governance Code designed to strengthen corporate governance in the corporate and financial sectors. Japanese agencies have also deepened their working relationships among themselves and with their foreign counterparts.
    Keywords: Japan;Asia and Pacific;
    Date: 2017–09–18
  8. By: Huang, Yajing; Liu, Taoxiong; Lien, Donald
    Abstract: In this paper, we argue that systemic risk should be understood from two different perspectives, the homogeneity of portfolios (or called asset homogeneity) and the contagion mechanism. The homogenization of portfolios held by different financial institutions increases the positive correlations among them and therefore the probability of simultaneous collapses of a considerable part of the network, which are prerequisites and amplifiers of contagion. We first theoretically analyze the influence of asset homogeneity on the initial risk, fragility and systemic risk of the network. Based on the theoretical predictions, we perform simulations on regular networks and Poisson random networks to illustrate the effects of portfolio homogeneity on systemic risk. It is shown that the relationship between asset homogeneity and systemic risk is not always positively related. When the network contagion is weak, then a high asset homogeneity will lead to a high systemic risk. However, if the network contagion is considerably strong, the systemic risk is quite likely to be negative related to the asset homogeneity, so that a high homogeneity will produce a low systemic risk. Moreover, networks with strong contagion and low asset homogeneity tend to have the greatest systemic risk. Results from logistic regression analysis further clarify the relationships between systemic risk and asset homogeneity.
    Keywords: Financial network; Portfolio homogenization; Contagion; Systemic risk
    JEL: D85 G01 G15 G32 G33
    Date: 2017–10–13
  9. By: International Monetary Fund
    Abstract: A comprehensive set of stress tests and interconnectedness were conducted to assess the resilience of Japan’s financial system and shed light on linkages and potential vulnerabilities. Japan has one of the largest and most sophisticated financial systems in the world. Financial conglomerates have a significant presence in the financial system. Banks play a major role in financial intermediation, but Japan’s highly concentrated insurance sector is also very sizeable. Similarly, Japanese securities markets rank among the largest in the world, and the system includes a heterogeneous set of securities firms. Various quantitative tools and models were used to examine the impact of short- and medium-term macrofinancial shocks on banks and insurers, and assess connectedness risks within and outside of the financial sector.
    Keywords: Asia and Pacific;Japan;
    Date: 2017–09–18
  10. By: Eling, Martin; Jia, Ruo; Schaper, Philipp
    Abstract: Extant literature suggests that the relationships among growth, profitability, and safety are reciprocal. Consequently, we develop a simultaneous equation model to test the three relationship pairs. Analyzing eleven years of data for 1,988 European insurance companies, we find that moderate firm growth has a positive impact on profitability; however, extremely high growth reduces profitability. Moderate firm growth also reduces firm risk. In addition, we document that less profitable companies are risk-seeking, a result in line with prospect theory. The longitudinal analysis illustrates that firms initially prioritizing profitability over growth are more likely to reach the ideal state of “profitable growth”.
    Keywords: firm performance, simultaneous equation model, goal conflicts, financial services, insurance
    Date: 2017–10
  11. By: Brendan K. Beare; Alexis Akira Toda
    Abstract: Many empirical studies document power law behavior in size distributions of economic interest such as cities, firms, income, and wealth. One mechanism for generating such behavior combines independent and identically distributed Gaussian additive shocks to log-size with a geometric age distribution. We generalize this mechanism by allowing the shocks to be non-Gaussian (but light-tailed) and dependent upon a Markov state variable. Our main results provide sharp bounds on tail probabilities and simple formulas for Pareto exponents. We present two applications: (i) we show that the tails of the wealth distribution in a heterogeneous-agent dynamic general equilibrium model with idiosyncratic endowment risk decay exponentially, unlike models with investment risk where the tails may be Paretian, and (ii) we show that a random growth model for the population dynamics of Japanese prefectures is consistent with the observed Pareto exponent but only after allowing for Markovian dynamics.
    Date: 2017–12
  12. By: International Monetary Fund
    Abstract: Luxembourg has an internationally significant fund management sector, to which it applies a strong and comprehensive regulatory framework. The industry is the largest in Europe by domiciled assets, and the second largest in the world, with funds that take the form of Undertakings for Collective Investment in Transferable Securities (UCITS) dominant.
    Keywords: Europe;Luxembourg;
    Date: 2017–08–28
  13. By: Saul Jacka; Seb Armstrong; Abdel Berkaoui
    Abstract: We examine the problem of dynamic reserving for risk in multiple currencies under a general coherent risk measure. The reserver requires to hedge risk in a time-consistent manner by trading in baskets of currencies. We show that reserving portfolios in multiple currencies $\V$ are time-consistent when (and only when) a generalisation of Delbaen's m-stability condition \cite{D06}, termed optional $\V$-m-stability, holds. We prove a version of the Fundamental Theorem of Asset Pricing in this context. We show that this problem is equivalent to dynamic trading across baskets of currencies (rather than just pairwise trades) in a market with proportional transaction costs and with a frictionless final period.
    Date: 2017–12
  14. By: Xing, Victor
    Abstract: • Non-bank financial institutions (“shadow banks”) filled the funding gap following banks’ retreat in the wake of the post-crisis regulatory tightening and amid pressure to bolster returns in response to central banks’ low rates policy • “Shadow banks” such as investment managers, insurance companies and pension funds reacted to policy-induced volatility suppression by moving up the risk ladder: longer term bonds, high yield debt, equities, and direct lending • Prolonged volatility dampening induced investors to forgo volatility hedging and fueled the growth of passive funds, and rising concentration of “flighty asset” in passive funds increased probability for a “shadow bank run” • Non-banks are becoming increasingly reliant on monetary authorities to continue volatility suppression, and many “reach for yield” and risk-parity strategies hinge on prolonged policy accommodation to ward against redemption • Looming increase in Fed balance sheet reinvestment cap and ECB QE taper will threaten years of non-bank risk accumulation made viable by low volatility, and a decline in asset prices will likely trigger a systemic VaR shock
    Keywords: Shadow banks, systemic risk, financial risk contagion, volatility, non-bank financial institutions
    JEL: E52 G12 G22 G23
    Date: 2017–11–26
  15. By: Neyer, Ulrike; Sterzel, André
    Abstract: This paper analyses whether the introduction of capital requirements for bank government bond holdings increases financial stability by making the banking sector more resilient to sovereign debt crises. Using a theoretical model, we show that a sudden increase in sovereign default risk may lead to liquidity issues in the banking sector. Our model reveals that in combination with a central bank acting as a lender of last resort, capital requirements for government bonds increase the shock-absorbing capacity of the banking sector and thus the financial stability. The driving force is a regulation-induced change in bank investment behaviour.
    Keywords: bank capital regulation,government bonds,sovereign risk,financial contagion,lender of last resort.
    JEL: G28 G21 G01
    Date: 2017
  16. By: Emmanouil Platanakis (School of Management, University of Bath); Athanasios Sakkas (Southampton Business School, University of Southampton); Charles Sutcliffe (ICMA Centre, Henley Business School, University of Reading)
    Abstract: Estimation errors in the inputs are the main problem when applying portfolio analysis. Markov regime switching models are used to reduce these errors, but they do not always improve out-of-sample portfolio performance. We investigate the levels of transaction costs and risk aversion below which the use of two regimes is superior to one regime for an investor with a CRRA utility function, allowing for skewed and kurtic returns. Our results suggest that, due to differences in risk and transactions costs, most retail investors should use one regime models, while investment banks should use two regime models.
    Keywords: finance, portfolio theory, regime shifting, transaction costs, risk aversion, constant relative risk aversion
    JEL: G11
    Date: 2017–09
  17. By: H Peyton Young; Mark Paddrik; Sriram Rajan
    Abstract: Abstract A major credit shock can induce large intra-day variation margin payments between counterparties in derivatives markets, which may force some participants to default on their payments. These payment shortfalls become amplified as they cascade through the network of exposures. Using detailed DTCC data we model the full network of exposures, the shock-induced payments, the initial margin collected, and liquidity buffers for about 900 firms operating in the U.S. credit default swaps market. We estimate the total amount of contagion, the marginal contribution of each firm to contagion, and the number of defaulting firms for credit shocks of different magnitudes. A novel feature of the model is that it allows for a range of possible responses to balance sheet stress, including delayed or partial payments. These `soft default' options distinguish our approach from conventional network models, which typically assume that full default is triggered whenever the default boundary is breached.
    Keywords: Financial networks, contagion, stress testing, credit default swaps
    JEL: D85 G23 L1
    Date: 2017–11–21
  18. By: Petar Sabtchevsky (London School of Economics); Paul Whelan (Copenhagen Business School); Andrea Vedolin (London School of Economics); Philippe Mueller (London School of Economics)
    Abstract: We study equity (EVRP) and Treasury variance risk premia (TVRP) jointly and document a number of findings: First, relative to their volatility, TVRP are comparable in magnitude to EVRP. Second, while there is mild positive co-movement between EVRP and TVRP unconditionally, time series estimates of correlation display distinct spikes in both directions and have been notably volatile since the financial crisis. Third $(i)$ short maturity TVRP predict excess returns on short maturity bonds; $(ii)$ long maturity TVRP and EVRP predict excess returns on long maturity bonds; and $(iii)$ while EVRP predict equity returns for horizons up to 6-months, long maturity TVRP contain robust information for long run equity returns. Finally, exploiting the dynamics of real and nominal Treasuries we document that short maturity break-even rates are a power determinant of the joint dynamics of EVRP, TVRP and their co-movement. We argue this result is consistent with an economy in which derivative markets embed fears about deflation.
    Date: 2017
  19. By: Mircea Epure; Irina Mihai; Camelia Minoiu; José-Luis Peydró
    Abstract: We analyze the effects of macroprudential policies on local bank credit cycles and interactions with international financial conditions. For identification, we exploit the comprehensive credit register containing all bank loans to individuals in Romania, a small open economy subject to external shocks, and the period 2004-2012, which covers a full boom-bust credit cycle when a wide range of macroprudential measures were deployed. Although household leverage is known to be a key driver of financial crises, to our knowledge this is the first paper that employs a household credit register to study leverage and macroprudential policies over a full economic cycle. Our results show that tighter macroprudential conditions are associated with a significant decline in household credit, with substantially stronger effects for FX loans than for local currency loans. The effects on FX loans are higher for: (i) ex-ante riskier borrowers proxied by higher debt-service-to-income ratios and (ii) banks with greater exposure to foreign funding. Moreover, tighter macroprudential policy has stronger dampening effects on FX lending when global risk appetite is high and foreign monetary policy is expansionary. Finally, quantitative effects are in general larger for borrower rather than lender macroprudential policies. Overall, the results suggest that macroprudential policies are effective in mitigating bank risk-taking in household lending over the local bank credit and global financial cycles, and therefore have important implications for policy and bank risk management.
    Keywords: macroprudential policies, global financial cycle, cross-border spillovers, household credit, bank loans
    JEL: E58 F0 F40 G21 G28 D14
    Date: 2017–12
  20. By: Andrea Morone; Francesco Nemore; Tiziana Temerario
    Abstract: In this paper we investigated group size impact on risk aversion when a majority rule is applied. Drawing on the widely used Holt and Laury’s (2002) lottery pairs, we observed a risky shift for both individual and groups regardless of their size. However, groups choices are shown to be closer to the risk-neutrality prediction. More interestingly, whereas smaller groups attitudes can be safely approximated by individual choices, larger groups reveal a statistically different risk-loving attitude. This risky shift becomes more prominent as group size increases.
    Keywords: Preferences; Group; Risk Attitude; Majority Rule; Laboratory.
    JEL: C91 C92 D01
    Date: 2017–11–12
  21. By: Laura Gianfagna (IMT School for advanced studies); Armando Rungi (IMT School for advanced studies)
    Abstract: In our contribution we study how the ownership channel affects the stock price volatility of listed stock markets. In particular, we study how a linkage between a parent company and its affiliates may drive differences in stock price volatility, within and across countries. We exploit a worldwide dataset of stock-exchange listed firms, controlling for several financial dimensions, to assess whether business groups matter to financial volatility. The answer is positive and does not depend on the definition of volatility used. Our results contribute to the corporate finance literature by defining the role of multinational corporate control in financial markets, and to the financial stability literature by assessing corporate control as an undiscovered channel of transmission for financial shocks.
    Keywords: corporate control, stock price volatility, multilevel model
    JEL: F23 G32
    Date: 2017–11
  22. By: Rui Luo; Weinan Zhang; Xiaojun Xu; Jun Wang
    Abstract: In this paper, we show that the recent integration of statistical models with deep recurrent neural networks provides a new way of formulating volatility (the degree of variation of time series) models that have been widely used in time series analysis and prediction in finance. The model comprises a pair of complementary stochastic recurrent neural networks: the generative network models the joint distribution of the stochastic volatility process; the inference network approximates the conditional distribution of the latent variables given the observables. Our focus here is on the formulation of temporal dynamics of volatility over time under a stochastic recurrent neural network framework. Experiments on real-world stock price datasets demonstrate that the proposed model generates a better volatility estimation and prediction that outperforms stronge baseline methods, including the deterministic models, such as GARCH and its variants, and the stochastic MCMC-based models, and the Gaussian-process-based, on the average negative log-likelihood measure.
    Date: 2017–11
  23. By: Paul McCloud
    Abstract: The Carr-Madan replication formula ensures that knowledge of the prices of options at every strike is equivalent to knowing the entire pricing distribution. In many situations, the available market data is insufficient to determine this distribution precisely, and the question arises: what are the bounds for the option price at a specified strike, given the market-implied constraints? Applying techniques from the analysis of quantum systems, operator algebra methods are here used to generate an upper bound for the price of a basket option, depending only on a covariance matrix generated from the constituent assets in the basket. The result is then used to create converging families of bounds for vanilla options, interpolate the volatility smile, and analyse the relationships between swaption and caplet prices.
    Date: 2017–12
  24. By: Afees A. Salisu (Centre for Econometric and Allied Research, University of Ibadan); Raymond Swaray (Economics Subject Group, University of Hull Business, University of Hull, Cottingham Road, UK); Tirimisyu F. Oloko (Centre for Econometric and Allied Research, University of Ibadan)
    Abstract: This study queries the act of making generalization about the dynamics of returns and volatility spillovers between oil price and U.S. stocks by merely considering only large cap stocks. It argues that this kind of generalization may be misleading, as the reactions of large cap, mid cap and small cap stocks to change in oil prices are not expected to be uniform. Our findings show that it is correct to make generalization about oil-U.S. stock relationship with large cap stocks when analysing return spillovers, but the generalization is incorrect when considering return volatility spillovers, particularly under falling and relatively stable oil prices.
    Keywords: Market capitalization, U.S. stocks, oil price dynamics
    JEL: G11 Q43
    Date: 2017–09

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