nep-rmg New Economics Papers
on Risk Management
Issue of 2018‒02‒05
eleven papers chosen by
Stan Miles
Thompson Rivers University

  1. Hedging under square loss By Bloznelis, Daumantas
  2. Evaluating the role of risk networks on risk identification, classification and emergence By Christos Ellinas; Neil Allan; Caroline Coombe
  3. The Fragility of Market Risk Insurance By Koijen, Ralph; Yogo, Motohiro
  4. Large-Scale Simulation of Multi-Asset Ising Financial Markets By Tetsuya Takaishi
  5. Competition and Risk-Taking in Investment banking By Radić, N; Fiordelisi, F; Girardone, C; Degl’Innocenti, M
  6. Numerical analysis on quadratic hedging strategies for normal inverse Gaussian models By Takuji Arai; Yuto Imai; Ryo Nakashima
  7. Equity Market Globalization and Portfolio Rebalancing By Kyungkeun Kim; Dongwon Lee
  8. The Efficiency Wage Hypothesis and monetary policy channels of transmission: developments and progress of Basel III leverage ratios By DiGabriele, Jim; Ojo, Marianne
  9. Dynamic Methods for Analyzing Hedge-Fund Performance: A Note Using Texas Energy-Related Funds By Chen, Jiaqi; Tindall, Michael
  10. Systemic Effects of Bank Equity Issues: Competition, Stabilization and Contagion By Valeriya Dinger; Vlad Marincas; Francesco Vallascas
  11. Redefault Risk in the Aftermath of the Mortgage Crisis: Why Did Modifications Improve More Than Self-Cures? By Calem, Paul S.; Jagtiani, Julapa; Maingi, Ramain Quinn; Abell, David

  1. By: Bloznelis, Daumantas
    Abstract: The framework of minimum-variance hedging rests on a highly restrictive foundation. The objective of variance minimization is only justifiable when variance coincides with expected squared forecast error. Nevertheless, the classical framework is routinely applied when the condition fails, giving rise to inaccurate risk assessments and suboptimal hedging decisions. This study proposes a new, improved framework of hedging which relaxes the above condition at no tangible cost. It derives a new objective function, an optimal hedge ratio, and a measure of hedging effectiveness under square loss. Their superior performance is demonstrated from a theoretical standpoint and by applying them to hedging the price risk of oil and natural gas. Simple yet general, the new framework is well suited to replace the classical one and facilitates adequate risk measurement and improved hedging decisions. It also provides fundamental insight into dealing with uncertainty under square loss and beyond.
    Keywords: Minimum-variance hedging, hedging effectiveness, optimal hedge ratio, risk, uncertainty, square loss, forecast error
    JEL: D81 G10 G11 Q02
    Date: 2017–12–21
  2. By: Christos Ellinas; Neil Allan; Caroline Coombe
    Abstract: Modern society heavily relies on strongly connected, socio-technical systems. As a result, distinct risks threatening the operation of individual systems can no longer be treated in isolation. Consequently, risk experts are actively seeking for ways to relax the risk independence assumption that undermines typical risk management models. Prominent work has advocated the use of risk networks as a way forward. Yet, the inevitable biases introduced during the generation of these survey-based risk networks limit our ability to examine their topology, and in turn challenge the utility of the very notion of a risk network. To alleviate these concerns, we proposed an alternative methodology for generating weighted risk networks. We subsequently applied this methodology to an empirical dataset of financial data. This paper reports our findings on the study of the topology of the resulting risk network. We observed a modular topology, and reasoned on its use as a robust risk classification framework. Using these modules, we highlight a tendency of specialization during the risk identification process, with some firms being solely focused on a subset of the available risk classes. Finally, we considered the independent and systemic impact of some risks and attributed possible mismatches to their emerging nature.
    Date: 2018–01
  3. By: Koijen, Ralph; Yogo, Motohiro
    Abstract: Insurers sell retail financial products called variable annuities that package mu- tual funds with minimum return guarantees over long horizons. Variable annuities accounted for $1.5 trillion or 34 percent of U.S. life insurer liabilities in 2015. Sales fell and fees increased after the 2008 financial crisis as the higher valuation of existing liabilities stressed risk-based capital. Insurers also made guarantees less generous or stopped offering guarantees entirely to reduce risk exposure. We develop an equilib- rium model of insurance markets in which financial frictions and market power are important determinants of pricing, contract characteristics, and the degree of market incompleteness.
    JEL: G22 G32
    Date: 2018–01
  4. By: Tetsuya Takaishi
    Abstract: We perform a large-scale simulation of an Ising-based financial market model that includes 300 asset time series. The financial system simulated by the model shows a fat-tailed return distribution and volatility clustering and exhibits unstable periods indicated by the volatility index measured as the average of absolute-returns. Moreover, we determine that the cumulative risk fraction, which measures the system risk, changes at high volatility periods. We also calculate the inverse participation ratio (IPR) and its higher-power version, IPR6, from the absolute-return cross-correlation matrix. Finally, we show that the IPR and IPR6 also change at high volatility periods.
    Date: 2018–01
  5. By: Radić, N; Fiordelisi, F; Girardone, C; Degl’Innocenti, M
    Abstract: How does competition affect the investment banking business and the risks individual institutions are exposed to? Using a large sample of investment banks operating in seven developed economies over 1997-2014, we apply a panel VAR model to examine the relationships between competition and risk without assuming any a priori restrictions. Our main finding is that investment banks’ higher risk exposure, measured as a long-term capital-at-risk and return volatility, was facilitated by greater competitive pressures especially for full service investment banks but also for boutique investment banks. Overall, we find some evidence that more competition leads to more fragility before and during the recent financial crisis.
    Keywords: Investment Banking, Competition, Risk, Panel VAR
    Date: 2018–01
  6. By: Takuji Arai; Yuto Imai; Ryo Nakashima
    Abstract: The authors aim to develop numerical schemes of the two representative quadratic hedging strategies: locally risk minimizing and mean-variance hedging strategies, for models whose asset price process is given by the exponential of a normal inverse Gaussian process, using the results of Arai et al. \cite{AIS}, and Arai and Imai. Here normal inverse Gaussian process is a framework of L\'evy processes frequently appeared in financial literature. In addition, some numerical results are also introduced.
    Date: 2018–01
  7. By: Kyungkeun Kim (Economic Research Institute, The Bank of Korea); Dongwon Lee (University of California, Riverside)
    Abstract: This paper examines how the financial globalization affects international equity mutual funds' portfolio choices in emerging markets. By examining the monthly holdings of 155 international funds, we first show that these funds actively engage in a rebalancing strategy to maintain their risk preferences upon realization of excess return changes. We also document robust evidence that these funds' propensity of rebalancing is larger in a country whose equity market is more strongly correlated with the global market. The results help understand how the financial globalization may raise the portfolio risk of the international funds' equity holdings in emerging economies.
    Keywords: Equity market globalization, Portfolio allocation, Portfolio rebalancing, Return correlation
    JEL: F3 G11 G15
    Date: 2017–06–13
  8. By: DiGabriele, Jim; Ojo, Marianne
    Abstract: It is argued that “ the ascendency of the emerging economies changed the relative returns to labor and capital – and that because these economies’ global integration has made labor more abundant, workers in developed countries have lost some of their bargaining power – thus putting downward pressure on real wages.” Central bankers’ misunderstanding of certain monetary implications have also been highlighted in that by keeping interest rates too low, they allowed a build up of excess liquidity which flowed into the prices of assets such as homes – contributing to the build up leading to the 2007-2009 global Financial Crisis. The introduction of the 2010 Basel III leverage ratios was intended not only to address shortcomings of the previous Basel capital framework, but also intended to serve as a complement to the risk based capital adequacy framework. However, as with many implementation challenges, other issues which involve calibration between the risk based and leverage based frameworks continue to constitute areas of concern for regulators – and supervisors. So also matters relating to disclosures – as evidenced by ongoing initiatives in respect of Pillar 3. This paper aims to highlight progress and developments being made since 2010 – as well as accentuate challenges still being encountered by the leverage based framework. Herein lies the importance of continued collaborative efforts aimed at facilitating comparability, consistency, understanding and communication between national and federal regulators and supervisors from different jurisdictions – in efforts aimed at realizing Basel III initiatives and objectives.
    Keywords: monetary policy; leverage ratios; risk based capital adequacy measures; disclosures; Efficiency wage Hypothesis
    JEL: E3 E5 E58 G3 G38 K2 M4
    Date: 2017–11
  9. By: Chen, Jiaqi (Federal Reserve Bank of Dallas); Tindall, Michael (Federal Reserve Bank of Dallas)
    Abstract: We apply dynamic regression to Texas energy-related hedge funds to track changes in portfolio structure and manager performance in response to changing oil prices. We apply hidden Markov models to compute shifts in portfolio performance from boom to bust states. Using these dynamic methods, we find that, in the recent oil-price decline, these funds raised their exposure to high-grade energy-related bonds in a bet that the spread to low-grade energy bonds would widen. When the high-grade bonds eventually fell, the hedge funds entered into a bust state.
    Keywords: Dynamic regression; Kalman filter; hidden Markov models
    Date: 2016–07–01
  10. By: Valeriya Dinger (University of Osnabrueck, Rolandstr. 8, DE and University of Leeds); Vlad Marincas (University of Osnabrueck, Rolandstr. 8, DE and University of Leeds); Francesco Vallascas (University of Leeds, Maurice Keyworth Building, Leeds LS2 9JT, UK)
    Abstract: We evaluate the abnormal returns of issuing and non-issuing banks around the announcement of Seasoned Equity Offerings (SEOs) and explore how the market reaction is influenced by aggregate systemic conditions and by the systemic risk contribution and exposure of banks. While we find evidence of negative abnormal returns for issuers, non-issuing banks benefit from positive abnormal returns around the SEO announcement. We show that these positive returns are not entirely explained by the competition channel, which has been well documented for non-financial firms. In contrast, we demonstrate that they also depend on a so far undocumented system-stabilizing channel. Furthermore, under certain circumstances, the system-stabilizing channel contributes to mitigating the negative reaction to SEO announcements for the issuing banks.
    Keywords: SEOs, Banking Regulation, Banking Crises, Contagion, Systemic Risk
    JEL: G21 G28 G32
    Date: 2018–01–24
  11. By: Calem, Paul S. (Federal Reserve Bank of Philadelphia); Jagtiani, Julapa (Federal Reserve Bank of Philadelphia); Maingi, Ramain Quinn (Federal Reserve Bank of Philadelphia); Abell, David (Federal Reserve Bank of Philadelphia)
    Abstract: This paper examines changes in the redefault rate of mortgages that were selected for modification during 2008–2011, compared with that of similarly situated self-cured mortgages during the same period. We find that while the performance of both modified and self-cured loans improved dramatically over this period, the decline in the redefault rate for modified loans was substantially larger, and we attribute this difference to a few key factors. First, the modification terms regarding repayments have become increasingly more generous, including more principal reduction, resulting in greater financial relief to the borrowers. Second, modifications in later vintages also benefited from improving economic conditions. Modifications became more effective as unemployment rates declined and home prices recovered. Third, we find that the difference between redefault rate improvement between modified loans and self-cured loans continue to persist even after controlling for all the relevant risk and economic factors. We attribute this difference to the servicers’ learning process — such as data collection and information sharing among industry participants — known as “learning-by doing.” Early in the mortgage crisis, many servicers had limited experience selecting the best borrowers for modification. As modification activity increased, lenders became more adept at screening borrowers for modification eligibility and in selecting appropriate modification terms. Our empirical findings suggest that mortgage modification effectiveness could be enhanced through the industry’s “learning-by-doing” process.
    Keywords: mortgage modification; mortgage default; mortgage servicing
    JEL: G21 G28
    Date: 2018–01–22

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