nep-rmg New Economics Papers
on Risk Management
Issue of 2018‒07‒09
twenty-one papers chosen by

  1. Leverage effects and stochastic volatility in spot oil returns: A Bayesian approach with VaR and CVaR applications By Liyuan Chen; Paola Zerilli; Christopher F Baum
  2. Regulation and risk shuffling in bank securities portfolios By Fuster, Andreas; Vickery, James
  3. Forecasting Expected Shortfall: Should we use a Multivariate Model for Stock Market Factors? By Fortin, Alain-Philippe; Simonato, Jean-Guy; Dionne, Georges
  4. Optimal investment of participating contracts under VaR-Regulation By Thai Nguyen; Mitja Stadje
  5. What Makes An Asset Useful? By Yves-Laurent Kom Samo; Dieter Hendricks
  6. Medida de aversión al Riesgo Mediante Volatilidades Implícitas Realizadas By Nicolás Álvarez; Antonio Fernandois; Andrés Sagner
  7. Capital Requirements, Risk-Taking and Welfare in a Growing Economy By Pierre-Richard Agénor; Luiz A. Pereira da Silva
  8. Corporate Currency Risk and Hedging in Chile: Real and Financial Effects By Roberto Alvarez; Erwin Hansen
  9. Dynamic connectedness of global currencies: a conditional Granger-causality approach By Tan Le; Franck Martin; Duc Nguyen
  10. How do banks and households manage interest rate risk? Evidence from mortgage applications and banks’ responses By Basten, Christoph; Guin, Benjamin; Koch, Catherine
  11. Guaranteed Renewable Life Insurance Under Demand Uncertainty By Michael Hoy; Afrasiab Mirza; Asha Sadanand
  12. Critical slowing down associated with critical transition and risk of collapse in cryptocurrency By Chengyi Tu; Paolo DOdorico; Samir Suweis
  13. Oil prices and stock markets: A review of the theory and empirical evidence By Stavros Degiannakis; George Filis; Vipin Arora
  14. Changing risk-return profiles By Crump, Richard K.; Giannone, Domenico; Hundtofte , Sean
  15. Measuring Skewness Premia By Langlois, Hugues
  16. Reclassification Risk in the Small Group Health Insurance Market By Sebastián Fleitas; Gautam Gowrisankaran; Anthony Lo Sasso
  17. Textual Sentiment, Option Characteristics, and Stock Return Predictability By Yi-Hsuan Chen, Cathy; Fengler, Matthias; Härdle, Wolfgang Karl; Liu, Yanchu
  18. Asymmetric response to PMI announcements in China's stock returns By Yingli Wang; Xiaoguang Yang
  19. Volatility-of-volatility risk By Huang, Darien; Schlag, Christian; Shaliastovich, Ivan; Thimme, Julian
  20. Counterparty credit risk and the effectiveness of banking regulation By Iman van Lelyveld; Sinziana Kroon
  21. Asset Pricing with Downside Liquidity Risks By Sean A. Anthonisz; Talis Putnins

  1. By: Liyuan Chen (University of York); Paola Zerilli (University of York); Christopher F Baum (Boston College; German Institute for Economic Research (DIW Berlin))
    Abstract: The crude oil markets have been quite volatile and risky in the past few decades due to the large fluctuations of oil prices. We contribute to the current debate by testing for the existence of the leverage effect when considering daily spot returns in the WTI and Brent crude oil markets and by studying the direct impact of the leverage effect on measures of risk such as VaR and CVaR. More specifically, we model spot crude oil returns using Stochastic Volatility (SV) models with various distributions of the errors. We find that the introduction of the leverage effect in the traditional SV model with Normally distributed errors is capable of adequately estimating risk for conservative oil suppliers in both the WTI and Brent markets while it tends to overestimate risk for more speculative oil suppliers. Our results also show that the choice of financial regulators, both on the supply and on the demand side, would not be affected by the introduction of leverage. Focusing instead on firm’s internal risk management, our results show that the introduction of leverage would be useful for firms who are on the demand side for oil, who use VaR for risk management and who are particularly worried about the magnitude of the losses exceeding VaR while wanting to minimize the opportunity cost of capital. Using the same logic, firms who are on the supply side would be better off not considering the leverage effect.
    Keywords: Value-at-Risk, Conditional Value-at-Risk, Asymmetric Laplace distribution, Stochastic volatility model, Bayesian Markov Chain Monte Carlo, leverage effect
    JEL: C11 C58 G17 G32
    Date: 2018–01–28
  2. By: Fuster, Andreas (Swiss National Bank); Vickery, James (Federal Reserve Bank of New York)
    Abstract: Bank capital requirements are based on a mix of market values and book values. We investigate the effects of a policy change that ties regulatory capital to the market value of the “available-for-sale" investment securities portfolio for some banking organizations. Our analysis is based on security-level data on individual bank portfolios matched to bond characteristics. We find little clear evidence that banks respond by reducing the riskiness of their securities portfolios, although there is some evidence of a greater use of derivatives to hedge securities exposures. Instead, banks respond by reclassifying securities to mitigate the effects of the policy change. This shift is most pronounced for securities with high levels of interest rate risk.
    Keywords: bank; securities; available-for-sale; capital regulation; fair value accounting
    JEL: G21 G23 G28
    Date: 2018–06–01
  3. By: Fortin, Alain-Philippe (HEC Montreal, Canada Research Chair in Risk Management); Simonato, Jean-Guy (HEC Montreal, Department of Finance); Dionne, Georges (HEC Montreal, Canada Research Chair in Risk Management)
    Abstract: When forecasting the market risk of stock portfolios, is a univariate or a multivariate modeling approach more effective? This question is examined in the context of forecasting the one-week-ahead Expected Shortfall for a portfolio equally invested in the Fama-French and momentum factors. Applying extensive tests and comparisons, we find that in most cases there are no statistically significant differences between the forecasting accuracy of the two approaches. This suggests that univariate models, which are more parsimonious and simpler to implement than multivariate models, can be used to forecast the downsize risk of equity portfolios without losses in precision.
    Keywords: Value-at-Risk; Expected Shortfall; Conditional Value-at-Risk; Elicitability; model comparison; backtesting; Fama-French and momentum factors
    JEL: C22 C32 C52 C53 G17
    Date: 2018–06–18
  4. By: Thai Nguyen; Mitja Stadje
    Abstract: This paper studies a VaR-regulated optimal portfolio problem of the equity holder of a participating life insurance contract. In a complete market setting the optimal solution is given explicitly for contracts with mortality risk using a martingale approach for constrained non-concave optimizations. We show that regulatory VaR constraints for participating insurance contracts lead to more prudent investment than the unconstrained solution in loss states. This result is contrary to the situation where the insurer maximizes the utility of the total wealth of the company (without distinguishing between equity and policy holders), in which case a VaR constraint may induce the insurer to take excessive risk leading to higher losses than in the case of no regulation, see Basak and Shapiro (2001). Furthermore, importantly for regulator we observe that for participating insurance contracts both relatively small or relatively large policyholder contributions yield rather risky and volatile strategies. Finally, we also discuss the regulatory effect of a portfolio insurance (PI), and analyze different choices for the parameters of the participating contract numerically.
    Date: 2018–05
  5. By: Yves-Laurent Kom Samo; Dieter Hendricks
    Abstract: Given a new candidate asset represented as a time series of returns, how should a quantitative investment manager be thinking about assessing its usefulness? This is a key qualitative question inherent to the investment process which we aim to make precise. We argue that the usefulness of an asset can only be determined relative to a reference universe of assets and/or benchmarks the investment manager already has access to or would like to diversify away from, for instance, standard risk factors, common trading styles and other assets. We identify four features that the time series of returns of an asset should exhibit for the asset to be useful to an investment manager, two primary and two secondary. As primary criteria, we propose that the new asset should provide sufficient incremental diversification to the reference universe of assets/benchmarks, and its returns time series should be sufficiently predictable. As secondary criteria, we propose that the new asset should mitigate tail risk, and the new asset should be suitable for passive investment (e.g. buy-and-hold or short-and-hold). We discuss how to quantify incremental diversification, returns predictability, impact on tail risk, and suitability for passive investment, and for each criterion, we provide a scalable algorithmic test of usefulness.
    Date: 2018–06
  6. By: Nicolás Álvarez; Antonio Fernandois; Andrés Sagner
    Abstract: In this paper, we estimate risk aversion contained in stock indices, exchange rates, and sovereign bond yields of a sample of developed and emerging countries. In particular, we use the methodology proposed by Bekaert et al. (2013) to decompose various measures of implicit variance into its realized variance and risk aversion components. Our results show a higher, generalized risk appetite during the last years, in a context of low financial volatility and high global political uncertainty. Lastly, we find that risk aversion tends to be higher during periods of financial fragility and recessions, and events of low risk aversion typically precede these episodes.
    Date: 2018–06
  7. By: Pierre-Richard Agénor; Luiz A. Pereira da Silva
    Abstract: The effects of capital requirements on risk-taking and welfare are studied in a stochastic overlapping generations model of endogenous growth with banking, limited liability, and government guarantees. Capital producers face a choice between a safe technology and a risky (but socially inefficient) technology, and bank risk-taking is endogenous. Setting the capital adequacy ratio above a structural threshold can eliminate the equilibrium with risky loans (and thus inefficient risk-taking), but numerical simulations show that this may entail a welfare loss. In addition, the optimal ratio may be too high in practice and may concomitantly require a broadening of the perimeter of regulation and a strengthening of financial supervision to prevent disintermediation and distortions in financial markets.
    Keywords: Capital Requirements, Bank risk-taking, Investment, Financial Stability, Economic Growth, Capital Goods, Financial Regulation, Financial Intermediaries, Financial Markets, risky investments, financial stability, financial regulation
    JEL: O41 G28 E44
    Date: 2017–03
  8. By: Roberto Alvarez; Erwin Hansen
    Abstract: This paper examines a panel (1994-2014) of Chilean non-financial firms, both publicly listed and private, which was built to analyze the determinants of the use of foreign currency debt and their potential consequences for firm investment and profitability. It is found that foreign assets and the use of FX derivatives are positively associated with firms' use of foreign currency debt. Also, depending on the estimation method, exports appear as an important determinant of the use of foreign currency debt. In terms of the potential effect of holding foreign currency debt on firms' performance after an exchange rate devaluation, no statistical differential effect is identified on either firm profitability or firm investment. This (lack of) result is interpreted as evidence that firms match liabilities and assets denominated in foreign currency and that firms actively involved in hedging aim to reduce their exposure to foreign exchange fluctuations.
    Keywords: Foreign Currency Debt, Foreign exchange, Bonds, Interest rates, Macroeconomics, Export Sales, Foreign Assets, Firm performance, foreign exchange, non-financial firms, interest rate
    JEL: E22 G31 F34
    Date: 2017–02
  9. By: Tan Le (CREM - Centre de recherche en économie et management - UNICAEN - Université de Caen Normandie - NU - Normandie Université - UR1 - Université de Rennes 1 - UNIV-RENNES - Université de Rennes - CNRS - Centre National de la Recherche Scientifique); Franck Martin (CREM - Centre de recherche en économie et management - UNICAEN - Université de Caen Normandie - NU - Normandie Université - UR1 - Université de Rennes 1 - UNIV-RENNES - Université de Rennes - CNRS - Centre National de la Recherche Scientifique); Duc Nguyen (IPAG - IPAG Business School - Ipag)
    Abstract: Conditional granger causality framework in Barnett and Seth (2014) is employed to measure the connectedness among the most globally traded currencies. The connectedness exhibits dynamics through time on both breadth and depth dimensions at three levels: node-wise, group-wise and system-wise. Overall, rolling connectedness series could capture major systemic events like Lehman Broth-ers' collapse and the get-through of Outright Monetary Transactions in Europe in September 2012. The rolling total breath connectedness series spike during high-risk episodes, becomes more stable in lower risk environment and is positively correlated with volatility index and Ted spread, thus, can be considered as a systemic risk indicator in light of Billio et al. (2012). Global currencies tend structure into communities based on connection strength and density. While more links are found related to currencies from emerging markets, G11 currencies are net spreaders of foreign exchange rate returns. Finally, hard currencies including Canadian dollar, Norwegian Krone and Japanese Yen frequently present among the top most connected, though the centrality positions vary over time.
    Keywords: conditional granger causality,exchange rates,connectedness,systemic risk
    Date: 2018–06–04
  10. By: Basten, Christoph (University of Zurich); Guin, Benjamin (Bank of England); Koch, Catherine (Bank for International Settlements)
    Abstract: We exploit a unique dataset that features both un-intermediated mortgage requests and independent responses from multiple banks to each request. We show that households typically are not prudent risk managers, but prioritize minimizing current mortgage payments over insurance against future rate increases. Contrary to assumptions in the previous literature, we find that banks do also influence contracted rate fixation periods. They trade off their own exposure to interest rate risk against household requests and against credit risk.
    Keywords: Interest rate risk; credit risk; maturity mismatch; duration; fixation period; repricing frequency; fixed-rate mortgage; adjustable rate mortgage
    JEL: D14 E43 G21
    Date: 2018–06–08
  11. By: Michael Hoy; Afrasiab Mirza; Asha Sadanand
    Abstract: Guaranteed renewability is a prominent feature in many health and life insurance markets. It is well established in the literature that, when there is (only) risk type uncertainty, the optimal GR contract with renewal price set at the actuarially fair price for low risk types provides full insurance against reclassification risk. We develop a model that includes unpredictable (and unobservable) fluctuations in demand for life insurance as well as changes in risk type (observable) over individuals' lifetimes. The presence of demand type heterogeneity leads to the possibility that optimal GR contracts may have a renewal price that is either above or below the actuarially fair price of the lowest risk type in the population. Individuals whose type turns out to be high risk but low demand renew more of their GR insurance than is efficient due to the attractive renewal price. This results in incomplete insurance against re-classification risk. Although a first best efficient contract is not possible in the presence of demand type heterogeneity, the presence of GR contracts nonetheless improves welfare relative to an environment with only spot markets. Our results also apply to a comparison of environments with short versus long term (front loaded) insurance contracts.
    Keywords: insurance, guaranteed renewability, re-classification risk, demand uncertainty
    JEL: D80 D86 G22
    Date: 2018
  12. By: Chengyi Tu; Paolo DOdorico; Samir Suweis
    Abstract: Cryptocurrencies are increasingly popular digital assets/cashes programmed to work as a medium of exchange that are "secure" by design (e.g., through block-chains and cryptography). The year 2017 saw the rise and fall of the cryptocurrency market, followed by high volatility in the price of each cryptocurrency. In this work, we study critical transitions in cryptocurrency residuals through the phenomenon of critical slowing down. We find that, regardless of the specific cryptocurrency or rolling window size, the autocorrelation always fluctuates around a high value and the standard deviation increases monotonically. In particular, we have detected two sudden jumps in the standard deviation, in the second quarter of 2017 and at the beginning of 2018, suggesting early warning signals of two majors price collapse that have happened in those periods. Our findings represent a first step towards a better diagnostic of the risk of critical transition in the price and/or volume of cryptocurrencies.
    Date: 2018–06
  13. By: Stavros Degiannakis (Department of Economics and Regional Development, Panteion University of Social and Political Sciences and Department of Accounting, Finance and Economics, Bournemouth University); George Filis (Department of Accounting, Finance and Economics, Bournemouth University); Vipin Arora (U.S. Energy Information Administration)
    Abstract: Do oil prices and stock markets move in tandem or in opposite directions? The complex and time varying relationship between oil prices and stock markets has caught the attention of the financial press, investors, policymakers, researchers, and the general public in recent years. In light of such attention, this paper reviews research on the oil price and stock market relationship. The majority of papers we survey study the impacts of oil markets on stock markets, whereas, little research in the reverse direction exists. Our review finds that the causal effects between oil and stock markets depend heavily on whether research is performed using aggregate stock market indices, sectoral indices, or firm-level data and whether stock markets operate in net oil-importing or net oil-exporting countries. Additionally, conclusions vary depending on whether studies use symmetric or asymmetric changes in the price of oil, or whether they focus on unexpected changes in oil prices. Finally, we find that most studies show oil price volatility transmits to stock market volatility, and that including measures of stock market performance improves forecasts of oil prices and oil price volatility. Several important avenues for further research are identified.
    Keywords: Oil prices; stock markets; interconnectedness; forecasting; oil-importers; oil-exporters
    JEL: G15 Q40 Q47
    Date: 2018–06
  14. By: Crump, Richard K. (Federal Reserve Bank of New York); Giannone, Domenico (Federal Reserve Bank of New York); Hundtofte , Sean (Federal Reserve Bank of New York)
    Abstract: We show that realized volatility, especially the realized volatility of financial sector stock returns, has strong predictive content for the future distribution of market returns. This is a robust feature of the last century of U.S. data and, most importantly, can be exploited in real time. Current realized volatility has the most information content on the uncertainty of future returns, whereas it has only limited content about the location of the future return distribution. When volatility is low, the predicted distribution of returns is less dispersed and probabilistic forecasts are sharper. Given this finding on the importance of financial sector volatility not just to financial equity return uncertainty but to the broader market, we test for changes in the realized volatility of banks over a $50 billion threshold associated with more stringent Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) requirements. We find that the equity volatility of these large banks is differentially lower by 9 percentage points after Dodd-Frank compared to pre-crisis levels, controlling for changes over the same period for all banks and all large firms.
    Keywords: stock returns; realized volatility; density forecasts; optimal pools; Dodd-Frank; financial intermediation; financial conditions
    JEL: C22 G17 G18
    Date: 2018–06–01
  15. By: Langlois, Hugues
    Abstract: We provide a new methodology to empirically investigate the respective roles of systematic and idiosyncratic skewness in explaining expected stock returns. Forming a risk factor that captures systematic skewness risk and forming idiosyncratic skewness sorted portfolios only require the ordering of stocks with respect to each skewness measure. Accordingly, we use a large number of predictors to forecast the cross-sectional ranks of systematic and idiosyncratic skewness which are considerably easier to predict than their actual values. Compared to other measures of ex ante systematic skewness, our forecasts create a significant spread in ex post systematic skewness. A predicted systematic skewness risk factor carries a significant risk premium that ranges from 7% to 12% per year and is robust to the inclusion of downside beta, size, value, momentum, profitability, and investment factors. In contrast to systematic skewness, the role of idiosyncratic skewness in pricing stocks is less robust. Finally, we document how the determinants of systematic skewness differ from those of idiosyncratic skewness.
    Keywords: Systematic skewness; coskewness; idiosyncratic skewness; large panel regression; forecasting
    JEL: G12
    Date: 2018–03–15
  16. By: Sebastián Fleitas; Gautam Gowrisankaran; Anthony Lo Sasso
    Abstract: We evaluate reclassification risk and adverse selection in the small group insurance market from a period before ACA community rating regulations. Using detailed individual-level data from a large insurer, we find a pass through of 5-43% from expected health risk to premiums. This limited reclassification risk cannot be explained by market power or search frictions but may be due to implicit long-term contracts. We find no evidence of adverse selection generated by reclassification risk. The observed pricing policy adds $2,346 annually in consumer welfare over 10 years relative to experience rating. Community rating would not increase consumer welfare substantially.
    JEL: I13 L13
    Date: 2018–05
  17. By: Yi-Hsuan Chen, Cathy; Fengler, Matthias; Härdle, Wolfgang Karl; Liu, Yanchu
    Abstract: We distill sentiment from a huge assortment of NASDAQ news articles by means of machine learning methods and examine its predictive power in single-stock option markets and equity markets. We provide evidence that single-stock options react to contemporaneous sentiment. Next, examining return predictability, we discover that while option variables indeed predict stock returns, sentiment variables add further informational content. In fact, both in a regression and a trading context, option variables orthogonalized to public and sentimental news are even more informative predictors of stock returns. Distinguishing further between overnight and trading-time news, we find the first to be more informative. From a statistical topic model, we uncover that this is attributable to the differing thematic coverage of the alternate archives. Finally, we show that sentiment disagreement commands a strong positive risk premium above and beyond market volatility and that lagged returns predict future returns in concentrated sentiment environments.
    Keywords: investor disagreement, option markets, overnight information, stock return predictability, textual sentiment, topic model, trading-time information
    JEL: C58 G12 G14
    Date: 2018–06
  18. By: Yingli Wang; Xiaoguang Yang
    Abstract: Considered an important macroeconomic indicator, the Purchasing Managers' Index (PMI) on Manufacturing generally assumes that PMI announcements will produce an impact on stock markets. International experience suggests that stock markets react to negative PMI news. In this research, we empirically investigate the stock market reaction towards PMI in China. The asymmetric effects of PMI announcements on the stock market are observed: no market reaction is generated towards negative PMI announcements, while a positive reaction is generally generated for positive PMI news. We further find that the positive reaction towards the positive PMI news occurs 1 day before the announcement and lasts for nearly 3 days, and the positive reaction is observed in the context of expanding economic conditions. By contrast, the negative reaction towards negative PMI news is prevalent during downward economic conditions for stocks with low market value, low institutional shareholding ratios or high price earnings. Our study implies that China's stock market favors risk to a certain extent given the vast number of individual investors in the country, and there may exist information leakage in the market.
    Date: 2018–06
  19. By: Huang, Darien; Schlag, Christian; Shaliastovich, Ivan; Thimme, Julian
    Abstract: We show that time-varying volatility of volatility is a significant risk factor which affects the cross-section and the time-series of index and VIX option returns, beyond volatility risk itself. Volatility and volatility-of-volatility measures, identified modelfree from the option price data as the VIX and VVIX indices, respectively, are only weakly related to each other. Delta-hedged index and VIX option returns are negative on average, and are more negative for strategies which are more exposed to volatility and volatility-of-volatility risks. Volatility and volatility of volatility significantly and negatively predict future delta-hedged option payoffs. The evidence is consistent with a no-arbitrage model featuring time-varying market volatility and volatility-of-volatility factors, both of which have negative market price of risk.
    Keywords: volatility of volatility,hedging errors,risk premiums
    JEL: G12 G13
    Date: 2018
  20. By: Iman van Lelyveld; Sinziana Kroon
    Abstract: We investigate how counterparty credit risk influences the prices of over-the-counter CDS contracts using confidential transaction level data for practically all Dutch trades. We confirm our prior of a significant negative relationship between the credit worthiness of the CDS seller and the price of the CDS contract. We find that an increase of 100 basis points in the credit spread of the seller, decreases the price of the CDS contract by 7.2 basis points. Also, the larger the size of the CDS contract the lower the price of the CDS contract. Finally, we find that regulatory exemptions have a statistically significant but economically negligible impact on CDS pricing: Transactions exempted from banking capital requirements for Credit Valuation Adjustment risk - mostly banks transacting with non-financial institutions, sovereigns and pension funds - trade 0.14 basis points lower, all else equal.
    Keywords: OTC market; counterparty credit risk; credit default swap
    JEL: G10 G12 G14 G20 G23
    Date: 2018–06
  21. By: Sean A. Anthonisz (University of Sydney); Talis Putnins (Finance Discipline Group, University of Technology Sydney)
    Abstract: We develop a parsimonious liquidity-adjusted downside capital asset pricing model to investigate whether phenomena such as downward liquidity spirals and flights to liquidity impact expected asset returns. We find strong empirical support for the model. Downside liquidity risk (sensitivity of stock liquidity to negative market returns) has an economically meaningful return premium that is 10 times larger than its symmetric analogue. The expected liquidity level and downside market risk are also associated with meaningful return premiums. Downside liquidity risk and its associated premium are higher during periods of low marketwide liquidity and for stocks that are relatively small, illiquid, volatile, and have high book-to-market ratios. These results are consistent with investors requiring compensation for holding assets susceptible to adverse liquidity phenomena. Our findings suggest that mitigation of downside liquidity risk can lower firms’ cost of capital.
    Keywords: liquidity risk; liquidity spiral; conditional moment; pricing kernel; downside risk
    Date: 2017–01–01

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