nep-rmg New Economics Papers
on Risk Management
Issue of 2018‒08‒20
twenty-two papers chosen by

  1. Quantile-Based Risk Sharing with Heterogeneous Beliefs By Paul Embrechts; Haiyan Liu; Tiantian Mao; Ruodu Wang
  2. Characterizing Cryptocurrency market with Levy's stable distributions By Shinji Kakinaka; Ken Umeno
  3. Panel quantile regressions for estimating and predicting the Value--at--Risk of commodities By Franti\v{s}ek \v{C}ech; Jozef Barun\'ik
  4. The risk asymmetry index By Elyas Elyasani; Luca Gambarelli; Silvia Muzzioli
  5. A unifying approach to constrained and unconstrained optimal reinsurance By Yuxia Huang; Chuancun Yin
  6. Modeling Systemic Risk with Markov Switching Graphical SUR Models By Daniele Bianchi; Monica Billio; Roberto Casarin; Massimo Guidolin
  7. Stressed Banks By Diane Pierret; Roberto Steri
  8. Financial Weather Derivatives for Corn Production in Northeastern China: Modelling the Underlying Weather Index By Sun, Baojing
  9. Brexit and CDS spillovers across UK and Europe By Jamal Bouoiyour; Refk Selmi
  10. CDS Central Counterparty Clearing Liquidation: Road to Recovery or Invitation to Predation? By Magdalena Tywoniuk
  11. Customer Complaining and Probability of Default in Consumer Credit By Stefano Cosma; Francesca Pancotto; Paola Vezzani
  12. Asset pledgeability and endogenously leveraged bubbles By BENGUI, Julien; PHAN, Toan
  13. Commodity Return Predictability: evidence from implied variance, skewness and their risk premia and their risk premia By Marinela Adriana Finta; José Renato Haas Ornelas
  14. Eyes Wide Shut? The Moral Hazard of Mortgage Insurers during the Housing Boom By Neil Bhutta; Benjamin J. Keys
  15. Feedlot Risk Management and Benchmarking Survey Summary By McKendree, Melissa G.S.; Tonsor, Glynn T.; Schulz, Lee L.
  16. Asset-Liability Management for Long-Term Insurance Business By Hansjoerg Albrecher; Daniel Bauer; Paul Embrechts; Damir Filipović; Pablo Koch-Medina; Ralf Korn; Stéphane Loisel; Antoon Pelsser; Frank Schiller; Hato Schmeiser; Joël Wagner
  17. Return and volatility spillovers between South African and Nigerian equity markets By Phume, Maphelane Palesa; Bonga-Bonga, Lumengo
  18. Valuation Risk Revalued By de Groot, Oliver; Richter, Alexander W.; Throckmorton, Nathaniel
  19. Fundamental Risk and Capital Structure By Jakub Hajda
  20. Always look on the bright side? Central counterparties and interbank markets during the financial crisis By Massimiliano Affinito; Matteo Piazza
  21. Emergence of correlations between securities at short time scales By S. Valeyre; D. S. Grebenkov; S. Aboura
  22. Branch Network Structure and Lending Behaviour By Tho Pham; Oleksandr Talavera; Andriy Tsapin

  1. By: Paul Embrechts (Swiss Federal Institute of Technology Zurich and Swiss Finance Institute); Haiyan Liu (Michigan State University); Tiantian Mao (University of Science and Technology of China (USTC)); Ruodu Wang (University of Waterloo)
    Abstract: We study risk sharing games with quantile-based risk measures and heterogeneous beliefs, motivated by the use of internal models in finance and insurance. Explicit forms of Pareto-optimal allocations and competitive equilibria are obtained by solving various optimization problems. For Expected Shortfall (ES) agents, Pareto-optimal allocations are shown to be equivalent to equilibrium allocations, and the equilibrium price is unique. For Value-at-Risk (VaR) agents or mixed VaR and ES agents, a competitive equilibrium does not exist. Our results generalize existing ones on risk sharing games with risk measures and belief homogeneity, and draw an interesting connection to early work on optimization properties of ES and VaR.
    Keywords: Risk Sharing, Competitive Equilibrium, Belief Heterogeneity, Quantiles, Non-Convexity, Risk Measures
    Date: 2017–12
  2. By: Shinji Kakinaka; Ken Umeno
    Abstract: Recent emergence of cryptocurrencies such as Bitcoin and Ethereum has posed possible alternatives to global payments as well as financial assets around the globe, so measuring their financial risk is crucial for investors and financial regulators. Analysis of price fluctuations in financial markets is often based on the assumption of a Gaussian distribution, which fails to capture the extreme values and leads to the underestimating of the risks. In this paper we first show that the behaviors of price fluctuations of cryptocurrencies can also be characterized by the fat-tail Levy's stable distribution by our parameter estimation method. After confirming that price returns of cryptocurrencies follow Levy's stable distribution, we discuss the recent market instability by focusing on one of the parameters of the distribution, which can characterize the fat-tailed behavior of cryptocurrency price returns. Our analysis shows that the fluctuations of estimated tail index parameter could be a candidate for the measure to capture extreme price behaviors of recently emerging cryptocurrencies and the tail index can be applicable for risk management and their financial modeling.
    Date: 2018–07
  3. By: Franti\v{s}ek \v{C}ech; Jozef Barun\'ik
    Abstract: This paper investigates how realized and option implied volatilities are related to the future quantiles of commodity returns. Whereas realized volatility measures ex-post uncertainty, volatility implied by option prices reveals the market's expectation and is often used as an ex-ante measure of the investor sentiment. Using a flexible panel quantile regression framework, we show how the future conditional quantiles of commodities returns depend on both ex-post and ex-ante uncertainty measures. Empirical analysis of the most liquid commodities covering main sectors including energy, food, agricultural, precious and industrial metals reveal several important stylized facts about the data. We document common patterns of the dependence between future quantile returns and ex-post as well as ex-ante volatilities. We further show that conditional returns distribution is platykurtic and time-invariant. The approach can serve as a useful risk management tools for investors interested in commodity future contracts.
    Date: 2018–07
  4. By: Elyas Elyasani; Luca Gambarelli; Silvia Muzzioli
    Abstract: The aim of this paper is to propose a simple and unique measure of risk, that subsumes the conflicting information in volatility and skewness indices and overcomes the limits of these indices in correctly measuring future fear or greed in the market. To this end, we exploit the concept of upside and downside corridor implied volatility, which accounts for the asymmetry in risk-neutral distribution, i.e. the fact that investors like positive spikes in returns, while they dislike negative ones. We combine upside and downside implied volatilities in a single asymmetry index called the risk-asymmetry index (RAX). The risk-asymmetry index (RAX) plays a crucial role in predicting future returns, since it subsumes all the information embedded in both the Italian skewness index ITSKEW and the Italian volatility index (ITVIX). The RAX index is the only index that is able to indicate (when reaching very high values) a clearly risky situation for the aggregate stock market, which is detected neither by the ITVIX ?index nor by the ITSKEW index
    Keywords: risk-neutral moments, model-free implied volatility, corridor implied volatility, skewness, skewness risk premium.
    JEL: G13 G14
    Date: 2016–12
  5. By: Yuxia Huang; Chuancun Yin
    Abstract: In this paper, we study two classes of optimal reinsurance models from perspectives of both insurers and reinsurers by minimizing their convex combination where the risk is measured by a distortion risk measure and the premium is given by a distortion premium principle. Firstly, we show that how optimal reinsurance models for the unconstrained optimization problem and constrained optimization problems can be formulated in a unified way. Secondly, we propose a geometric approach to solve optimal reinsurance problems directly. This paper considers a class of increasing convex ceded loss functions and derives the explicit solutions of the optimal reinsurance which can be in forms of quota-share, stop-loss, change-loss, the combination of quota-share and change-loss or the combination of change-loss and change-loss with different retentions. Finally, we consider two specific cases: Value at Risk (VaR) and Tail Value at Risk (TVaR).
    Date: 2018–07
  6. By: Daniele Bianchi; Monica Billio; Roberto Casarin; Massimo Guidolin
    Abstract: We propose a Markov Switching Graphical Seemingly Unrelated Regression (MS-GSUR) model to investigate time-varying systemic risk based on a range of multi-factor asset pricing models. Methodologically, we develop a Markov Chain Monte Carlo (MCMC) scheme in which latent states are identified on the basis of a novel weighted eigenvector centrality measure. An empirical application to the constituents of the S&P100 index shows that cross-firm connectivity significantly increased over the period 1999-2003 and during the financial crisis in 2008-2009. Finally, we provide evidence that firm-level centrality does not correlate with market values and it is instead positively linked to realized financial losses. Keywords: Markov Regime-Switching, Weighted Eigenvector Centrality, Graphical Models, MCMC, Systemic Risk, Network Connectivity JEL codes: C11, C15, C32, C58
    Date: 2018
  7. By: Diane Pierret (University of Lausanne and Swiss Finance Institute); Roberto Steri (University of Lausanne and Swiss Finance Institute)
    Abstract: We investigate the risk taking incentives of "stressed banks" — the banks that are subject to annual regulatory stress tests in the U.S. since 2011. We document that stress tests effectively encourage prudent investment from stressed banks through regulatory monitoring, but also provide them with steeper risk-taking incentives through tighter capital requirements. Our results highlight the importance of regulatory monitoring of banks' portfolios in parallel to setting more stringent capital requirements.
    Keywords: Capital Regulation, Dodd-Frank Act, Regulatory Monitoring, Stress Tests
    JEL: G01 G21 G28
    Date: 2017–11
  8. By: Sun, Baojing
    Abstract: The focus in this study is on estimating the underlying weather index for pricing financial derivatives to hedge weather risks in crop production. Different index estimation methods for growing degree days (GDDs) are compared. In particular, daily average temperatures for deriving GDDs are simulated using an econometric model and a stochastic process that uses three methods to estimate the mean-reversion parameter. Finally, the historical approach based on a five-year moving average of GDDs is compared with the econometric and stochastic models. Results indicate that econometric model provides the best fit, followed by the the historical average method and then the stochastic process with a high mean reversion parameter. Premiums from the econometric model with sine function and historical average approaches are closer to those based on realized weather values compared with the stochastic approach. Therefore, the econometric model with sine function and the historical average approach provide better pricing estimates than other methods.
    Keywords: Agricultural Finance, Crop Production/Industries
    Date: 2017–05–10
  9. By: Jamal Bouoiyour (CATT - Centre d'Analyse Théorique et de Traitement des données économiques - UPPA - Université de Pau et des Pays de l'Adour); Refk Selmi (CATT - Centre d'Analyse Théorique et de Traitement des données économiques - UPPA - Université de Pau et des Pays de l'Adour)
    Abstract: Understanding the transmission process between markets is critical for risk management and economic policy. The objective of this paper is twofold. First, it identifies when UK and European (France, Germany, Italy and Spain) Credit Default Swaps (CDSs) exhibit explosivity with respect to their past behaviors. Second, it quantifies the dynamics of CDS volatility spillover effects surrounding the UK's EU membership referendum commonly known as " Brexit ". Using a recursive identification algorithm and new spillover measures suggested by Diebold and Yilmaz (2012), quite interesting results were drawn. We detect significant build-ups in CDS prices for all countries under study soon after the day relative to the announcement of Brexit. Besides, we show that the great uncertainty over Brexit generates significant volatility spillovers across the underlined CDS. In particular, we find that UK, Italy and Spain are the " net volatility transmitters " , while France and Germany seem the " net volatility receivers ". Such information can help policy makers in undertaking decoupling policies to (1) insulate the economy from risk spillovers effects, (2) lighten the spread of the damage done by Brexit and (3) preserve the stability of financial system. To attenuate the risk transmission across CDS markets over Brexit, regulators can, for example, put forth preventive strategies by foregrounding the most influential volatility senders (UK, Italy and Spain).
    Keywords: Volatility spillover effects,Brexit,Credit Default Swaps,Explosivity,UK,Europe
    Date: 2018–07–31
  10. By: Magdalena Tywoniuk (University of Geneva and Swiss Finance Institute)
    Abstract: Recent regulation mandating the clearing of credit default swaps (CDS) by a Central Clearing Counterparties (CCP), has rendered the latter a systemically important institution, whose failure poses a serious threat to global financial stability. This work investigates the potential failure of a CCP initiated by the default of a large dealer bank and the unwinding of its positions. The theoretical model examines variation margin exchange between dealer banks and the price impact of liquidation and predatory selling. It provides a measure of covariance between assets in banks’ portfolios; price impact affects assets to varying degrees, based on their relative distance to defaulted assets. Key results show that liquidation lowers CCP profits, and how predation decreases the profits of all members, pushing banks to default. Furthermore, a hybrid CCP (vs. current) structure provides a natural disciplinary mechanism for predation. Also, it more incentive compatible for the CCP, in expectation of a large loss. A multi-period, dynamic simulation, calibrated to market data, provides parameter sensitivities, as well as, regulatory implications for a Lender of Last Resort in various liquidity scenarios.
    Keywords: Systemic Risk, CCP Recovery, CDS, CDS Spread Fire Sales, Liquidation, Predation, Price Impact, Contagion, Financial Network, Over the Counter Markets.
    JEL: G00 G01 G02 G14 G10 G18 G20 G23 G33
    Date: 2017–09
  11. By: Stefano Cosma; Francesca Pancotto; Paola Vezzani
    Abstract: In many countries, Banking Authorities have adopted an Alternative Dispute Resolution (ADR) procedure to manage complaints that customers and financial intermediaries cannot solve by themselves. As a consequence, banks have had to implement complaint management systems in order to deal with customers’ demands. The growth rate of customer complaints has been increasing during the last few years. This does not seem to be only related to the quality of financial services or to lack of compliance in banking products. Another reason lies in the characteristics of the procedures themselves, which are very simple and free of charge. The paper analyzes some determinants regarding the willingness to complain. In particular, it examines whether a high customers’ probability of default leads to an increase in non-valid complaints. The paper uses a sample of approximately 1,000 customers who received a loan and made a claim against the lender. The analysis shows that customers with higher Probability of Default are more likely to make claims against Financial Institutions. Moreover, it shows that opportunistic behaviors and non-valid complaints are more likely if the customer is supported by a lawyer or other professionals and if the reason for the claim may result in a refund or damage compensation.
    Keywords: Alternative Dispute Resolution (ADR); credit complaints; consumer credit; customer relationship
    JEL: G21 G23
    Date: 2018–03
  12. By: BENGUI, Julien; PHAN, Toan
    Abstract: We develop a simple model of defaultable debt and rational bubbles in the price of an asset, which can be pledged as collateral in a competitive credit pool. When the asset pledgeability is low, the down payment is high, and bubble investment is unleveraged, as in a standard rational bubble model. When the pledgeability is high, the down payment is low, making it easier for leveraged borrowers to invest in the bubbly asset. As loans are packaged together into a competitive pool, the pricing of individual default risk may facilitate risk-taking. In equilibrium, credit-constrained borrowers may optimally choose a risky leveraged investment strategy – borrow to invest in the bubbly asset and default if the bubble bursts. The model predicts joint boom-bust cycles in asset prices and securitized credit.
    Keywords: Rational bubbles; collateral; credit pool; household debt; equilibrium default
    JEL: E12 E24 E44 G01
    Date: 2018
  13. By: Marinela Adriana Finta; José Renato Haas Ornelas
    Abstract: This paper investigates the role of realized, implied and risk premium moments (variance and skewness) for commodities’ future returns. We estimate these moments from high frequency and commodity futures option data that results in forward-looking measures. Risk premium moments are computed as the difference between implied and realized moments. We highlight, from a cross-sectional and time-series perspective, the strong positive relation between commodity returns and implied skewness. Moreover, we emphasize the high performance of skewness risk premium. Additionally, we show that their portfolios exhibit the best risk-return tradeoff. Most of our results are robust to other factors such as the momentum and roll yield
    Date: 2018–07
  14. By: Neil Bhutta; Benjamin J. Keys
    Abstract: In the U.S. mortgage market, private mortgage insurance (PMI) is mandated for high-leverage mortgages purchased by Fannie Mae and Freddie Mac to serve as a private market check on GSE risk-taking. However, we document that PMI firms dramatically expanded insurance on high-risk mortgages at the tail-end of the housing boom, contradicting the industry's own research regarding house price risk. Using three detailed sources of mortgage and insurance data, we examine PMI application denial rates, default rates on PMI-backed loans, and growth rates of high-leverage lending around the GSE conforming loan limit, along with information extracted from company, industry and regulatory filings and reports. We conclude that PMI behavior during the housing boom in part reflects a "moral hazard" incentive inherent to insurance companies in general to underprice risk and be undercapitalized. Our results suggest that rather than providing discipline, private mortgage insurers facilitated GSE risk-taking.
    JEL: G21 G22 L10 L14
    Date: 2018–07
  15. By: McKendree, Melissa G.S.; Tonsor, Glynn T.; Schulz, Lee L.
    Keywords: Agribusiness, Farm Management, Livestock Production/Industries, Marketing, Production Economics, Risk and Uncertainty
    Date: 2017–10–23
  16. By: Hansjoerg Albrecher (University of Lausanne and Swiss Finance Institute); Daniel Bauer (University of Alabama); Paul Embrechts (Swiss Federal Institute of Technology Zurich and Swiss Finance Institute); Damir Filipović (Ecole Polytechnique Fédérale de Lausanne and Swiss Finance Institute); Pablo Koch-Medina (University of Zurich and Swiss Finance Institute); Ralf Korn (University of Kaiserslautern); Stéphane Loisel (University of Lyon 1); Antoon Pelsser (Maastricht University); Frank Schiller (MunichRe); Hato Schmeiser (University of Muenster and University of St. Gallen); Joël Wagner (University of Lausanne and Swiss Finance Institute)
    Abstract: This is a summary of the main topics and findings from the Swiss Risk and Insurance Forum 2017. That event gathered experts from academia, insurance industry, regulatory bodies, and consulting companies to discuss past and current developments as well as future perspectives in dealing with asset-liability management for long-term insurance business. Topics include valuation, innovations in insurance products, investment, and modelling aspects.
    Keywords: asset-liability management, long-term insurance, valuation, insurance products, investments, models
    JEL: G22 G11
    Date: 2017–12
  17. By: Phume, Maphelane Palesa; Bonga-Bonga, Lumengo
    Abstract: South Africa and Nigeria are the wo biggest African economies by the size of their economies, translated in their gross domestic product (GDP). Portfolio investors who are interested to invest in the African stock markets should be interested in uncovering whether the two stock exchange markets complement and provide the opportunity for asset diversification or that the two markets are strictly substitutable. It is in that context that this paper evaluates the cross-transmission of returns and volatility shocks between the two countries to infer the extent of interdependence of the two stock exchange markets. Moreover, the paper makes inferences on optimal portfolio weights and hedge ratios when holding assets from the two markets. To that end, estimations based on multivariate GARCH (general autoregressive conditional heteroscedastic) model are used. The results of the empirical analysis suggest evidence of stock market returns and volatility spillovers from South African stock markets to Nigerian stock markets , and not other way around. Moreover, the results suggest that it is ideal to constitute a portfolio and set an optimal hedge ratio by combining assets from the South African and Nigerian stock markets and that investors should engage in dynamic rebalancing of portfolio weights and hedge ratio.
    Keywords: South Africa, Nigeria, return and volatility soillovers, equity markets, portfolio selection, hedge ratio.
    JEL: C5 G11 G15
    Date: 2018–05–16
  18. By: de Groot, Oliver (University of St. Andrews); Richter, Alexander W. (Federal Reserve Bank of Dallas); Throckmorton, Nathaniel (College of William & Mary)
    Abstract: The recent asset pricing literature finds valuation risk is an important determinant of key asset pricing moments. Valuation risk is modelled as a time preference shock within Epstein-Zin recursive utility preferences. While this form of valuation risk appears to fit the data extremely well, we show the preference specification violates an economically meaningful restriction on the weights in the Epstein-Zin time-aggregator. The same model with the corrected preference specification performs nearly as well at matching asset pricing moments, but only if the risk aversion parameter is well above the accepted range of values used in the literature. When the corrected preference specification is combined with Bansal-Yaron long-run risk, the estimated model significantly downgrades the role of valuation risk in determining asset prices. The only significant contribution of valuation risk is to help match the volatility of the risk-free rate.
    Keywords: Epstein-Zin Utility; Valuation Risk; Equity Premium Puzzle; Risk-Free Rate Puzzle
    JEL: D81 G12
    Date: 2018–07–20
  19. By: Jakub Hajda (University of Lausanne and Swiss Finance Institute)
    Abstract: I develop a dynamic capital structure model to examine how the nature of risk affects firm’s debt policy. In the model, firm’s fundamental risk, captured by its cash flow process, consists of transitory and persistent parts with markedly different dynamics. The model explains the observed dispersion in the risk-leverage relationship. Firms with similar total volatility adopt distinctive debt policies when the composition of their risk differs and issue less debt when their cash flows are more persistent to preserve debt capacity needed to fund investment. The model also provides rationale why the observable dispersion in cash flow persistence is low, which is at odds with the large degree of heterogeneity in other firm characteristics, as well as why persistence and leverage are weakly related in the data.
    Keywords: dynamic capital structure, fundamental risk, transitory and persistent shocks, leverage-risk trade-off
    JEL: G31 G32
    Date: 2017–11
  20. By: Massimiliano Affinito (Bank of Italy); Matteo Piazza (Bank of Italy)
    Abstract: This paper joins the debate on the growing use of CCPs in interbank markets by analysing a scarcely explored source of risk. Namely, that central clearing may provide riskier banks that are cut off from the bilateral segment with another means of accessing the interbank market, thereby eluding market discipline and potentially increasing the risks borne by the financial system. We investigate this issue using monthly granular data on Italian banks from January 2004 to June 2013, and find that during the global financial crisis riskier banks increased the share of their interbank funding obtained via CCPs due to both the impact of general market uncertainty and heightened attention to counterparty risk in the bilateral segment of the market. More tellingly, we show that, for riskier banks only, this increase was accompanied by a decline in the duration of bilateral relationships, indicating that longer-standing counterparts, typically the most informed ones, withdrew from these relationships. This suggests that, compared with banks operating in the bilateral segment, on average banks working with CCPs may be riskier, confirming the importance of ongoing efforts to ensure that CCPs have a proper risk management framework.
    Keywords: CCPs, central clearing, central counterparties, financial crisis, interbank markets, networks, interbank lending relationships
    JEL: E58 G21
    Date: 2018–07
  21. By: S. Valeyre; D. S. Grebenkov; S. Aboura
    Abstract: The correlation matrix is the key element in optimal portfolio allocation and risk management. In particular, the eigenvectors of the correlation matrix corresponding to large eigenvalues can be used to identify the market mode, sectors and style factors. We investigate how these eigenvalues depend on the time scale of securities returns in the U.S. market. For this purpose, one-minute returns of the largest 533 U.S. stocks are aggregated at different time scales and used to estimate the correlation matrix and its spectral properties. We propose a simple lead-lag factor model to capture and reproduce the observed time-scale dependence of eigenvalues. We reveal the emergence of several dominant eigenvalues as the time scale increases. This important finding evidences that the underlying economic and financial mechanisms determining the correlation structure of securities depend as well on time scales.
    Date: 2018–07
  22. By: Tho Pham (School of Management, Swansea University); Oleksandr Talavera (School of Management, Swansea University); Andriy Tsapin (National Bank of Ukraine; National University of Ostroh Academy)
    Abstract: This paper examines the link between branch network structure and bank lending. The unique dataset allows us to differentiate the structures of contact points which do not have decision-making authority and delegated branches which can affect loan decisions. We find that a large and dispersed network of contact points can help increase credit supply and mitigate risks through diversification. Further, banks benefit from information advantage brought by the dispersion of delegated branches. However, longer distance between headquarters and local delegations can also amplify agency problems, which outweigh the benefits. Our findings suggest that the optimal structure could be the centralized network of delegated branches combined with the diversified access point network.
    Keywords: consolidation, centralization, decision-making, risk management, lending, access points, delegated branches
    JEL: G01 G21
    Date: 2018–08

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