nep-rmg New Economics Papers
on Risk Management
Issue of 2018‒09‒03
sixteen papers chosen by
Stan Miles
Thompson Rivers University

  1. Scenario-based Risk Evaluation By Ruodu Wang; Johanna F. Ziegel
  3. U.S. shale producers: a case of dynamic risk management? By Ferriani, Fabrizio; Veronese, Giovanni
  4. Scalar multivariate risk measures with a single eligible asset By Zachary Feinstein; Birgit Rudloff
  5. A factor-model approach for correlation scenarios and correlation stress-testing By Natalie Packham; Fabian Woebbeking
  6. Business Complexity and Risk Management: Evidence from Operational Risk Events in U.S. Bank Holding Companies By Anna Chernobai; Ali Ozdagli; Jianlin Wang
  7. Is size everything? By Antill, Samuel; Sarkar, Asani
  8. On smile properties of volatility derivatives and exotic products: understanding the VIX skew By Elisa Al\`os; David Garc\'ia-Lorite; Aitor Muguruza
  9. Price Risk Management: Are Futures Markets Adequate? By Bullock, J. Bruce
  10. Life Insurance and Life Settlement Markets with Overconfident Policyholders By Hanming Fang; Zenan Wu
  11. Risks and Returns of Cryptocurrency By Yukun Liu; Aleh Tsyvinski
  12. Demand and potential subsidy level for forest insurance market in Demand and potential subsidy level for forest insurance market in Italy By Cipollaro, Maria; Sacchelli, Sandro
  13. A Profit-to-Provisioning Approach to Setting the Countercyclical Capital Buffer: The Czech Example By Lukas Pfeifer; Martin Hodula
  14. Dissecting the ‘doom loop’: the bank-sovereign credit risk nexus during the US debt ceiling crisis By Gori, Filippo
  15. Ausgewählte Instrumente zum Risikomanagement in der Landwirtschaft: Systematische Zusammenstellung und Bewertung By Offermann, Frank; Efken, Josef; Ellßel, Raphaela; Hansen, Heiko; Klepper, Rainer; Weber, Sascha
  16. The Effects of the Margin Protection Program for Dairy Producers By Mark, Tyler B.; Burdine, Kenneth H.; Cessna, Jerry; Dohlman, Erik

  1. By: Ruodu Wang; Johanna F. Ziegel
    Abstract: Risk measures such as Expected Shortfall (ES) and Value-at-Risk (VaR) have been prominent in banking regulation and financial risk management. Motivated by practical considerations in the assessment and management of risks, including tractability, scenario relevance and robustness, we consider theoretical properties of scenario-based risk evaluation. We propose several novel scenario-based risk measures, including various versions of Max-ES and Max-VaR, and study their properties. We establish axiomatic characterizations of scenario-based risk measures that are comonotonic-additive or coherent and an ES-based representation result is obtained. These results provide a theoretical foundation for the recent Basel III & IV market risk calculation formulas. We illustrate the theory with financial data examples.
    Date: 2018–08
  2. By: Kireum, Mercy
    Abstract: Agriculture is a sector that is sensitive to climate variability and extreme weather conditions such as droughts and floods. The occurrence of these events is predicted to increase in frequency and intensity due to climate change. These events have adverse effects on agriculture especially rain-fed agriculture which is significantly exposed to weather leading to food insecurity for millions of people. As a result, it is necessary to determine approaches that ensure better estimation and management of resources needed given the occurrence of these extreme weather events. This is important for better financial risk management and consequently enhancing sustainable growth of the agricultural sector. In this study, we explore the application of Value at Risk (VaR) method in estimating financial loss as a result of drought. Agricultural loss as a result of rainfall variability and drought is calculated. Extreme Value Theory (EVT) is used to model the distribution of the agricultural loss. The VaR method is used to determine the catastrophic risk. Future actions will be proposed with a view enhancing financial risk management in the agricultural sector. This has the potential to enhance resilience to disasters.
    Keywords: Agricultural and Food Policy, Agricultural Finance, Community/Rural/Urban Development, Crop Production/Industries, Environmental Economics and Policy
    Date: 2016–08–25
  3. By: Ferriani, Fabrizio; Veronese, Giovanni
    Abstract: Using more than a decade of firm-level data on U.S. oil producers’ hedging portfolios, we document for the first time a strong positive link between net worth and hedging in the oil producing sector. We exploit as quasi-natural experiments two similarly dramatic oil price slumps, in 2008 and in 2014-2015, and we show how a shock to net worth differently affects risk management practices among E&P firms. The link between net worth and hedging decisions holds in both episodes, but in the second oil slump we also find a significant role of leverage and credit constraints in reducing the hedging activity, a result that we attribute to the marked increase in leverage following the diffusion of the shale technology. Finally, we test if collateral constraints also impinge the extensive margin of risk management. Though in this case the effect is less apparent, our results generally points to a more limited use of linear derivative contracts when firms’ net worth increases.
    Keywords: dynamic risk management, hedging, derivatives, shale revolution, oil price collapse
    JEL: D22 G00 G32
    Date: 2018
  4. By: Zachary Feinstein; Birgit Rudloff
    Abstract: In this paper we present results on scalar risk measures in markets with transaction costs. Such risk measures are defined as the minimal capital requirements in the cash asset. First, some results are provided on the dual representation of such risk measures, with particular emphasis given on the space of dual variables as (equivalent) martingale measures and prices consistent with the market model. Then, these dual representations are used to obtain the main results of this paper on time consistency for scalar risk measures in markets with transaction costs. It is well known from the typical example, the superhedging risk measure in markets with transaction costs (expressed in the cash asset) as in Jouini and Kallal (1995), Roux and Zastawniak (2016), and Loehne and Rudloff (2014), that the usual scalar concept of time consistency is too strong and not satisfied. More generally, when it comes to scalarizing a multivariate risk measure with the same scalarization weight at each time (as this is the case in this paper as the risk measures are expressed in the cash asset), one cannot expect these scalar risk measures to be time consistent. This aligns with recent research on scalarizations of multivariate problems as in Karnam et al. (2017) and Kovacova and Rudloff (2018). Surprisingly, we will show that a weaker notion of time consistency can be defined, which corresponds to the usual scalar time consistency but under any fixed consistent pricing process. We will prove the equivalence of this weaker notion of time consistency and a certain type of backward recursion with respect to the underlying risk measure with a fixed consistent pricing process. Several examples are given, with special emphasis on the superhedging risk measure.
    Date: 2018–07
  5. By: Natalie Packham; Fabian Woebbeking
    Abstract: In 2012, JPMorgan accumulated a USD 6.2 billion loss on a credit derivatives portfolio, the so-called "London Whale", partly as a consequence of de-correlations of non-perfectly correlated positions that were supposed to hedge each other. Motivated by this case, we devise a factor model for correlations that allows for scenario-based stress-testing of correlations. We derive a number of analytical results related to a portfolio of homogeneous assets. Using the concept of Mahalanobis distance, we show how to identify adverse scenarios of correlation risk. As an example, we apply the factor-model approach to the "London Whale" portfolio and determine the value-at-risk impact from correlation changes. Since our findings are particularly relevant for large portfolios, where even small correlation changes can have a large impact, a further application would be to stress-test portfolios of central counterparties, which are of systemically relevant size.
    Date: 2018–07
  6. By: Anna Chernobai (Syracuse University); Ali Ozdagli (Federal Reserve Bank of Boston); Jianlin Wang (University of California Berkeley)
    Abstract: Recent regulatory proposals tie a financial institution's systemic importance to its complexity. However, little is known about how complexity affects banks' risk management. Using the 1996-1999 deregulation of banks' nonbanking activities as a natural experiment, we show that U.S. banks' operational risk increased significantly with their business complexity. This trend is stronger for banks that were constrained by regulations beforehand, especially for those with a Section 20 subsidiary, compared to other banks and also to nonbank financial institutions that were never subject to these regulations. We provide evidence that this pattern results from managerial failure rather than strategic risk taking.
    Date: 2018
  7. By: Antill, Samuel (Stanford Graduate School of Business); Sarkar, Asani (Federal Reserve Bank of New York)
    Abstract: We examine sources of systemic risk (threshold size, complexity, and interconnectedness) with factors constructed from equity returns of large financial firms, after accounting for standard risk factors. From the factor loadings and factor returns, we estimate the implicit government subsidy for each systemic risk measure, and find that, from 1963 to 2006, only our big-versus-huge threshold size factor, TSIZE, implies a positive implicit subsidy on average. Further, pre-2007 TSIZE-implied subsidies predict the Federal Reserve’s liquidity facility loans and the Treasury’s TARP loans during the crisis, both in the time series and the cross section. TSIZE-implied subsidies increase around the bailout of Continental Illinois in 1984 and the Gramm-Leach-Bliley Act of 1999, as well as around changes in Fitch Support Ratings indicating higher probability of government support. Since 2007, however, the relative share of TSIZE-implied subsidies falls, especially after Lehman’s failure, whereas complexity and interconnectedness-implied subsidies are substantial, resulting in an almost sevenfold increase in total implicit subsidies. The results, which survive a variety of robustness checks, indicate that the market’s perception of the sources of systemic risk changes over time.
    Keywords: “too big to fail”; systemic risk; implicit subsidies; interconnectedness; complexity; financial crisis; bailout; TARP; Fed; GSIB
    JEL: G01 G12 G21 G28
    Date: 2018–08–01
  8. By: Elisa Al\`os; David Garc\'ia-Lorite; Aitor Muguruza
    Abstract: We develop a method to study the implied volatility for exotic options and volatility derivatives with European payoffs such as VIX options. Our approach, based on Malliavin calculus techniques, allows us to describe the properties of the at-the-money implied volatility (ATMI) in terms of the Malliavin derivatives of the underlying process. More precisely, we study the short-time behaviour of the ATMI level and skew. As an application, we describe the short-term behavior of the ATMI of VIX and realized variance options in terms of the Hurst parameter of the model, and most importantly we describe the class of volatility processes that generate a positive skew for the VIX implied volatility. In addition, we find that our ATMI asymptotic formulae perform very well even for large maturities. Several numerical examples are provided to support our theoretical results.
    Date: 2018–08
  9. By: Bullock, J. Bruce
    Keywords: Demand and Price Analysis, Risk and Uncertainty
  10. By: Hanming Fang (Department of Economics, University of Pennsylvania); Zenan Wu (Department of Economics, Peking University)
    Abstract: We analyze how the life settlement market - the secondary market for life insurance - may affect consumer welfare in a dynamic equilibrium model of life insurance with one-sided commitment and overconfident policyholders. As in Daily et al. (2008) and Fang and Kung (2010), policyholders may lapse their life insurance policies when they lose their bequest motives; but in our model the policyholders may underestimate their probability of losing their bequest motive, or be overconfident about their future mortality risks. For the case of overconfidence with respect to bequest motives, we show that in the absence of life settlement overconfident consumers may buy too much" reclassiffication risk insurance for later periods in the competitive equilibrium. In contrast, when consumers are overconfident about their future mortality rates in the sense that they put too high a subjective probability on the low-mortality state, the competitive equilibrium contract in the absence of life settlement exploits the consumer bias by offering them very high face amounts only in the low-mortality state. In both cases, life settlement market can impose a discipline on the extent to which overconfident consumers can be exploited by the primary insurers. We show that life settlement may increase the equilibrium consumer welfare of overconfident consumers when they are sufficiently vulnerable in the sense that they have a sufficiently large intertemporal elasticity of substitution of consumption.
    Keywords: life insurance, secondary market, overconfidence
    JEL: D03 D86 G22 L11
    Date: 2017–03–20
  11. By: Yukun Liu; Aleh Tsyvinski
    Abstract: We establish that the risk-return tradeoff of cryptocurrencies (Bitcoin, Ripple, and Ethereum) is distinct from those of stocks, currencies, and precious metals. Cryptocurrencies have no exposure to most common stock market and macroeconomic factors. They also have no exposure to the returns of currencies and commodities. In contrast, we show that the cryptocurrency returns can be predicted by factors which are specific to cryptocurrency markets. Specifically, we determine that there is a strong time-series momentum effect and that proxies for investor attention strongly forecast cryptocurrency returns. Finally, we create an index of exposures to cryptocurrencies of 354 industries in the US and 137 industries in China.
    JEL: G12 G32
    Date: 2018–08
  12. By: Cipollaro, Maria; Sacchelli, Sandro
    Abstract: The projections for climate change in the coming decades highlight that European and Mediterranean forests will have to deal with negative biotic and abiotic impacts. Extreme meteorological events seem to be one of the main source of risk. Financial strategies can be a form of risk management. In this framework the work analyse the Willingness to Stipulate forest insurance schemes at national level by owners and managers of stands, based on owners characteristics, forest typology and localization as well as Willingness To Pay. Results are also defined at spatial level (macroregions for Italy: northern, central and southern regions) in order to be compared with premium. Preliminary results confirm how WTP is related with both statistical and perceived risk of damage. Moreover, forest owners appear more available to pay for insurance in case of high forest (in particular coniferous) in respect to coppices. Among motivations for not stipulating insurance, the main reason seems to be the preference for alternative form of risk management (e.g. post-event public compensation or silvicultural interventions). The paper stresses the difference between premium and WTP depicting the area where public subsidy could have a greater impact for insurance diffusion. Finally, discussion for future improvements and integration of the research are performed.
    Keywords: Agricultural and Food Policy, Environmental Economics and Policy
    Date: 2018–07–21
  13. By: Lukas Pfeifer; Martin Hodula
    Abstract: Over the last few years, national macroprudential authorities have developed different strategies for setting the countercyclical capital buffer (CCyB) rate in the banking sector. The existing approaches are based on various indicators used to identify the current phase of the financial cycle. However, to our knowledge, there is no approach that directly takes into consideration banks' prudential behavior over the financial cycle as well as cyclical risks in the banking sector. In this paper, we propose a new profit-to-provisioning approach that can be used in the macroprudential decision-making process. We construct a new set of indicators that largely capture the risk of cyclicality of profit and loan loss provisions. We argue that banks should conserve a portion of the cyclically overestimated profit (non-materialized expected loss) in their capital during a financial boom. We evaluate the performance of our newly proposed indicators using two econometric exercises. Overall, they exhibit good statistical properties, are relevant to the CCyB decision-making process, and may contribute to a more precise assessment of both systemic risk accumulation and risk materialization. We believe that the relevance of the profit-to-provisioning approach and the related set of newly proposed indicators increases under IFRS 9.
    Keywords: Banking prudence indicators, countercyclical capital buffer, financial stability, macroprudential policy, profit-to-provisioning approach
    JEL: E58 G21 G28
    Date: 2018–05
  14. By: Gori, Filippo
    Abstract: Political events matter in economics. This paper uses the 2011 political standoff over the rise of the US debt ceiling to characterise an instrument that is then used to estimate the impact of sovereign on bank credit risk. Results show that a 100 basis points increase in the US sovereign default risk implies a 41 basis points increase in bank credit risk; this effect is about three times larger than the corresponding effect of bank default risk on sovereign’s. Finally, calculation suggest that during the first two quarters of 2011, as a consequence of the debt ceiling crisis, US bank funding costs increased by approximately 18 basis points.
    Keywords: Banks, Sovereign default risk
    JEL: G18 G21 G28
    Date: 2018–07–06
  15. By: Offermann, Frank; Efken, Josef; Ellßel, Raphaela; Hansen, Heiko; Klepper, Rainer; Weber, Sascha
    Abstract: Zusammenfassung In Deutschland ist das Interesse an (neuen) Risikomanagementinstrumente n für die Landwir t- schaft in letzter Zeit stark gestiegen. Vor diesem Hintergrund erfolgt i n diesem Working Paper eine systematische Zusammenstellung und Bewertung ausgewählter Instrumente zum Ris ikom a- nagement in der Landwirtschaft. Der Fokus liegt dabei auf außerbetriebli chen Risikomanage- mentinstrumenten, die in Deutschland derzeit nicht weit verbreitet sind oder deren Ausgesta l- tung aktuell besonders intensiv diskutiert wird. Ein weiterer Schwerpu nkt der Analysen liegt auf der exemplarischen Kostenabschätzung der Implementierung neuer Ansätze in Deut schland. Die Ergebnisse zeigen, dass eine große Vielfalt an potenziellen Instrumenten zur Verbesserung des RisikoŵaŶageŵeŶts iŶ der LaŶdǁirtsĐhaft existiert. IŶstruŵeŶte, die aŶ der AŶsatzstell e ‚Erlös‘ ansetzen, spielen in den USA eine große Rolle, sind jedoch in der EU bisher kaum verbreitet. I n- strumente, die an übergeordneten Erfolgskriterien wie Margen oder Einkommen an setzen, bi e- ten eine hohe Effektivität der Absicherung. Sie stellen aber in der praktisch en Umsetzung oft enorme Anforderungen an die Administration/Verwaltung. Dies kann als wesentl icher Er klä- rungsgrund für die auch international vergleichsweise geringe Verbreitung entsprec hender I n- strumente gesehen werden. Indexbasierte (staatlich unterstützte) Absicherungen si nd in den USA vergleichsweise weit verbreitet, werden in europäischen Ländern derzeit jedoch nur vereinzelt angeboten. Hier besteht Potenzial für zukünftige Weiterentwicklungen , die das Basisrisiko i nde x- basierter Ansätze reduzieren . Abstract Interest in (new) risk management instruments for agriculture has greatly increased in Germany in recent years. Against this background, this working paper provides a systematic compilation and assessment of selected instruments for managing risk in agriculture, focu sing on off-farm risk management instruments which are not yet widely used in Germany or who se design is subject to current intensive discussions. In addition, the analyses provide an exemplary assessment of the potential costs of selected new instruments in Germany. The results show that a great variety of potential instruments to improve risk management in agriculture exists. Instru ments targeting revenues play an important role in the US but are not widespread in t he EU. The effectiveness of instruments which target financial success criteria like margins or income is high. However, the practical implementation of such instruments generally presents enormous ad ministrative chal- lenges, which is one of the key factors explaining their low prevalence . Index-based (subsided) protection schemes are comparably widespread in the US, while their availabil ity in Europe is limited to a few cases . There is potential for future further developments which reduce the basic risk inherent in index-based approaches.
    Keywords: Agricultural and Food Policy, Risk and Uncertainty
    Date: 2017–04–30
  16. By: Mark, Tyler B.; Burdine, Kenneth H.; Cessna, Jerry; Dohlman, Erik
    Abstract: The Margin Protection Program for Dairy Producers is a voluntary risk-management program for dairy farmers—it offers protection when the national average margin (the difference between the U.S. all-milk price and the estimated average feed cost) falls below a level selected by the dairy farmer. This study examines the potential impact of the program on average margins and risk at different levels of coverage for both the protected margin ($4.00-$8.00 per hundredweight) and the percentage of production history covered (25-90 percent). Margins are constructed for 13 major production regions, and risk-reduction levels are assessed using regional milk and feed prices as though the program had been in place during 2002-13. Results suggest that small operations (those with a 4-million-pound production history) would have seen increases in average margins and reductions in downside margin risk with more milk covered at higher coverage levels. Larger operations (those with a production history of 20 or 40 million pounds) would have generally seen increases in average margins when protected up to the $6.50 level, with margins being maximized at $6.00 coverage.
    Keywords: Agricultural and Food Policy, Livestock Production/Industries, Risk and Uncertainty
    Date: 2016–09–01

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