nep-rmg New Economics Papers
on Risk Management
Issue of 2018‒11‒12
twenty-one papers chosen by
Stan Miles
Thompson Rivers University

  1. Implications of bank regulation for loan supply and bank stability: A dynamic perspective By Bucher, Monika; Dietrich, Diemo; Hauck, Achim
  2. Expected Utility Maximization and Conditional Value-at-Risk Deviation-based Sharpe Ratio in Dynamic Stochastic Portfolio Optimization By Sona Kilianova; Daniel Sevcovic
  3. Asset-liability management in life insurance: Evidence from France By victor Lyonnet
  4. Systemic Financial Risk Indicators and Securitised Assets: an Agent-Based Framework By Mazzocchetti, Andrea; Lauretta, Eliana; Raberto, Marco; Teglio, Andrea; Cincotti, Silvano
  5. Residual Shape Risk on Czech Natural Gas Market By Karel Janda; Jakub Kourilek
  6. Model Risk Measurement Under Wasserstein Distance By Yu Feng; Erik Schlogl
  7. Systemic Greeks: Measuring risk in financial networks By Nils Bertschinger; Julian Stobbe
  8. Predicting Aggregate and State-Level US House Price Volatility: The Role of Sentiment By Rangan Gupta; Chi Keung Marco Lau; Wendy Nyakabawo
  10. A Relaxed Optimization Approach for Cardinality-Constrained Portfolio Optimization By Jize Zhang; Tim Leung; Aleksandr Aravkin
  11. Can we afford a defined benefit pension By Woon K. Wong
  12. An agent based early warning indicator for financial market instability By David Vidal-Tomás; Simone Alfarano
  13. Pricing American Options with Jumps in Asset and Volatility By Blessing Taruvinga; Boda Kang; Christina Sklibosios Nikitopoulos
  14. Asymmetric Connectedness of Fears in the U.S. Financial Sector By Jozef Barunik; Mattia Bevilacqua; Radu Tunaru
  15. "Bond risk premia and restrictions on risk prices" By Constantino Hevia; Martin Sola
  16. Why political risk matters for banking flows? By Ana Mafalda Vasconcelos
  17. Methods for Analytical Barrier Option Pricing with Multiple Exponential Time-Varying Boundaries By Otto Konstandatos
  18. Reflection for higher order risk preferences By Han (H.) Bleichrodt; Paul van Bruggen
  19. Quantifying the Model Risk Inherent in the Calibration and Recalibration of Option Pricing Models By Yu Feng; Ralph Rudd; Christopher Baker; Qaphela Mashalaba; Melusi Mavuso; Erik Schlogl
  20. Golden options in financial mathematics By Balbas Aparicio, Raquel; Balbas Aparicio, Beatriz; Balbás de la Corte, Alejandro
  21. Vanna-Volga Method for Normal Volatilities By Volodymyr Perederiy

  1. By: Bucher, Monika; Dietrich, Diemo; Hauck, Achim
    Abstract: A bank's decision on loan supply and capital structure determines its immediate bankruptcy risk as well as the future availability of internal funds. These internal funds in turn determine a bank's future costs of external finance and future vulnerability to bankruptcy risks. We study these intra- and intertemporal links and analyze the influence of risk-weighted capital-to-asset ratios, liquidity coverage ratios and regulatory margin calls on the dynamics of loan supply and bank stability. Only regulatory margin calls or large liquidity coverage ratios achieve bank stability for all risk levels, but for large risks a bank will stop credit intermediation.
    Keywords: bank lending,banking crisis,bank capital regulation,liquidity regulation
    JEL: G01 G21 G28 E32
    Date: 2018
  2. By: Sona Kilianova; Daniel Sevcovic
    Abstract: In this paper we investigate the expected terminal utility maximization approach for a dynamic stochastic portfolio optimization problem. We solve it numerically by solving an evolutionary Hamilton-Jacobi-Bellman equation which is transformed by means of the Riccati transformation. We examine the dependence of the results on the shape of a chosen utility function in regard to the associated risk aversion level. We define the Conditional value-at-risk deviation ($CVaRD$) based Sharpe ratio for measuring risk-adjusted performance of a dynamic portfolio. We compute optimal strategies for a portfolio investment problem motivated by the German DAX 30 Index and we evaluate and analyze the dependence of the $CVaRD$-based Sharpe ratio on the utility function and the associated risk aversion level.
    Date: 2018–10
  3. By: victor Lyonnet (CREST; HEC Paris)
    Abstract: This paper studies the asset-liability management of life insurers. We start with a life insurance investor’s problem of the optimal date to redeem; as a function of taxes and rates of return. The model predicts that life insurers whose investors’ contract age is relatively young should be more exposed to redemption risk. We then build a novel confidential dataset and test whether life insurers’ portfolio choice is responsive to redemption risk. Using different measures of redemption risk and controlling for year fixed effects; we find that a one standard deviation increase in redemption risk is associated with an average decrease in the share of directly-held stocks by 2.3% or slightly more than one-half of its standard deviation (4.5%). This result remains valid when accounting for indirect stock investment through funds. Finally; we check our model’s prediction that redemption risk depends on insurers’ investor contract age and use this to propose and exogenous measure of redemption risk and make a causal attempt.
    Keywords: Insurance companies, life insurance, surrender risk, redemption risk.
    JEL: G22 G28 G32
    Date: 2018–08–05
  4. By: Mazzocchetti, Andrea; Lauretta, Eliana; Raberto, Marco; Teglio, Andrea; Cincotti, Silvano
    Abstract: The paper presents an agent-based model of a credit economy which includes a securitisation process and a bailout mechanism for banks' bankruptcies. Within this model's framework banks are able to sell mortgages to a Financial Vehicle Corporation, which finances its activity by creating Mortgage-Backed Securities and selling them to a mutual fund. In turn, the mutual fund collects liquidity by selling shares to households and remunerating them with a monthly interest rate. The impact of this mechanism is analysed by means of computational experiments for different levels of securitisation propensities of banks. Furthermore, we study a set of systemic risk indicators which have the aim to assess financial imbalances within the financial system. Two of them are the mortgage-to-GDP ratio and the Capital Adequacy Ratio which are constructed to detect only the in-balance sheet changes in banks' credit exposure. We consider two additional indicators, similar to the previous ones with the only difference that they are able to account also for the off-balance sheet items. Moreover, we introduce a novel indicator, the so-called VUC indicator, which also targets the off-balance assets. Results confirm that higher securitisation propensities weaken the financial stability of banks with relevant effects on different sectors of the economy. Most important, the analysis of systemic risk reveals the important issue of designing suitable systemic risk indicators for predicting incoming financial crises, finding that an essential feature of these indicators should be to integrate banks' off-balance sheet assets.
    Keywords: sytemic financial risk indicators, securitisation, housing market, agent-based models
    JEL: C63 G21 G23 R31
    Date: 2018–10–24
  5. By: Karel Janda (Institute of Economic Studies, Faculty of Social Sciences, Charles University in Prague, Smetanovo nabrezi 6, 111 01 Prague 1, Czech Republic; Department of Banking and Insurance, Faculty of Finance and Accounting, University of Economics, Namesti Winstona Churchilla 4, 13067 Prague, Czech Republic); Jakub Kourilek (Institute of Economic Studies, Faculty of Social Sciences, Charles University in Prague, Smetanovo nabrezi 6, 111 01 Prague 1, Czech Republic)
    Abstract: This paper introduces residual shape risk as a new subclass of energy commodity risk. Residual shape risk is caused by insufficient liquidity of energy forward market when retail energy supplier has to hedge his short sales by a non-exible standard baseload product available on wholesale market. Because of this inflexibility energy supplier is left with residual unhedged position which has to be closed at spot market. The residual shape risk is defined as a difference between spot and forward prices weighted by residual unhedged position which size depends on the shape of customers' portfolio of a given retail energy supplier. For empirical evaluation of residual shape risk we use a real portfolio of a leading natural gas retail supplier in the Czech Republic over the period 2016-2017. The size of residual shape risk in our example corresponds approximately to 1 percent of profit margin of natural gas retail supplier.
    Keywords: natural gas markets, spot prices, forward prices, residual shape risk
    JEL: C51 C58 Q41 Q47
    Date: 2018–10
  6. By: Yu Feng (Finance Discipline Group, UTS Business School, University of Technology Sydney); Erik Schlogl (Finance Discipline Group, UTS Business School, University of Technology Sydney)
    Abstract: The paper proposes a new approach to model risk measurement based on the Wasserstein distance between two probability measures. It formulates the theoretical motivation resulting from the interpretation of fictitious adversary of robust risk management. The proposed approach accounts for all alternative models and incorporates the economic reality of the fictitious adversary. It provides practically feasible results that overcome the restriction and the integrability issue imposed by the nominal model. The Wasserstein approach suits for all types of model risk problems, ranging from the single-asset hedging risk problem to the multi-asset allocation problem. The robust capital allocation line, accounting for the correlation risk, is not achievable with other non-parametric approaches.
    Date: 2018–09–01
  7. By: Nils Bertschinger; Julian Stobbe
    Abstract: Since the latest financial crisis, the idea of systemic risk has received considerable interest. In particular, contagion effects arising from cross-holdings between interconnected financial firms have been studied extensively. Drawing inspiration from the field of complex networks, these attempts are largely unaware of models and theories for credit risk of individual firms. Here, we note that recent network valuation models extend the seminal structural risk model of Merton (1974). Furthermore, we formally compute sensitivities to various risk factors -- commonly known as Greeks -- in a network context. In particular, we propose the network $\Delta$ as a quantitative measure of systemic risk and illustrate our findings on some numerical examples.
    Date: 2018–10
  8. By: Rangan Gupta (Department of Economics, University of Pretoria, Pretoria, South Africa); Chi Keung Marco Lau (Huddersfield Business School, University of Huddersfield, Huddersfield, United Kingdom); Wendy Nyakabawo (Department of Economics, University of Pretoria, Pretoria, South Africa)
    Abstract: This paper examines the predictive ability of housing-related sentiment on housing market volatility for 50 states, District of Columbia, and the aggregate US economy, based on quarterly data covering 1975:3 and 2014:3. Given that existing studies have already shown housing sentiment to predict movements in aggregate and state-level housing returns, we use a k-th order causality-in-quantiles test for our purpose, since this methodology allows us to test for predictability for both housing returns and volatility simultaneously. In addition, this test being a data-driven approach accommodates the existing nonlinearity (as detected by formal tests) between volatility and sentiment, besides providing causality over the entire conditional distribution of (returns and) volatility. Our results show that barring 5 states (Connecticut, Georgia, Indiana, Iowa, and Nebraska), housing sentiment is observed to predict volatility barring the extreme ends of the conditional distribution. As far as returns are concerned, except for California, predictability is observed for all of the remaining 51 cases.
    Keywords: Housing sentiment, housing market returns and volatility, higher-order nonparametric causality-in-quantiles test, overall and regional US economy
    JEL: C22 C32 C53 R3
    Date: 2018–10
  9. By: Rudolf KLEIN (University of Dubuque); Alina KLEIN (University of Dubuque)
    Abstract: This paper analyzes the components of the influential Baker and Wurgler (BW) indices of investor sentiment and their contribution to the volatility of U.S. stock portfolios. Using the Klein ? Chow (2013) symmetric method of variance decomposition, we orthogonalize the five proxies of sentiment (dividend premium, first-day return on IPOs, number of IPOs, closed-end fund discount, and equity share in new issues) and determine the proportions of systematic risk contributed by these measures. We find that even portfolios that show no economically significant contemporaneous or lagged sensitivity to the BW indicators may still exhibit important sentiment risk, which raises serious questions about the validity of some of the proxies or the use of Principal Component Analysis to compute the sentiment indices. For instance, after controlling for the Fama ? French three factors and for momentum, for the time interval 07/1965 ? 12/2014, the first-day return on IPOs explains roughly 9.8 and 19.2 percent of the systematic variance of high 10 ? low 10 (long-short) Fama ? French portfolios formed on variance and on accruals, respectively. For the same interval and portfolios, the overall BW sentiment-levels indicator explains, respectively, 1.7 and 0.0 percent of the systematic risk.
    Keywords: Systematic Risk Decomposition, Investor Sentiment, Principal Component Analysis, Fama-French Portfolios
    Date: 2018–07
  10. By: Jize Zhang; Tim Leung; Aleksandr Aravkin
    Abstract: A cardinality-constrained portfolio caps the number of stocks to be traded across and within groups or sectors. These limitations arise from real-world scenarios faced by fund managers, who are constrained by transaction costs and client preferences as they seek to maximize return and limit risk. We develop a new approach to solve cardinality-constrained portfolio optimization problems, extending both Markowitz and conditional value at risk (CVaR) optimization models with cardinality constraints. We derive a continuous relaxation method for the NP-hard objective, which allows for very efficient algorithms with standard convergence guarantees for nonconvex problems. For smaller cases, where brute force search is feasible to compute the globally optimal cardinality- constrained portfolio, the new approach finds the best portfolio for the cardinality-constrained Markowitz model and a very good local minimum for the cardinality-constrained CVaR model. For higher dimensions, where brute-force search is prohibitively expensive, we find feasible portfolios that are nearly as efficient as their non-cardinality constrained counterparts.
    Date: 2018–10
  11. By: Woon K. Wong (Cardiff Business School)
    Abstract: CA representative pensioner is considered for the evaluation of some of the cost factors for the career-average-revalued-earnings (CARE) defined benefit scheme of USS (the Universities Superannuation Scheme). Since the promised benefit increases with inflation, the return on the pension portfolio is required to exceed the rate of inflation in order for the scheme to be fully funded. Therefore, given current low interest rates, the de-risking of replacing equities with bonds in the portfolio significantly increases the risk of under-funding and hence is prohibitively expensive. On the other hand, the risk of holding equities in the portfolio can be effectively mitigated through the principle of time diversification, thereby resulting in not only a high probability of a fully-funded scheme, but also possible lower contributions from both scheme sponsors and members in the future. Moreover, it is shown that a zero or negative real interest rate provides the condition for allocating all funds into equities if minimising the probability of underfunding is the sole objective. Finally, the paper finds that the promised benefit will be cheaper to fund if the pensioner has (i) made more years of contribution; (ii) has become a deferred member; (iii) has a slower wage growth; and (iv) has made the contribution earlier. The implication is that the current CARE scheme is cheaper and less risky than the final-salary scheme.
    Keywords: pension, defined benefit, time diversification, de-risking, USS
    Date: 2018–11
  12. By: David Vidal-Tomás (LEE & Economics Department, Universitat Jaume I, Castellón-Spain); Simone Alfarano (LEE & Economics Department, Universitat Jaume I, Castellón-Spain)
    Abstract: Inspired by the Bank of America Merrill Lynch Global Breath Rule, we propose an investor sentiment index based on the collective movement of stock prices in a given market. We show that the time evolution of the sentiment index can be reasonably described by the herding model proposed by Kirman on his seminal paper “Ants, rationality and recruitment” (Kirman, 1993). The correspondence between the index and the model allows us to easily estimate its parameters. Based on the model and the empirical evolution of the sentiment index, we propose an early warning indicator able to identify optimistic and pessimistic phases of the market. As a result, investors and policymakers can set different strategies anticipating financial market instability. The former, reducing the risk of their portfolio, and the latter, setting more efficient policies to avoid the effect of financial crashes on the real economy. The validity of our results is supported by means of a robustness analysis showing the application of the early warning indicator in eight different stock markets.
    Keywords: Herding behaviour, Kirman model, Financial market
    JEL: G10 C61 D84
    Date: 2018
  13. By: Blessing Taruvinga (Finance Discipline Group, UTS Business School, University of Technology Sydney); Boda Kang; Christina Sklibosios Nikitopoulos (Finance Discipline Group, UTS Business School, University of Technology Sydney)
    Abstract: Jump risk plays an important role in current financial markets, yet it is a risk that cannot be easily measured and hedged. We numerically evaluate American call options under stochastic volatility, stochastic interest rates and jumps in both the asset price and volatility. By employing the Method of Lines (Meyer (2015)), the option price, the early exercise boundary and the Greeks are computed as part of the solution, which makes the numerical implementation time efficient. We conduct a numerical study to gauge the impact of jumps and stochastic interest rates on American call option prices and on their free boundaries. Jumps tend to increase the values of OTM and ATM options while decreasing the value of ITM options. The option delta is affected in a similar way. The impact of jumps on the free boundary is substantial and depends on the time to maturity. Near expiry, including asset jumps lowers the free boundary and the option holder is more likely to exercise the option, whilst including asset-volatility jumps elevates the free boundary and the option holder is less likely to exercise the option. This relation reverses at the beginning of the options life. The volatility, interest rates and their volatilities have a positive impact on the free boundaries and the option holder is less likely to exercise as these parameters increase.
    Keywords: American options; Method of Lines; stochastic interest rate; Jumps; Greeks
    JEL: C60 G13
    Date: 2018–10–01
  14. By: Jozef Barunik; Mattia Bevilacqua; Radu Tunaru
    Abstract: We study how shocks to the forward-looking expectations of investors buying call and put options transmit across the financial system. We introduce a new contagion measure, called asymmetric fear connectedness (AFC), which captures the information related to "fear" on the two sides of the options market and can be used as a forward-looking systemic risk monitoring tool. The decomposed connectedness measures provide timely predictive information for near-future macroeconomic conditions and uncertainty indicators, and they contain additional valuable information that is not included in the aggregate connectedness measure. The role of a positive/negative "fear" transmitter/receiver emerges clearly when we focus more closely on idiosyncratic events for financial institutions. We identify banks that are predominantly positive/negative receivers of "fear", as well as banks that positively/negatively transmit "fear" in the financial system.
    Date: 2018–10
  15. By: Constantino Hevia; Martin Sola
    Abstract: Researchers who estimate affine term structure models often impose overidentifying restrictions (restrictions on parameters beyond those necessary for identification) for a variety of reasons. While some of those restrictions seem to have minor effects on the extracted factors and some measures of risk premia, such as the forward risk premium, they may have a large impact on other measures of risk premia that is often ignored. In this paper we analyze how apparently innocuous overidentifying restrictions imposed on affine term structure models can lead to large differences in several measures of risk premiums.
    Keywords: Bond risk premia, affine term structure models, risk prices
    JEL: E43 G12
    Date: 2018–10
  16. By: Ana Mafalda Vasconcelos (Università degli Studi di Torino and Collegio Carlo Alberto)
    Abstract: In this paper we rely on an extensive dataset on cross-border banking flows to understand the effect of political risk on international lending. Moreover, our paper is the first that analyses the effect of several factors of political risk in cross-border banking flows using a sample that is larger than that of previous studies, i.e. covering the period 1984 ? 2013. Moreover - and given the importance of the 9/11 attacks as a turning point both in the political atmosphere and on the global economy ? our paper sets out to investigate how the September 11, 2001 attacks shaped the importance of political risk as a determinant of cross-border banking flows.We find that political risk is an important consideration for foreign investors and that it is perceived differently in developed and non-developed countries. Moreover, we find that the 9/11/2001 attacks change the perception of political risk, and the factors of the aforementioned risk that drive international lending - both in developed and non-developed countries - also changed with the September 11, 2001 attacks.
    Keywords: political risk, cross-border banking flows, international lending, 9/11/2001 attacks
    JEL: G15 E00
    Date: 2018–07
  17. By: Otto Konstandatos (Finance Discipline Group, UTS Business School, University of Technology Sydney)
    Abstract: We develop novel methods for efficient analytical solution of all types of partial time barrier options with both single and double exponential and time varying boundaries, and specifically to treat forward-starting partial double barrier options, which present the simplest non-trivial example of the multiple exponential time-varying barrier case. Our methods reduce the pricing of all barrier options with time-varying boundaries to the pricing of a single European option. We express our novel results solely in terms of European first and second order Gap options. We are motivated by similar structures appearing in Structural Credit Risk models for firm default.
    Keywords: Exotic Options; Method of Images; Partial Time Double Barrier Options; Window Double Barrier Options; Partial-time barrier options; Credit Risk
    JEL: C65
    Date: 2018–10–01
  18. By: Han (H.) Bleichrodt (Erasmus School of Economics, Australian National University); Paul van Bruggen (Erasmus School of Economics)
    Abstract: Higher order risk preferences are important determinants of economic behaviour. We apply behavioural insights to this topic: we measure higher order risk preferences for pure gains and pure losses by controlling the reference point. We find a reflection effect not only for second order risk preferences, as in Kahneman and Tversky 1979, but also for higher order risk preferences: we find risk aversion, prudence and intemperance for gains, but risk loving preferences, imprudence and temperance for losses. The risk aversion and intemperance for gains and the imprudence for losses is evidence against a preference for combining good with bad or good with good, which previous theoretical and empirical results suggest may underlie higher order risk preferences.
    Keywords: Risk Apportionment; Higher Order Risk Preferences; Risk Aversion; Prudence; Temperance; Reference Dependence
    JEL: C91 D81 D91
    Date: 2018–10–28
  19. By: Yu Feng (Finance Discipline Group, UTS Business School, University of Technology Sydney); Ralph Rudd; Christopher Baker; Qaphela Mashalaba; Melusi Mavuso; Erik Schlogl (Finance Discipline Group, UTS Business School, University of Technology Sydney)
    Abstract: We focus on two particular aspects of model risk: the inability of a chosen model to fit observed market prices at a given point in time (calibration error) and the model risk due to recalibration of model parameters (in contradiction to the model assumptions). In this context, we follow the approach of Glasserman and Xu (2014) and use relative entropy as a pre-metric in order to quantify these two sources of model risk in a common framework, and consider the trade–offs between them when choosing a model and the frequency with which to recalibrate to the market. We illustrate this approach applied to the models of Black and Scholes (1973) and Heston (1993), using option data for Apple (AAPL) and Google (GOOG). We find that recalibrating a model more frequently simply shifts model risk from one type to another, without any substantial reduction of aggregate model risk. Furthermore, moving to a more complicated stochastic model is seen to be counterproductive if one requires a high degree of robustness, for example as quantified by a 99% quantile of aggregate model risk.
    Date: 2018–10–01
  20. By: Balbas Aparicio, Raquel; Balbas Aparicio, Beatriz; Balbás de la Corte, Alejandro
    Abstract: This paper deals with the construction of smooth good deals (SGD), i.e., sequences of self- nancing strategies whose global risk diverges to ∞ and such that every security in every strategy of the sequence is a smooth derivative with a bounded delta. If the selected risk measure is the value at risk then these sequences exist under quite weak conditions, since one can involve risks with both bounded and unbounded expectation, as well as non-friction-free pricing rules. Moreover, every strategy in the sequence is composed of an European option plus a position in a riskless asset. The strike of the option is easily computed in practice, and the ideas may also apply in some actuarial problems such as the selection of an optimal reinsurance contract. If the chosen risk measure is a coherent one then the general setting is more limited. Indeed, though frictions are still accepted, expectations and variances must remain nite. The existence of SGDs will be characterized, and computational issues will be properly addressed as well. It will be shown that SGDs often exist, and for the conditional value at risk they are composed of the riskless asset plus easily replicable European puts. Numerical experiments will be presented in all of the studied cases.
    Keywords: Dual approach; Smooth good deal; Risk measure; Golden option
    JEL: C65 C61 G13 G11
    Date: 2018–11
  21. By: Volodymyr Perederiy
    Abstract: Vanna-volga is a popular method for interpolation/extrapolation of volatility smiles. The technique is widely used in the FX markets context, due to its ability to consistently construct the entire lognormal smile using only three lognormal market quotes. However, the derivation of vanna-volga method itself is free of distributional assumptions. To this end, it is surprising there have been actually no attempts to apply the method to Normal volatilities which are the current standard for interest rate markets. We show how the method can be modified to build Normal volatility smiles. As it turns out, that requires only minor modifications compared to the lognormal case. Moreover, as the inversion of Normal volatilities from option prices is easier in the Normal case, the smile construction can occur at a machine-precision level using analytical formulae, making the approximations via Taylor-series unnecessary. Apart from being based on practical and intuitive hedging arguments, the vanna-volga has further important advantages. In comparison to the Normal SABR model, the vanna-volga can easily fit both classical convex and atypical concave smiles ("frowns"). Concave smile patters are sometimes observed around ATM strikes in the interest rate markets, in particular in the situations of anticipated jumps (with unclear outcome) in interest rates. Besides, concavity is often observed towards the lower/left end of the Normal volatility smiles of interest rates. At least in these situations, the vanna-volga can be expected to interpolate/extrapolate better than SABR.
    Date: 2018–10

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