nep-rmg New Economics Papers
on Risk Management
Issue of 2018‒12‒10
seventeen papers chosen by
Stan Miles
Thompson Rivers University

  1. Calculating CVaR and bPOE for Common Probability Distributions With Application to Portfolio Optimization and Density Estimation By Matthew Norton; Valentyn Khokhlov; Stan Uryasev
  2. Backtesting Expected Shortfall via Multi-Quantile Regression By Ophélie Couperier; Jérémy Leymarie
  3. Active Asset Managers Face Asymmetric Risks from Paradigm Shift By Xing, Victor
  4. Lending standards and macroeconomic dynamics By Gete, Pedro
  5. New Challenges of Globalization in Pension Systems By Dan Constantinescu
  6. Hedging Labor Income Risk over the Life-Cycle By Fabio C. Bagliano; Raffaele Corvino; Carolina Fugazza; Giovanna Nicodano
  7. EU FDI Network and Systemic Risks By Giulia De Masi; Giorgio Ricchiuti
  8. The pitfalls of central clearing in the presence of systematic risk By Kubitza, Christian; Pelizzon, Loriana; Getmansky, Mila
  9. An analysis of cryptocurrencies conditional cross correlations By Nektarios Aslanidis; Aurelio F. Bariviera; Oscar Martinez-Iba\~nez
  10. Endogenous Debt Maturity: Liquidity Risk vs. Default Risk By Manuelli, Rodolfo E.; Sanchez, Juan M.
  11. Repayment Flexibility and Risk Taking: Experimental Evidence from Credit Contracts By Gulesci, Selim
  12. Companies’ Characteristics and the Choice of Hedge Accounting for Derivatives Reporting: Evidence from Malaysian Listed Companies By Abdullah, Azrul; Ku Ismail, Ku Nor Izah
  13. To Ask or Not To Ask? Bank Capital Requirements and Loan Collateralization By Degryse, Hans; Karapetyan, Artashes; Karmakar, Sudipto
  14. Optimal insurance coverage of low probability-high severity risks By Alexis Louaas; Pierre Picard
  15. An Early Warning System for Systemic Banking Crises: A Robust Model Specification By O'Brien, Martin; Wosser, Michael
  16. Fair Odds for Noisy Probabilities By Ulrik W. Nash
  17. Model Averaging and its Use in Economics By Steel, Mark F. J.

  1. By: Matthew Norton; Valentyn Khokhlov; Stan Uryasev
    Abstract: Conditional Value-at-Risk (CVaR) and Value-at-Risk (VaR), also called the superquantile and quantile, are frequently used to characterize the tails of probability distribution's and are popular measures of risk. Buffered Probability of Exceedance (bPOE) is a recently introduced characterization of the tail which is the inverse of CVaR, much like the CDF is the inverse of the quantile. These quantities can prove very useful as the basis for a variety of risk-averse parametric engineering approaches. Their use, however, is often made difficult by the lack of well-known closed-form equations for calculating these quantities for commonly used probability distribution's. In this paper, we derive formulas for the superquantile and bPOE for a variety of common univariate probability distribution's. Besides providing a useful collection within a single reference, we use these formulas to incorporate the superquantile and bPOE into parametric procedures. In particular, we consider two: portfolio optimization and density estimation. First, when portfolio returns are assumed to follow particular distribution families, we show that finding the optimal portfolio via minimization of bPOE has advantages over superquantile minimization. We show that, given a fixed threshold, a single portfolio is the minimal bPOE portfolio for an entire class of distribution's simultaneously. Second, we apply our formulas to parametric density estimation and propose the method of superquantile's (MOS), a simple variation of the method of moment's (MM) where moment's are replaced by superquantile's at different confidence levels. With the freedom to select various combinations of confidence levels, MOS allows the user to focus the fitting procedure on different portions of the distribution, such as the tail when fitting heavy-tailed asymmetric data.
    Date: 2018–11
  2. By: Ophélie Couperier (CREST - Centre de Recherche en Economie et Statistique [Bruz] - ENSAI - Ecole Nationale de la Statistique et de l'Analyse de l'Information [Bruz]); Jérémy Leymarie (LEO - Laboratoire d'économie d'Orleans - UO - Université d'Orléans - Université de Tours - CNRS - Centre National de la Recherche Scientifique)
    Abstract: In this article, we propose a new approach to backtest Expected Shortfall (ES) exploiting the definition of ES as a function of Value-at-Risk (VaR). Our methodology jointly assesses the quality of VaRs along the tail distribution of the risk model, and encompasses the Basel Committee recommendation of verifying quantiles at risk levels 97.5%, and 99%. We introduce four easy-to-use backtests which regress the ex-post losses on the VaR forecasts in a multi-quantile regression model, and test the resulting parameter estimates. Monte-Carlo simulations show that our tests are powerful to detect various model misspecifications. We apply our backtests on S&P500 returns over the period 2007-2012. Our tests clearly identify misleading ES forecasts in this period of financial turmoil. Empirical results also show that the detection abilities are higher when the evaluation procedure involves more than two quantiles, which should accordingly be taken into account in the current regulatory guidelines.
    Keywords: Banking regulation,Financial risk management,Forecast evaluation,Hypothesis testing,Tail risk
    Date: 2018–10–31
  3. By: Xing, Victor
    Abstract: Active asset managers face asymmetric risks from a paradigm shift in monetary policy regimes and inflation trends, as some active funds increased risk-taking to compete with passive funds - the primary beneficiaries of prolonged low volatility. A decade of volatility and term premium suppression also led some active funds to adapt a bearish volatility stance and increased their vulnerabilities to a regime change in inflation dynamics, as they transfer risks from debt issuers onto their balance sheets. A growing body of research now point to cumulative policy costs from prolonged unconventional monetary easing, and aversion to mounting policy costs and retreat from globalization would heighten volatility and financial instability. Likelihood of regulatory scrutiny would rise if non-bank financial institutions' complacency on volatility contribute to financial stability, and "Volcker-like" rules imposed on non-bank asset managers would lead to crippling impacts on fund operations. Thus, active portfolio managers adept at managing volatility can minimize regulatory scrutiny by counterbalancing systemic risks from passive strategies.
    Keywords: Active fund management, passive fund management, volatility, monetary policy, quantitative easing, policy costs, financial stability risks, regulatory measures
    JEL: E0 E3 E4 E5 G1 G2
    Date: 2018–11–04
  4. By: Gete, Pedro
    Abstract: This paper proposes a tractable way to incorporate lending standards ("credit qualification thresholds") into macro models of financial frictions. Banks can reject borrowers whose risk is above an endogenous threshold at which no lending rate sufficiently compensates banks for the borrowers’ default risk. Firms denied credit cut employment and labor reallocates mostly towards safer producers. Lending standards propagate bank capital shortfalls through labor misallocation causing deeper and more persistent real effects. The paper also shows that lending spreads are insufficient indicators of credit supply disruptions. That is, for the same increase in credit spreads, output falls faster when denial rates are increasing. Finally, with endogenous lending standards, first-moment bank capital shocks look like second-moment shocks. JEL Classification: E32, E44, E47, G2
    Keywords: bank capital, bank losses, extensive margin, labor reallocation, lending standards, misallocation
    Date: 2018–11
  5. By: Dan Constantinescu (Ecological University of Bucharest)
    Abstract: After many years in which the social problems have been treated as an attribute of each state’s internal politics, the beginning of the third millennium marks the onset of a concentrated effort to reform the social security systems in most of the world’s states. For pension systems, the greatest common challenge is the attenuation of the demographic pressure, whose effect – on medium and long period of time – consists in the depreciation of financial sustainability of public systems and in accentuating the discrepancy between the benefits received from the public system and retired workers necessary of financial resources. In the context of European Union’s state members, the legislation on the people’s liberty and mobility domain implies the creation of a social security basic (minimal) system, which also regards aspects of pension benefits extraterritoriality. Meanwhile, the free circulation of services principle generates new problems regarding state border supervision. The last economical-financial crisis proved that, although the diversity principle allows each state member to decide on the pension system most agreeable, a certain series of common guidelines cannot be eluded, like the ones regarding investment regulation, the risk-based approach of supervising or the coordination of tax systems.
    Keywords: population ageing, pension deficit, investment, regulations, replacement rates, minimum returns, supervision, crisis, risk management
    JEL: H55 H75 J32
    Date: 2018–04
  6. By: Fabio C. Bagliano (Department of Economics and Statistics (Dipartimento di Scienze Economico-Sociali e Matematico-Statistiche), University of Torino, Italy); Raffaele Corvino (Faculty of Finance, Cass Business School, City, University of London, UK); Carolina Fugazza (Department of Economics and Statistics (Dipartimento di Scienze Economico-Sociali e Matematico-Statistiche), University of Torino, Italy); Giovanna Nicodano (Department of Economics and Statistics (Dipartimento di Scienze Economico-Sociali e Matematico-Statistiche), University of Torino, Italy)
    Abstract: We show that the decision to participate in the stock market depends on the ability of equities to hedge the individual permanent earnings shocks, consistent with implications of life-cycle models. Those households who refrain from stock investing display positive correlation between their own permanent income innovations and market returns. These results owe to a two-step empirical strategy. First, a minimum distance estimation disentangles the aggregate from the idiosyncratic permanent of labor income risks. The second step reconstructs the individual life-cycle dynamics of persistent shocks through a Kalman filter applied to the estimated labor income process. We are thus able to obtain the full cross-sectional distribution of individual correlations between permanent shock and market returns.
    Keywords: Labor income-risk return correlation, Permanent income shocks, Kalman filter.
    JEL: G10 G11 D14
    Date: 2018–12
  7. By: Giulia De Masi; Giorgio Ricchiuti
    Abstract: Fragmentation of production certainly is a possible channel of economic contagion and is playing a key role in the study of Systemic Risk. The investments abroad of firms implicitly create long range economic dependencies between investors and the economies of destination, possibly triggering contagion phenomena. Complex Network theory is a primary tool to highlight economic mutual relationships and paths of economic contagion, shedding light on intrinsic systemic risks. In this paper we reconstruct the networks of EU28 foreign direct investments and we study the networks' evolution from 2003 to 2015 for 38 economic sectors. Our analysis aims at detecting the change of topological properties of foreign direct investment network during the crisis, in order to assess its effect on the architecture of economic relationships. Trough a detailed study of correlations at different time lags between network measurements and macroeconomic variables, we assess systemic risks based on network topology. The main results are: (i) a sharp change of network topology from a sparse to a strongly clusterized network is clearly visible before the crisis and a quantitative evaluation of the network communities is given; (ii) after the crisis, investments from EU28 investors are mainly concentrated in EU28 countries there the Union becomes on of core cluster; (iii) time-lagged correlations between macro-economic variables and topological measurements show that network's topology measures anticipate the change of macro-economic variables.
    Keywords: Foreign Direct Investment, Economic networks, Projected network, Systemic Risks
    JEL: F23 D85
    Date: 2018
  8. By: Kubitza, Christian; Pelizzon, Loriana; Getmansky, Mila
    Abstract: Through the lens of market participants' objective to minimize counterparty risk, we provide an explanation for the reluctance to clear derivative trades in the absence of a central clearing obligation. We develop a comprehensive understanding of the benefits and potential pitfalls with respect to a single market participant's counterparty risk exposure when moving from a bilateral to a clearing architecture for derivative markets. Previous studies suggest that central clearing is beneficial for single market participants in the presence of a sufficiently large number of clearing members. We show that three elements can render central clearing harmful for a market participant's counterparty risk exposure regardless of the number of its counterparties: 1) correlation across and within derivative classes (i.e., systematic risk), 2) collateralization of derivative claims, and 3) loss sharing among clearing members. Our results have substantial implications for the design of derivatives markets, and highlight that recent central clearing reforms might not incentivize market participants to clear derivatives.
    Keywords: Central Clearing,Counterparty Risk,Systematic Risk,OTC markets,Derivatives,Loss Sharing,Collateral,Margin
    JEL: G01 G14 G18 G28
    Date: 2018
  9. By: Nektarios Aslanidis; Aurelio F. Bariviera; Oscar Martinez-Iba\~nez
    Abstract: This letter explores the behavior of conditional correlations among main cryptocurrencies, using a generalized DCC class model. From a portfolio management point of view, asset correlation is a key metric in order to construct efficient portfolios. We found that correlations including Monero are more stable in time than other correlation pairs.
    Date: 2018–11
  10. By: Manuelli, Rodolfo E. (Washington University in St. Louis; Federal Reserve Bank of St. Louis); Sanchez, Juan M. (Federal Reserve Bank of St. Louis)
    Abstract: We study the endogenous determination of corporate debt maturity in a setting with default risk. We assume that firms must access the bond market and they issue debt with a flexible structure (coupon, face value, and maturity). Initially, the firm is in a low growth/illiquid state that requires debt refinancing if it matures. Since lenders do not refinance projects with positive but small net present value, firms may be forced to default in the first phase. We call this liquidity risk. The technology is such that earnings can switch to a higher (but riskier) level. In this second phase firms have access to the equity market but they may default if this is the best option. We call this strategic default risk. In the model optimal maturity balances these two risks. We show that firms with poor prospects and firms in more unstable industries will choose shorter maturities even if it is feasible to issue longer debt. The model also offers predictions on how asset maturity, asset salability, and leverage influence maturity. Even though our model is extremely stylized we find that the predictions are roughly consistent with the evidence. Moreover, it offers some insights into the factors that determine the structure of the debt.
    Keywords: Bonds; Debt; Maturity; Default; Bankruptcy; Leverage; Risk; Liquidity
    JEL: G23 G32 G33
    Date: 2018–10–01
  11. By: Gulesci, Selim
    Abstract: A widely-held view is that small firms in developing countries are prevented from making profitable investments by lack of access to credit and insurance markets. One solution is to provide repayment flexibility in credit contracts. Repayment flexibility eases both the credit constraint, as it allows for increased spending during the startup phase, and offers insurance, in case of fluctuations in income. In a field experiment among microcredit borrowers in Bangladesh, we randomly assign the option to delay up to 2 monthly repayments at any point during a 12-month loan cycle. The flexible contract leads to substantial (0.2 standard deviation) improvements in business outcomes and socio-economic status, combined with lower default rates. The results are driven by an increase in entrepreneurial risk taking, implying that the primary mechanism is insurance provision. Repayment flexibility also attracts less risk-averse borrowers. Our findings suggest that lack of insurance is an important constraint for small firms but that a simple financial product that increases repayment flexibility can be an effective tool for enabling enterprise growth.
    Keywords: credit; entrepreneurship; Insurance; Microfinance; Repayment flexibility
    Date: 2018–11
  12. By: Abdullah, Azrul; Ku Ismail, Ku Nor Izah
    Abstract: This paper investigates the adoption of hedge accounting by Malaysian listed companies in reporting their use of derivatives for hedging activities. Based on a sample of 300 Malaysian listed companies, we found that only 162 companies (54 percent) used derivatives to hedge their financial risks exposure and only 30 percent of the companies chose to apply hedge accounting. In addition, this study examines the relationship between the company specific characteristics and their application of hedge accounting. The logistic regression results showed that the decision to apply hedge accounting by Malaysian companies is positively influenced by the company size and leverage. The implications of the findings were discussed.
    Keywords: Derivatives; Financial instruments; Hedge Accounting; Company Specific Characteristics
    JEL: M21 M41 M48
    Date: 2017–06–09
  13. By: Degryse, Hans; Karapetyan, Artashes; Karmakar, Sudipto
    Abstract: We study the impact of higher capital requirements on banks' decisions to grant collateralized rather than uncollateralized loans. We exploit the 2011 EBA capital exercise, a quasi-natural experiment that required a number of banks to increase their regulatory capital but not others. This experiment makes secured lending more attractive vis-à-vis unsecured lending for the affected banks as secured loans require less regulatory capital. Using a loan-level dataset covering all corporate loans in Portugal, we identify a novel channel of higher capital requirements: relative to the control group, treated banks require loans to be collateralized more often after the shock, but less so for relationship borrowers. This applies in particular for collateral that saves more on regulatory capital.
    Keywords: Capital requirements; Collateral; Lending Technology; relationship lending
    JEL: G21 G28 G32
    Date: 2018–11
  14. By: Alexis Louaas (Department of Economics, Ecole Polytechnique - X - École polytechnique - CNRS - Centre National de la Recherche Scientifique); Pierre Picard (X - École polytechnique)
    Abstract: Catastrophic risks are often characterized by a low probability and a high severity. Taking these specificities into account, we analyze the intrinsic reasons for which catastrophic risks may be more or less insurable, independently from the market failures frequently observed in practice. On the demand side, we characterize individual preferences under which the willingness to pay for the coverage of large losses remains significant, although their occurrence probability is very small. On the supply side, the correlation between individual losses affects the insurance pricing through the insurers' cost of capital. Analyzing the interaction between demand and supply yields the key determinants of insurability and of a socially optimal risk sharing strategy.
    Keywords: Disaster insurance,catastrophic risk,risk aversion,capital costs
    Date: 2018–11–15
  15. By: O'Brien, Martin (Central Bank of Ireland); Wosser, Michael (Central Bank of Ireland)
    Abstract: Using a panel dataset of 27 developed economies, estimated quarterly from 1980-2016, we develop a flexible systemic banking crisis early warning system (EWS). Evidence is provided that fitted multivariate logit probabilities, estimated recursively against documented crises, yield more informative crisis signals than any single macroeconomic, credit aggregate or asset price variable does independently. When the model robustness techniques of Young and Holsteen (2017) are applied, even stronger crisis signals are generated. Deciding which variables to include in the model is determined by adopting a signals-based approach to each prospective indicator, with the most informative yet robust variables identified in terms of their performance according to noise-to-signal ratios, weighted noise-to-signal ratios and an Alessi and Detken (2011) “usefulness” measure. The latter takes policy-makers’ preferences for false versus missed signals into account. The approach ensures a parsimonious yet effective EWS yielding forwardlooking indicators that outperform all raw input indicators in crisis-signaling terms.
    Keywords: early warning system, systemic banking crises, macroprudential policy, model robustness, financial stability
    JEL: G01 G21 G28 E58
    Date: 2018–09
  16. By: Ulrik W. Nash
    Abstract: We suggest that one individual holds multiple degrees of belief about an outcome, given the evidence. We then investigate the implications of such noisy probabilities for a buyer and a seller of binary options and find the odds agreed upon to ensure zero-expectation betting, differ from those consistent with the relative frequency of outcomes. More precisely, the buyer and the seller agree to odds that are higher (lower) than the reciprocal of their averaged unbiased probabilities when this average indicates the outcome is more (less) likely to occur than chance. The favorite-longshot bias thereby emerges to establish the foundation of an equitable market. As corollaries, our work suggests the old-established way of revealing someone's degree of belief through wagers may be more problematic than previously thought, and implies that betting markets cannot generally promise to support rational decisions.
    Date: 2018–11
  17. By: Steel, Mark F. J.
    Abstract: The method of model averaging has become an important tool to deal with model uncertainty, for example in situations where a large amount of different theories exist, as are common in economics. Model averaging is a natural and formal response to model uncertainty in a Bayesian framework, and most of the paper deals with Bayesian model averaging. The important role of the prior assumptions in these Bayesian procedures is highlighted. In addition, frequentist model averaging methods are also discussed. Numerical methods to implement these methods are explained, and I point the reader to some freely available computational resources. The main focus is on uncertainty regarding the choice of covariates in normal linear regression models, but the paper also covers other, more challenging, settings, with particular emphasis on sampling models commonly used in economics. Applications of model averaging in economics are reviewed and discussed in a wide range of areas, among which growth economics, production modelling, finance and forecasting macroeconomic quantities.
    Keywords: Bayesian methods; Model uncertainty; Normal linear model; Prior specification; Robustness
    JEL: C11 C15 C20 C52 O47
    Date: 2017–09–19

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