nep-rmg New Economics Papers
on Risk Management
Issue of 2019‒09‒23
eight papers chosen by
Stan Miles
Thompson Rivers University

  1. Virtual Historical Simulation for estimating the conditional VaR of large portfolios By Francq, Christian; Zakoian, Jean-Michel
  2. Dependency of Real Estate and International Financial Markets – A GARCH-Copula Approach to Model Extreme Market Risk By Carsten Fritz; Cay Oertel
  3. Risk pooling and ruin probability, or why high risks are not bad risks. By Debora Zaparova; Sandrine Spaeter
  4. Systemic risk and insurance regulation By Fabiana Gómez; Jorge Ponce
  5. Empirical evidence on time-varying risk attitudes By Matthieu Gilson
  6. A risk-mitigation model driven from the level of forecastability of Black Swans: prepare and respond to major Earthquakes through a dynamic Temporal and Spatial Aggregation forecasting framework By Konstantinos Nikolopoulos; Fotios Petropoulos; Vasco Sanchez Rodrigues; Stephen Pettit; Anthony Beresford
  7. American Step Options By Jerôme Detemple; Souleymane Laminou Abdou; Franck Moraux
  8. News, sovereign debt maturity, and default risk By Maximiliano Dvorkin; Emircan Yurdagul; Horacio Sapriza; Juan Sanchez

  1. By: Francq, Christian; Zakoian, Jean-Michel
    Abstract: In order to estimate the conditional risk of a portfolio's return, two strategies can be advocated. A multivariate strategy requires estimating a dynamic model for the vector of risk factors, which is often challenging, when at all possible, for large portfolios. A univariate approach based on a dynamic model for the portfolio's return seems more attractive. However, when the combination of the individual returns is time varying, the portfolio's return series is typically non stationary which may invalidate statistical inference. An alternative approach consists in reconstituting a "virtual portfolio", whose returns are built using the current composition of the portfolio and for which a stationary dynamic model can be estimated. This paper establishes the asymptotic properties of this method, that we call Virtual Historical Simulation. Numerical illustrations on simulated and real data are provided.
    Keywords: Accuracy of VaR estimation, Dynamic Portfolio, Estimation risk, Filtered Historical Simulation, Virtual returns.
    JEL: C13 C32 C58
    Date: 2019–09–10
  2. By: Carsten Fritz; Cay Oertel
    Abstract: The behaviour of single investment positions such as securitized real estate, stocks and bonds as well as the dependency between them are central topics in financial literature. Science as well as praxis are constantly seeking for improvements to model risk and returns of financial assets. With regard to the isolated behaviour of positions such as securitized real estate, the asset class shows characteristics, which cause Gaussian assumptions to fail. These include non-normality as well as serial correlation of return distributions. Thus, the extreme value theorem-driven GARCH modelling for volatility patterns is a feasible alternative to model single asset behaviour and its associated risk. Additionally to the isolated behaviour of single assets, the joint behaviour of securitized real estate and other asset classes has widely been discussed. With regard to these dependency features, challenging characteristics such as fat tail exposure, volatility clustering and non-linearity should be highlighted. Thus, the dependency modelling needs more flexible concepts, which allow for upper and lower tail dependency between the return distributions.The paper will solve the above-named challenges by applying the so-called GARCH-EVT-Copula approach. Therefore, financial time series of securitized real estate as well as other asset classes will be individually modelled by classic GARCH models as well as its asymmetric peers including EGARCH, TGARCH, and PGARCH. By doing so, a the iid residuals will be extracted as the proxy for extreme market risk, since they represent the modelling error for each series. Subsequently the joint behaviour of the residuals is modelled by copulas to allow for extreme joint behaviour in the tail region of the distribution. We will then estimate the bivariate copula parameters to assess which kind of copula is the best-fitting type including different dependency structures such as archimedian, elliptical and especially asymmetric copulas. The fit will be assessed based on LL, AIC and BIC citeria. The named fit-parameters for each bivariate copula will reveal the characteristics of extreme market risk, represented by potentially asymmetric lower tail dependent copulas, to illustrate potentially extreme market risk for the joint behaviour.
    Keywords: copula; dependency modelling; extreme market risk; Portfolio Allocation
    JEL: R3
    Date: 2019–01–01
  3. By: Debora Zaparova; Sandrine Spaeter
    Abstract: The aim of this paper is to show that high risks being bad risks is a misinterpretation. We discuss the role of the risk-bearing capital in the insurance process. In particular, we explicit the link between insurer’s risk, capital, size and composition of an insurance pool. Those parameters have a tangible impact on the insurer’s ruin probability when his size is limited. An additional policyholder may increase the ruin probability, while a specific combination of risk types may produce a significant decrease. Those implications should be considered given the legal requirements relative to the insurer’s insolvency. A strategy that consists in attracting only low-risk agents is not necessarily expedient for an insurer.
    Keywords: high risks, insurance, risk loading.
    JEL: D81 G22 G28
    Date: 2019
  4. By: Fabiana Gómez (University of Bristol); Jorge Ponce (Banco Central del Uruguay)
    Abstract: Without systemic risk exposure, the formal model in this paper predicts that optimal regulation may be implemented by capital regulation (alike that observed in practice) and actuarially fair technical reserve. However, these instruments are not enough when insurance companies are exposed to systemic risk. In this case, prudential regulation should also add a systemic component to capital requirements which is non-decreasing in the firm's exposure to systemic risk. Implementing the optimal policy implies to separate insurance firms in two categories according to their exposure to systemic risk: those with relatively low exposure should be eligible for bailouts, while those with high exposure should not benefit from public support if a systemic event occurs.
    Abstract: Se propone un modelo formal de una empresa de seguros. En la ausencia de riesgo sistémico, el modelo predice que la regulación óptima puede ser implementada mediante un requisito de capital y reservas técnicas similares a lo observado en la práctica. Sin embargo, en el caso de riesgo sistémico, la regulación prudencial debería incorporar un componente sistémico al requerimiento de capital. Para implementar la regulación óptima se debería, además, separar las empresas de seguros en dos categorías: aquellas poco expuestas al riesgo sistémico serían elegibles para asistencia financiera en caso de problemas, mientras que aquellas relativamente más expuestas no accederían a tal asistencia.
    Keywords: Insurance companies, systemic risk, optimal regulation
    JEL: G22 G28
    Date: 2018
  5. By: Matthieu Gilson
    Abstract: My thesis focuses on the risk-taking behavior of financial agents, aiming particularlyat better understanding how risk attitudes can change over time. It alsoexplores the implications that these changes have on financial markets, and on theeconomy as a whole.The first paper, which is a joint work with Kim Oosterlinck and Andrey Ukhov,studies how risk aversion of financial markets’ participants is affected by the SecondWorld War. The literature links extreme events to changes in risk aversion but failsto find a consensus on the direction of this change. Moreover, due to data limitationsand difficulties in estimation of risk aversion, the speed of the change in risk aversionhas seldom been analyzed. This paper develops an original methodology to overcomethe latter limitation. To estimate changes in attitude toward risk, we rely on thedaily market prices of lottery bonds issued by Belgium. We provide evidence on thedynamic of risk attitude before, during and after the Second World War. We findsubstantial variations between 1938 and 1946. Risk aversion increased at the outbreakof the war, decreased dramatically during the occupation to increase again afterthe war. To our knowledge, this finding of reversal in risk attitude is unique in theliterature. We discuss several potential explanations to this pattern, namely changesin economic perspectives, mood, prospect theory, and background risk. While theymight all have played a role, we argue that habituation to background risk mostconsistently explains the observed behavior over the whole period. Living continuouslyexposed to war-related risks has gradually changed the risk-taking behavior ofinvestors.In the second paper, I derive a measure of risk aversion from asset prices andanalyze what are its main drivers. Given the complexity of eliciting risk aversionfrom asset prices, few papers provide empirical evidence on the dynamics of riskaversion in a long-term perspective. This paper tries to fill the gap. First, I providea measure of risk aversion that is original, both because of the length of its sampleperiod (1958- 1991) and the methodology used. I study the relationship betweenthis new measure of risk aversion and several key economic variables in a structuralvector autoregression. Results show that risk aversion varies over the period. Aworsening of economic conditions, a decrease in stock prices or a tighter monetarypolicy lead to an increase in risk aversion. On the other hand, an increase in riskaversion is linked to a larger corporate bond credit spread and has an adverse effecton stock prices.The third paper explores the impact of asset price bubbles on the riskiness offinancial institutions. I investigate the effect of a real estate boom on the financialstability of commercial banks in the United States using exogenous variations intheir exposure to real estate prices. I find that the direction of the effect dependson bank characteristics. Although higher real estate prices have a positive impacton bank stability on average, small banks and banks that operate in competitivebanking markets experience a negative effect. I reconcile these findings by providingevidence that higher real estate prices benefit commercial banks by raising the valueof collateral pledged by borrowers but at the cost of an increase in local bankingcompetition. This increase in competition affects banks that have a low marketpower more severely, which explains why small banks and banks facing a high degreeof competition display relatively lower stability during a real estate boom.
    Keywords: risk aversion; lottery; bonds; banking
    Date: 2019–09–05
  6. By: Konstantinos Nikolopoulos (Bangor University); Fotios Petropoulos (University of Bath); Vasco Sanchez Rodrigues (Cardiff University); Stephen Pettit (Cardiff University); Anthony Beresford (Cardiff University)
    Abstract: Major earthquakes are black swan, or quasi-random, events capable of disrupting supply chains to an entire country, region or even the whole world as the case of the Fukushima disaster profoundly demonstrated. They are amongst the most unpredictable types of natural disasters, and can have a severe impact on supply chains and distribution networks. This research develops a supply chain risk management model in the anticipation of such a black swan event. The research considers major earthquake data for the period 1985 – 2014, and temporal as well as spatial aggregation is undertaken. The aim is to identify the optimum grid size where forecasting variance is minimized and forecastability is maximized. Building on that a risk-mitigation model is developed. The dynamic model – updated every time a new event is added in the database - includes preparedness, responsiveness and centralization strategies for the different levels of time and geographical aggregation.
    Keywords: Risk, Black Swans, Forecastability, Statistical Aggregation, Disaster Relief;
    Date: 2019–08
  7. By: Jerôme Detemple (Questrom School of Business, - BU - Boston University [Boston]); Souleymane Laminou Abdou (CREM - Centre de recherche en économie et management - UNICAEN - Université de Caen Normandie - NU - Normandie Université - UR1 - Université de Rennes 1 - UNIV-RENNES - Université de Rennes - CNRS - Centre National de la Recherche Scientifique); Franck Moraux (CREM - Centre de recherche en économie et management - UNICAEN - Université de Caen Normandie - NU - Normandie Université - UR1 - Université de Rennes 1 - UNIV-RENNES - Université de Rennes - CNRS - Centre National de la Recherche Scientifique)
    Abstract: This paper examines the valuation of American knock-out and knock-in step options. The structures of the immediate exercise regions of the various contracts are identified. Typical properties of American vanilla calls, such as uniqueness of the optimal exercise boundary, upconnectedness of the exercise region or convexity of its t-section, are shown to fail in some cases. Early exercise premium representations of step option prices, involving the Laplace transforms of the joint laws of Brownian motion and its occupation times, are derived. Systems of coupled integral equations for the components of the exercise boundary are deduced. Numerical implementations document the behavior of the price and the hedging policy. The paper is the first to prove that finite maturity exotic American Options written on a single underlying asset can have multiple disconnected exercise regions described by a triplet of coupled boundaries.
    Keywords: Risk management,Multiple exercise boundaries,Occupation time,Step options,American options,Multiple exercise boundaries.
    Date: 2019
  8. By: Maximiliano Dvorkin (Federal Reserve Bank of St. Louis); Emircan Yurdagul (Universidad Carlos III de Madrid); Horacio Sapriza (Federal Reserve Board); Juan Sanchez (Federal Reserve Bank of St. Louis)
    Abstract: Leading into a debt crisis, interest rate spreads on sovereign debt rise before the economy experiences a decline in productivity, suggesting that news may play an important role in these episodes. The empirical evidence also shows that a news shock has a significantly larger contemporaneous impact on sovereign credit spreads than a comparable shock to labor productivity. We develop a quantitative model of news and sovereign debt default with endogenous maturity choice that generates impulse responses very similar to the empirical estimates. The model allows us to interpret the empirical evidence and to identify key parameters. We find that, first, the increase in sovereign yield spreads around a debt crisis episode is due mostly to the lower expected productivity following a bad news shock, and not to the borrowing choices of the government. Second, a shorter debt maturity increases the chance that bad news shocks trigger a debt crisis. Third, an increase in the precision of news allows the government to improve its debt maturity management, especially during periods of high financial stress, and thus face lower spreads and default risk while holding the amount of debt constant.
    Date: 2019

This nep-rmg issue is ©2019 by Stan Miles. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.