nep-rmg New Economics Papers
on Risk Management
Issue of 2019‒10‒21
twenty papers chosen by
Stan Miles
Thompson Rivers University

  1. Splitting credit risk into systemic, sectorial and idiosyncratic components By Álvaro Chamizo; Alfonso Novales
  2. The Risk Weighted Ownership Index: an ex-ante measure of banks' risk and performance By Luca Bellardini; Pierluigi Murro; Daniele Previtali
  3. Systems Thinking in Risk Management by Preventive & Detective Controls as an Ago-Antagonistic Systems Approach in the French Nuclear Sector By Diana Paola Moreno Alarcon; Jean François Vautier; Guillaume Hernandez; Franck Guarnieri
  4. Interest Rate Risk Management by Financial Engineering in Pakistani Non-Financial Firms By Bashir, Taqadus; Khalid, Shujaat; Iqbal Khan, Kanwal; Javed, Saman
  5. Eigen-entropy measure to study phase separation in market behavior By Anirban Chakraborti; Hrishidev; Kiran Sharma; Hirdesh K. Pharasi
  6. Buildings' energy efficiency and the probability of mortgage default: The Dutch case By Billio, Monica; Costola, Michele; Pelizzon, Loriana; Riedel, Max
  7. Survey of Credit Rating Methodologies of Mutual Funds: Standard and Poor’s and Moody’s By Guha Niyogi, Gargi; Mandal, Nivedita; Das, Rituparna
  8. Optimal ratcheting of dividends in insurance By Hansjoerg Albrecher; Pablo Azcue; Nora Muler
  9. A BSDE-based approach for the optimal reinsurance problem under partial information By Matteo Brachetta; Claudia Ceci
  10. The real effects of bank distress: Evidence from bank bailouts in Germany By Bersch, Johannes; Degryse, Hans; Kick, Thomas; Stein, Ingrid
  11. Pricing contingent claims with short selling bans By Guiyuan Ma; Song-Ping Zhu; Ivan Guo
  12. Ownership, wealth, and risk taking: Evidence on private equity fund managers By Bienz, Carsten; Thorburn, Karin S; Walz, Uwe
  13. A Note to “Do ETFs Increase Volatility?”: An Improved Method to Predict Assignment of Stocks into Russell Indexes By Itzhak Ben-David; Francesco Franzoni; Rabih Moussawi
  14. It's the tail-risk, stupid! Precluding regulatory arbitrage in shadow banking with a normatively charged approach to supervision capitalizing on multipolar regulatory dialogues By Thiemann, Matthias; Tröger, Tobias
  15. Ripples on financial networks By Kumar, Sudarshan; Bansal, Avijit; Chakrabarti, Anindya S.
  16. A generalised CIR process with externally-exciting and self-exciting jumps and its applications in insurance and finance By Dassios, Angelos; Jang, Jiwook; Zhao, Hongbiao
  17. Pure Rank Preferences and Variation in Risk-Taking Behavior By Stark, Oded; Budzinski, Wiktor; Jakubek, Marcin
  18. The countercyclical capital buffer and the composition of bank lending By Auer, Raphael; Ongena, Steven
  19. The Long-term Rate and Interest Rate Volatility in Monetary Policy Transmission By Chen, Zhengyang
  20. Optimal Dynamic Futures Portfolio in a Regime-Switching Market Framework By Tim Leung; Yang Zhou

  1. By: Álvaro Chamizo (BBVA.); Alfonso Novales (Instituto Complutense de Análisis Económico (ICAE), and Department of Economic Analysis, Facultad de Ciencias Económicas y Empresariales, Universidad Complutense, 28223 Madrid, Spain.)
    Abstract: We provide a methodology to estimate a global credit risk factor from CDS spreads that can be very useful for risk management. The global risk factor (GRF) reproduces quite well the different epis- odes that have affected the credit market over the sample period. It is highly correlated with standard credit indices, but it contains much higher explanatory power for fluctuations in CDS spreads across sectors than the credit indices themselves. The additional information content over iTraxx seems to be related to some financial interest r ates. We first use the estimated GRF to analyze the extent to which the eleven sectors we consider are systemic. After that, we use it to split the credit risk of indi- vidual issuers into systemic, sectorial, and idiosyncratic components, and we perform some analyses to test that the estimated idiosyncratic components are actually firm-specific. The systemic and sec- torial components explain around 65% of credit risk in the European industrial and financial firms and 50% in the North American firms in those sectors, while 35% and 50% of risk, respectively, has an idiosyncratic nature. Thus, there is a significant margin for portfolio diversification. We also show that our decomposition allows us to identify those firms whose credit would be harder to hedge. We end up analyzing the relationship between the estimated components of risk and some synthetic risk factors, in order to learn about the different nature of the credit risk components.
    Keywords: Credit Risk; Systemic Risk; Sectorial Risk; Idiosyncratic Risk; Asset Allocation.
    JEL: C58 F34 G01 G32
    Date: 2019–09
  2. By: Luca Bellardini (University of Rome Tor Vergata); Pierluigi Murro (LUISS University); Daniele Previtali (University of Naples Parthenope)
    Abstract: Attributing ratings to the top-20 owners, we construct a Risk-Weighted Ownership index (RWO) to measure the profitability and risk-taking behaviour of the ownership structure at banks. Collecting data from 19 European countries plus the UK over the 2008-2017 period, preliminary results show strong evidence that RWO measures are significant in explaining bank performance and risk, at both an accounting and a market-based level. Overall, these results suggest that not only markets and regulators should look at bank’s owners: instead, it is far more relevant to assess the contribution carried by top-owners to bank risk, both individually and collectively.
    Keywords: bank, ownership, risk, corporate governance
    JEL: G21 G32
    Date: 2019–04
  3. By: Diana Paola Moreno Alarcon (CRC - Centre de recherche sur les Risques et les Crises - PSL - PSL Research University - MINES ParisTech - École nationale supérieure des mines de Paris); Jean François Vautier (CEA - Commissariat à l'énergie atomique et aux énergies alternatives); Guillaume Hernandez (CEA - Commissariat à l'énergie atomique et aux énergies alternatives); Franck Guarnieri (CRC - Centre de recherche sur les Risques et les Crises - PSL - PSL Research University - MINES ParisTech - École nationale supérieure des mines de Paris)
    Abstract: The French Atomic Energy and Alternative Energies Commission (CEA) employ preventive and detective controls, fundamental elements of risk management in the nuclear facilities of the French nuclear sector. Using an ago-antagonistic systems (AAS) approach, CEA managers balance two ago-antagonistic (AA) forces (preventive and detective controls) that together make an AA couple, to mitigate subcontracting risks. The systemic vision of AAS, underpinned by systems thinking, enables managers to consider the collective impact of adjusting either a single force or both forces, particularly as action(s) on the couple may rebalance the overall system. This paper illustrates how preventive and detective controls meet Bernard-Weil's eight principal characteristics of AAS. The temporal aspect of preventive and detective controls, at the nucleus of the AA model, and their time-sensitive role in averting and detecting an event are also discussed. Examples are provided of how CEA managers mitigate risk through AA couples by pursuing forces and considering them collectively in terms of "both /and" rather than separately in terms of "either/or".
    Keywords: Systems Thinking,Ago-antagonistic Systems (AAS),Management Controls,Subcontracting,Nuclear Sector,Defence in Depth,Temporal aspects,Detective Controls,Preventive Controls,Risk Management
    Date: 2019–09–22
  4. By: Bashir, Taqadus; Khalid, Shujaat; Iqbal Khan, Kanwal; Javed, Saman
    Abstract: The study aimed to investigate firm decisions of using interest rate derivatives and factors affecting this decision. Study is conducted by selecting data of 191 non-financial sector companies listed on PSX from 2010 to 2015. Logit model was employed to detect contribution magnitude of foreign sales, profitability, leverage, liquidity, price to earnings, interest coverage ratio and dividend payout towards decisions by a firm of using the interest rate derivatives. The expected users of interest rate derivatives for purpose of interest rate exposure management were the firms with high foreign sales, lesser leverage, low profits, low dividend payout ratio and low interest coverage ratio. The examination concludes that these derivatives are financial engineering tools and serve as immunization instruments for a firm from anticipated future financial risk.
    Keywords: Risk management, Interest rate derivatives, Foreign sales, Hedging, Panel logit model
    JEL: G1 G2 G3
    Date: 2019–09–01
  5. By: Anirban Chakraborti; Hrishidev; Kiran Sharma; Hirdesh K. Pharasi
    Abstract: One of the spectacular examples of a complex system is the financial market, which displays rich correlation structures among price returns of different assets. The eigenvalue decomposition of a correlation matrix into partial correlations - market, group and random modes, enables identification of dominant stocks or "influential leaders" and sectors or "communities". The correlation-based network of leaders and communities changes with time, especially during market events like crashes, bubbles, etc. Using a novel entropy measure - eigen-entropy, computed from the eigen-centralities (ranks) of different stocks in the correlation-network, we extract information about the "disorder" (or randomness) in the market and its modes. The relative-entropy measures computed for these modes enable us to construct a "phase space", where the different market events undergo "phase-separation" and display "order-disorder" transitions, as observed in critical phenomena in physics. We choose the US S&P-500 and Japanese Nikkei-225 financial markets, over a 32-year period, and study the evolution of the cross-correlation matrices computed over different short time-intervals or "epochs", and their corresponding eigen-entropies. We compare and contrast the empirical results against the numerical results for Wishart orthogonal ensemble (WOE), which has the maximum disorder (randomness) and hence, the highest eigen-entropy. This new methodology helps us to better understand market dynamics, and characterize the events in different phases as anomalies, bubbles, crashes, etc. This can be easily adapted and broadly applied to the studies of other complex systems such as in brain science or environment.
    Date: 2019–10
  6. By: Billio, Monica; Costola, Michele; Pelizzon, Loriana; Riedel, Max
    Abstract: In this paper, we investigate the relation between buildings' energy efficiency and the probability of mortgage default. To this end, we construct a novel panel dataset by combining Dutch loan-level mortgage information with provisional building energy ratings that are calculated by the Netherlands Enterprise Agency. By employing the Logistic regression and the extended Cox model, we find that buildings' energy efficiency is associated with lower likelihood of mortgage default. The results hold for a battery of robustness checks. Additional findings indicate that credit risk varies with the degree of energy efficiency.
    Keywords: Mortgages,Energy Efficiency,Credit Risk
    JEL: G21
    Date: 2019
  7. By: Guha Niyogi, Gargi; Mandal, Nivedita; Das, Rituparna
    Abstract: Credit rating literature attracted attention of academics since the subprime crisis 2008. In the wake of the crisis hundred billion dollars’ worth securities that were awarded AAA rating by the world’s leading credit rating agencies downgraded to junk. So is the survey on credit rating methodology. This work intends to survey the methodologies Moody’s and S&P follow in assessing the performance of equity funds and debt funds. The authors conclude that in these rating methodologies of S&P and Moody’s the link between equity fund and debt fund, i.e. how downgrade of debt fund can lead to downgrade of equity fund is not captured. Secondly Moody’s shakes off or manages the risk of loss of goodwill in the wake of failure of short term debt fund rating in the case of certain systemic factors like suspending or discouraging withdrawals and redemptions, by prescribing automatic downgrade to junk.
    Keywords: net asset value, expense ratio,asset management, fund credit quality rating, assets under management, funds risk
    JEL: G23 G24
    Date: 2019–02–06
  8. By: Hansjoerg Albrecher; Pablo Azcue; Nora Muler
    Abstract: We address a long-standing open problem in risk theory, namely the optimal strategy to pay out dividends from an insurance surplus process, if the dividend rate can never be decreased. The optimality criterion here is to maximize the expected value of the aggregate discounted dividend payments up to the time of ruin. In the framework of the classical Cram\'{e}r-Lundberg risk model, we solve the corresponding two-dimensional optimal control problem and show that the value function is the unique viscosity solution of the corresponding Hamilton-Jacobi-Bellman equation. We also show that the value function can be approximated arbitrarily closely by ratcheting strategies with only a finite number of possible dividend rates and identify the free boundary and the optimal strategies in several concrete examples. These implementations illustrate that the restriction of ratcheting does not lead to a large efficiency loss when compared to the classical un-constrained optimal dividend strategy.
    Date: 2019–10
  9. By: Matteo Brachetta; Claudia Ceci
    Abstract: We investigate the optimal reinsurance problem under the criterion of maximizing the expected utility of terminal wealth when the insurance company has restricted information on the loss process. We propose a risk model with claim arrival intensity and claim sizes distribution affected by an unobservable environmental stochastic factor. By filtering techniques (with marked point process observations), we reduce the original problem to an equivalent stochastic control problem under full information. Since the classical Hamilton-Jacobi-Bellman approach does not apply, due to the infinite dimensionality of the filter, we choose an alternative approach based on Backward Stochastic Differential Equations (BSDEs). Precisely, we characterize the value process and the optimal reinsurance strategy in terms of the unique solution to a BSDE driven by a marked point process.
    Date: 2019–10
  10. By: Bersch, Johannes; Degryse, Hans; Kick, Thomas; Stein, Ingrid
    Abstract: How does bank distress impact their customers' probability of default and trade credit availability? We address this question by looking at a unique sample of German firms from 2000 to 2011. We follow their firm-bank relationships through times of distress and crisis, featuring the different transmission of bank distress shocks into already weakened firm balance sheets. We find that a distressed bank bailout, which is subject to restructuring and deleveraging conditions, leads to a bank-induced increase of firms' probabilities of default. Moreover, bailouts tend to reduce trade credit availability and ultimately firms' sales. We further find that the direction and magnitude of the effects depends on firm quality and the relationship orientation of banks.
    Keywords: bank distress,bank risk channel,firm risk channel,relationship banking,firm defaults,financial crisis
    JEL: G01 G21 G24 G33
    Date: 2019
  11. By: Guiyuan Ma; Song-Ping Zhu; Ivan Guo
    Abstract: Guo and Zhu (2017) recently proposed an equal-risk pricing approach to the valuation of contingent claims when short selling is completely banned and two elegant pricing formulae are derived in some special cases. In this paper, we establish a unified framework for this new pricing approach so that its range of application can be significantly expanded. The main contribution of our framework is that it not only recovers the analytical pricing formula derived by Guo and Zhu (2017) when the payoff is monotonic, but also numerically produces equal-risk prices for contingent claims with non-monotonic payoffs, a task which has not been accomplished before. Furthermore, we demonstrate how a short selling ban affects the valuation of contingent claims by comparing equal-risk prices with Black-Scholes prices.
    Date: 2019–10
  12. By: Bienz, Carsten; Thorburn, Karin S; Walz, Uwe
    Abstract: We examine the incentive effects of private equity (PE) professionals' ownership in the funds they manage. In a simple model, we show that managers select less risky firms and use more debt financing the higher their ownership. We test these predictions for a sample of PE funds in Norway, where the professionals' private wealth is public. Consistent with the model, firm risk decreases and leverage increases with the manager's ownership in the fund, but largely only when scaled with her wealth. Moreover, the higher the ownership, the smaller is each individual investment, increasing fund diversification. Our results suggest that wealth is of first order importance when designing incentive contracts requiring PE fund managers to coinvest.
    Keywords: buyouts; general partner; incentives; ownership; private equity; Risk Taking; Wealth
    JEL: D86 G12 G31 G32 G34
    Date: 2019–08
  13. By: Itzhak Ben-David; Francesco Franzoni; Rabih Moussawi
    Abstract: A growing literature uses the Russell 1000/2000 reconstitution event as an identification strategy to investigate corporate finance and asset pricing questions. To implement this identification strategy, researchers need to approximate the ranking variable used to assign stocks to indexes. We develop a procedure that predicts assignment to the Russell 1000/2000 with significant improvements relative to previous approaches. We apply this methodology to extend the tests in Ben-David, Franzoni, and Moussawi (2018).
    JEL: G12 G14 G15
    Date: 2019–10
  14. By: Thiemann, Matthias; Tröger, Tobias
    Abstract: The use of contractual engineering to create channels of credit intermediation outside of the realm of banking regulation has been a recurring activity in Western financial systems over the last 50 years. After the financial crisis of 2007 and 2008, this phenomenon, at that time commonly referred to as 'shadow banking', evoked a large-scale regulatory backlash, including several specific regulatory constraints being placed on non-bank financial institutions (NBFI). This paper proposes a different avenue for regulators to keep regulatory arbitrage under control and preserve sufficient space for efficient financial innovation. Rather than engaging in the proverbial race between hare and hedgehog that is emerging with increasingly specific regulation of particular contractual arrangements, this paper argues for a normative approach to supervision. We outline this approach in detail by showing that regulators should primarily analyse the allocation of tail risk inherent in the respective contractual arrangements. Our paper proposes to assign regulatory burdens equivalent to prudential banking regulation, in case these arrangements become only viable through indirect or direct access to an (ad hoc) public backstop. In order to make the pivotal assessment, regulators will need information about recent contractual innovations and their risk-allocating characteristics. According to the scholarship on regulatory networks serving as communities of interpretation, we suggest in particular how regulators should structure their relationships with semi-public gatekeepers such as lawyers, auditors and consultants to keep abreast of the real-world implications of evolving transactional structures. This paper then uses the rise of credit funds as a non-bank entities economically engaged in credit intermediation to apply this normative framework, pointing to recent contractual innovations that call for more regulatory scrutiny in a multipolar regulatory dialogue.
    Keywords: shadow banking,regulatory arbitrage,principles-based regulation,credit funds,prudential supervision,non-bank financial intermediation
    JEL: G21 G28 H77 K22 K23 L22
    Date: 2019
  15. By: Kumar, Sudarshan; Bansal, Avijit; Chakrabarti, Anindya S.
    Abstract: In the financial markets, asset returns exhibit collective dynamics masking individual impacts on the rest of the market. Hence, it is still an open problem to identify how shocks originating from one particular asset would create spillover effects across other assets. The problem is more acute when there is a large number of simultaneously traded assets, making the identification of which asset affects which other assets even more difficult. In this paper, we construct a network of the conditional volatility series estimated from asset returns and propose a many-dimensional VAR model with unique identification criteria based on the network topology. Because of the interlinkages across stocks, volatility shock to a particular asset propagates through the network creating a ripple effect. Our method allows us to find the exact path the ripple effect follows on the whole network of assets.
    Date: 2019–10–14
  16. By: Dassios, Angelos; Jang, Jiwook; Zhao, Hongbiao
    Abstract: In this paper, we study a generalised CIR process with externally-exciting and self-exciting jumps, and focus on the distributional properties and applications of this process and its aggregated process. The aim of the paper is to introduce a more general process that includes many models in the literature with self-exciting and external-exciting jumps. The first and second moments of this jump-diffusion process are used to calculate the insurance premium based on mean-variance principle. The Laplace transform of aggregated process is derived, and this leads to an application for pricing default-free bonds which could capture the impacts of both exogenous and endogenous shocks. Illustrative numerical examples and comparisons with other models are also provided.
    Keywords: contagion risk; insurance premium; aggregate claims; default-free bond pricing; self-exciting process; Hawkes process; CIR process
    JEL: G32
    Date: 2019
  17. By: Stark, Oded (University of Bonn); Budzinski, Wiktor (University of Warsaw); Jakubek, Marcin (Institute of Economics, Polish Academy of Sciences)
    Abstract: Assuming that an individual's rank in the wealth distribution is the only factor determining the individual's wellbeing, we analyze the individual's risk preferences in relation to gaining or losing rank, rather than the individual’s risk preferences towards gaining or losing absolute wealth. We show that in this characterization of preferences, a high-ranked individual is more willing than a low-ranked individual to take risks that can provide him with a rise in rank: relative risk aversion with respect to rank in the wealth distribution is a decreasing function of rank. This result is robust to incorporating (the level of) absolute wealth in the individual's utility function.
    Keywords: rank in the wealth distribution, rank-based utility, variation in risk-taking behavior, relative risk aversion
    JEL: D01 D31 D81 G32
    Date: 2019–09
  18. By: Auer, Raphael; Ongena, Steven
    Abstract: Do macroprudential regulations on residential lending influence commercial lending behavior too? To answer this question, we identify the compositional changes in banks' supply of credit using the variation in their holdings of residential mortgages on which extra capital requirements were uniformly imposed by the countercyclical capital buffer (CCyB) introduced in Switzerland in 2012. We find that the CCyB's introduction led to higher growth in commercial lending although this was unrelated to conditions in regional housing markets. Interest rates and fees charged to the firms concurrently increased. We rationalize these findings in a model featuring both private and firm-specific collateral.
    Keywords: bank capital; credit; macroprudential policy; Spillovers; systemic risk
    JEL: E51 E58 E60 G01 G21 G28
    Date: 2019–08
  19. By: Chen, Zhengyang
    Abstract: The federal funds rate became uninformative about the stance of monetary policy from December 2008 to November 2015. During the same period, unconventional monetary policy actions, like large-scale asset purchases, show the Federal Reserve’s intention to depress longer-term interest rates. This paper considers a long-term real interest rate as an alternative monetary policy indicator in a structural VAR framework. Based on an event study of FOMC announcements, I advance a novel measure of long-term interest rate volatility with important implication for monetary policy identification. I find that monetary policy shocks identified with this volatility measure drive significant swings in credit market sentiments and real output. In contrast, monetary policy shocks identified by otherwise standard unexpected policy rate changes lead to muted responses of financial frictions and production. Our results support the validity of the risk-taking channel and suggest an indispensable role of financial markets in monetary policy transmission.
    Keywords: Monetary policy transmission,Structural VAR,Risk-taking channel,High-frequency identification
    JEL: E3 E4 E5
    Date: 2019
  20. By: Tim Leung; Yang Zhou
    Abstract: We study the problem of dynamically trading futures in a regime-switching market. Modeling the underlying asset price as a Markov-modulated diffusion process, we present a utility maximization approach to determine the optimal futures trading strategy. This leads to the analysis of the associated system of Hamilton-Jacobi-Bellman (HJB) equations, which are reduced to a system of linear ODEs. We apply our stochastic framework to two models, namely, the Regime-Switching Geometric Brownian Motion (RS-GBM) model and Regime-Switching Exponential Ornstein-Uhlenbeck (RS-XOU) model. Numerical examples are provided to illustrate the investor's optimal futures positions and portfolio value across market regimes.
    Date: 2019–10

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