nep-rmg New Economics Papers
on Risk Management
Issue of 2019‒12‒02
twenty-two papers chosen by
Stan Miles
Thompson Rivers University

  1. Multivariate Crash Risk By Fousseni Chabi-Yo; Markus Huggenberger; Florian Weigert
  2. Environmental Hazards and Risk Management in the Financial Sector: A Systematic Literature Review By Miriam Breitenstein; Duc Khuong Nguyen; Thomas Walther
  3. Firm-Level Political Risk: Measurement and Effects By Tarek A. Hassan; Stephan Hollander; Laurence van Lent; Ahmed Tahoun
  4. Artificial intelligence approach to momentum risk-taking By Ivan Cherednik
  5. Informed Corporate Credit Market Before Monetary Policy Surprises: Explaining Pre-FOMC Stock Market Movements By Farshid Abdi; Botao Wu;
  6. Cyber bonds and their pricing models By Oleg Kolesnikov; Alexander Markov; Daulet Smagulov; Sergejs Solovjovs
  7. Low on Trust and High on Risks: Is Sidechain a Good Solution to Bitcoin Problems? By Jamal Bouoiyour; Refk Selmi; Olivier Hueber
  8. Office Market Interconnectedness and Systemic Risk Exposure By Roland Füss; Daniel Ruf
  9. Unproductive Debt and the Impairment of the Real Economy By Savvakis C. Savvides
  10. A Moving Average Heterogeneous Autoregressive Model for Forecasting the Realized Volatility of the US Stock Market: Evidence from Over a Century of Data By Afees A. Salisu; Rangan Gupta; Ahamuefula E. Ogbonna
  11. Should the CCYB be enhanced with a sectoral dimension? The case of Italy By Roberta Fiori; Claudia Pacella
  12. Financial Conditions and 'Growth at Risk' in Italy By Piergiorgio Alessandri; Leonardo Del Vecchio; Arianna Miglietta
  13. Bayesian regularized artificial neural networks for the estimation of the probability of default By Sariev, Eduard; Germano, Guido
  14. Loss Aversion And The Demand For Index Insurance By Immanuel Lampe; Daniel Würtenberger
  15. Optimally solving banks' legacy problems By Anatoli Segura; Javier Suarez
  16. Optimal Pension Plan Default Policies when Employees are Biased By Asen Ivanov
  17. The move towards riskier pensions: The importance of mortality By Anne G. Balter; Malene Kallestrup-Lamb; Jesper Rangvid
  18. A Closer Look at Credt Rating Processes: Uncovering the Impact of Analyst Rotation By Kilian R. Dinkelaker; Andreas-Walter Mattig; Stefan Morkoetter
  19. Reorganizing Power Markets: A Reliability insurance Business Model for Utilities By Rolando Fuentes; Jorge Blazquez; Iqbal Adjali
  20. Credit Variance Risk Premiums By Manuel Ammann; Mathis Mörke
  21. The geometry of mortality change: Convex hulls for demographic analysis By Lai, Audrey F.; Noymer, Andrew; Tai, Tsuio
  22. Health shocks and risk aversion: Panel and experimental evidence from Vietnam By Priebe, Jan; Rink, Ute; Stemmler, Henry

  1. By: Fousseni Chabi-Yo; Markus Huggenberger; Florian Weigert
    Abstract: This paper investigates whether multivariate crash risk is priced in the crosssection of expected stock returns. Motivated by a theoretical asset pricing model, we capture the multivariate crash risk of a stock by a combined measure based on its expected shortfall and its multivariate lower tail dependence with the systematic risk factors of the Carhart (1997) model. We find that stocks with a high exposure to joint crashes of the market and the momentum factor bear a risk premium which is not explained by traditional linear factor models or by other downside risk measures. Our results indicate that accounting for the multivariate crash risk of established state variables helps to understand the cross-section of expected stock returns without further expanding the factor zoo.
    Keywords: Asset pricing, Non-linear dependence, Copulas, Crash aversion, Downside risk, Lower tail dependence, Tail risk
    JEL: C58 G01 G11 G12 G17
    Date: 2019–02
  2. By: Miriam Breitenstein; Duc Khuong Nguyen; Thomas Walther
    Abstract: We conduct a systematic literature review on environmental and climate related risk management in the financial sector. The systematic literature review identified a total of 36 relevant articles. A formal coding leads to the aggregation and classification of papers to three main categories that consider the impact of environmental concerns on financial risk, the current state of environmental risk practices in the finance sector, and lastly measures to assess those risks within financial institutions. Our results put forward the risk reduction for financial institutions which highly commit with environmental responsibility and performance. More importantly, investors’ increase in awareness and willingness to assess climate-related financial risk would incentivize corporate managers to adopt more proactive environmental policies and practices. These findings also allow for intriguing discussions about several alleys for future research.
    Keywords: Environment, Climate, Risk Management, Banking, Financial Institutions
    Date: 2019–07
  3. By: Tarek A. Hassan (Boston University); Stephan Hollander (Tilburg University); Laurence van Lent (Frankfurt School of Finance and Management); Ahmed Tahoun (London Business School)
    Abstract: We adapt simple tools from computational linguistics to construct a new measure of political risk faced by individual US firms: the share of their quarterly earnings conference calls that they devote to political risks. We validate our measure by showing it correctly identifies calls containing extensive conversations on risks that are political in nature, that it varies intuitively over time and across sectors, and that it correlates with the firm`s actions and stock market volatility in a manner that is highly indicative of political risk. Firms exposed to political risk retrench hiring and investment and actively lobby and donate to politicians. These results continue to hold after controlling for news about the mean (as opposed to the variance) of political shocks. Interestingly, the vast majority of the variation in our measure is at the firm level rather than at the aggregate or sector level, in the sense that it is neither captured by the interaction of sector and time fixed effects, nor by heterogeneous exposure of individual firms to aggregate political risk. The dispersion of this firm level political risk increases significantly at times with high aggregate political risk. Decomposing our measure of political risk by topic, we find that firms that devote more time to discussing risks associated with a given political topic tend to increase lobbying on that topic, but not on other topics, in the following quarter.
    Keywords: Political uncertainty, quantification, firm-level, lobbying
    JEL: D8 E22 E24 E32 E6 G18 G32 G38 H32
    Date: 2019–06
  4. By: Ivan Cherednik
    Abstract: We propose a mathematical model of momentum risk-taking, which is real-time risk management, and discuss its implementation: an automated momentum equity trading system. Risk-taking is one of the key components of general decision-making, a challenge for artificial intelligence and machine learning. We begin with a simple continuous model of news impact and then perform its discretization, adjusting it to dealing with discontinuous functions. Stock charts are the main examples for us; stock markets are quite a test for any risk management theories. An entirely automated trading system based on our approach proved to be successful in extensive historical and real-time experiments. Its preimage is a new contract card game presented at the end of the paper.
    Date: 2019–11
  5. By: Farshid Abdi; Botao Wu;
    Abstract: We show that U.S. corporate bond market movements during the days preceding FOMC announcements can predict monetary policy surprises, as well as the pre-FOMC stock market movements. Starting several days before an expansionary (contractionary) surprise in FOMC decisions, corporate bond prices surge (decline) and yield spreads decline (surge). The pattern is statistically and economically significant. Moreover, corporate bond customers buy (sell) more often from dealers before expansionary (contractionary) surprises, suggesting that in aggregate they have more accurate information about the outcome of FOMC announcements. A portfolio that mimics customer trades is profitable with a Sharpe ratio of 0.64 and is profitable before both contractionary and expansionary surprises. Furthermore, consistent with the informativeness of corporate bond transactions, we show that lagged corporate bond customer-dealer trade imbalances can predict pre-FOMC stock market movements and explain pre-FOMC drift. Corporate bond yield changes "Granger-cause" stock pre-FOMC movements, and a 1% surge in the constructed TRACE bond yield during a 2 p.m.-to-2 p.m. period ending one day before an FOMC announcement, predicts a 5.8% decline in the S&P 500 index for the 2 p.m.-to-2 p.m. period ending on the FOMC meeting day. This bond-to-stock granger causality does not exist for non-pre-FOMC periods and is stronger for the companies with higher probability of default.
    Keywords: Pre-FOMC Announcement Drift, Corporate Bond, Credit Risk, Enhanced TRACE, TAQ
    JEL: G10 G12 E44 E52
    Date: 2018–08
  6. By: Oleg Kolesnikov; Alexander Markov; Daulet Smagulov; Sergejs Solovjovs
    Abstract: Motivated by the developments in cyber risk treatment in the finance industry, we propose a general framework of cyber bond, whose main purpose is to insure (compensate) losses of a cyber attack. Based on a database of publicly available cyber events, we determine cyber loss distribution parameters and use them to numerically simulate cyber bond price, yield, and other characteristics. We also consider two possible approaches to cyber bond coupon calculation.
    Date: 2019–11
  7. By: Jamal Bouoiyour (IRMAPE - Institut de Recherche en Management et Pays Emergents - ESC Pau, CATT - Centre d'Analyse Théorique et de Traitement des données économiques - UPPA - Université de Pau et des Pays de l'Adour); Refk Selmi (IRMAPE - Institut de Recherche en Management et Pays Emergents - ESC Pau, CATT - Centre d'Analyse Théorique et de Traitement des données économiques - UPPA - Université de Pau et des Pays de l'Adour); Olivier Hueber (GREDEG - Groupe de Recherche en Droit, Economie et Gestion - UNS - Université Nice Sophia Antipolis - UCA - Université Côte d'Azur - CNRS - Centre National de la Recherche Scientifique)
    Abstract: Over the past few years, cryptocurrencies (especially Bitcoin) have attracted a particular attention. As the number of transactions increase, these systems tend to become slower, expensive, and unsustainable for a use-case such as payment. In this way, the Bitcoin sidechain seeks to provide prompt and confidential transactions between major trading platforms. Although poor performance and high volatility can push potential users away from Bitcoin, this study reveals that the introduction of sidechain solves some of the problems Bitcoin is facing. Using relatively new techniques, we find that the implementation of sidechain reduces Bitcoin price volatility, rises its efficiency, and enhances its usefulness as a transaction tool and a diversifier. We explain these changes in Bitcoin characteristics by the sidechain"s capacity to speed up the circulation of money by shortening block validation times and to an improvement in the scalability of Proof of Work and Bitcoin payment services. Our results also indicate that the sidechain liquid network lead to a less energy-consuming and in turn to less polluting Bitcoin system. But a weakly vanishing causality between Bitcoin mining and Bitcoin energy consumption implies that the concentration of miners is still follow available electrical supply.
    Keywords: Bitcoin,Volatility,Efficiency,Risk management,Energy use,Sidechain
    Date: 2019–11–05
  8. By: Roland Füss; Daniel Ruf
    Abstract: This paper empirically studies how systemic risk in the banking sector affects return co-movements among financial center office markets. We compute an aggregated measure of systemic risk in financial centers that is related to the expected capital shortfall of financial institutions. The empirical results show that office market interconnectedness arises from systemic banking risk during financial turmoil periods. Our identification strategy is based on a double counterfactual approach. We find no evidence of return co-movements during normal times and among the counterfactual retail markets. The decline in office market returns during financial turmoil is larger in financial centers compared to non-financial centers. Our findings demonstrate how correlated risk among seemingly uncorrelated assets emerges in times when risk diversification is most needed.
    Keywords: Commercial real estate, cross-sectional dependence, financial center, spatial econometrics, systemic risk
    JEL: G15 R30
    Date: 2018–04
  9. By: Savvakis C. Savvides (Visiting Lecturer, John Deutsch Institute for the Study of Economic Policy, Queen’s University, Canada)
    Abstract: This paper discusses some of the issues and causes of modern-day failing economies. Unproductive debt and the “liberalisation” of financial services are identified to be the main reasons why the real economies of many developed countries are experiencing financial crises and are seriously threatened with recession. It highlights that the main driver that is preventing the efficient allocation of economic resources into productive uses, which enhance economic and social welfare, is the concentration of money and power. In addition, the elusive pursuit of return without risk inevitably leads to the transfer of existing wealth through a failing banking system which collaborates with hedge funds and global wealth management groups who seek low risk and high returns for the benefit of their wealthy clients. The end result is a gross misallocation of economic resources and lack of funding for new capital investment. Because of wasteful lending, commercial banks find themselves increasingly constrained by a balance sheet fatigue as a direct consequence of the resulting excessive levels of private debt. Hence, they resort to selling their loans to hedge funds and asset management companies. The paper points out that availability of funding does not create wealth unless it is directed towards economically viable projects. Moreover, it is argued that the conditions conducive to economic development hardly exist in highly indebted countries. Conversely, wasteful finance inevitably brings about financial crises and recessions. It is therefore imperative for governments to intervene and take corrective action to reduce debt and to stimulate domestic demand. It is also argued that there is no real return without risk. The promise of a return without risk leads financial intermediaries to direct funding towards the purchase of existing assets rather than being invested back in the real economy.
    Keywords: Economic development, repayment capability, project evaluation, corporate lending, credit risk.
    JEL: D61 G17 G21 G32 G33 H43
    Date: 2019–10
  10. By: Afees A. Salisu (Department for Management of Science and Technology Development, Ton Duc Thang University, Ho Chi Minh City, Vietnam and Faculty of Business Administration, Ton Duc Thang University, Ho Chi Minh City, Vietnam); Rangan Gupta (Department of Economics, University of Pretoria, Pretoria, 0002, South Africa); Ahamuefula E. Ogbonna (Centre for Econometric & Allied Research, University of Ibadan and Department of Statistics, University of Ibadan)
    Abstract: This study forecasts the monthly realized volatility of the US stock market covering the period of February, 1885 to September, 2019 using a recently developed novel approach – a moving average heterogeneous autoregressive (MAT-HAR) model, which treats threshold as a moving average generated time varying parameter rather than as a fixed or unknown parameter. The significance of asymmetric information in realized volatility of stock market forecasting is also considered by examining the case of good and bad realized volatility. The Clark and West (2007) forecast evaluation approach is employed to evaluate the forecast performance of the proposed predictive model vis-à-vis the conventional HAR and threshold HAR (T-HAR) models. We find evidence in favour of the MAT-HAR model relative to the HAR and T-HAR models. Also observed is the significant role of asymmetry in modeling the realized volatility as good realized volatility and bad realized volatility yield dissimilar predictability results. Our results are not sensitive to the choice of sample periods and realized volatility measures.
    Keywords: Realized volatility, US stock market, Forecast evaluation, HAR models
    JEL: C22 C53 G12
    Date: 2019–11
  11. By: Roberta Fiori (Bank of Italy); Claudia Pacella (Bank of Italy)
    Abstract: The paper investigates whether there is sufficient empirical support in Italy for the introduction of a sectoral countercyclical capital buffer (CCyB) in the macroprudential framework. We study the sectoral decomposition of the credit-to-GDP gap over the period 1990Q1-2017Q2. Overall, our results suggests that a sectoral CCyB could be a useful addition to the macroprudential framework as both the timing for activation and the size of the capital buffer can differ when accounting for the sectoral dimension of the credit-to-GDP gap. We find that the synchronicity of sectoral credit cycles decreases as we move from a two-sector to a six-sector decomposition. Moreover, the contribution of sectoral cycles to systemic stress, as measured by the system-wide new bad debt rate, as well as the prudential requirements associated with their risk exposure differ quite significantly. While exuberance in the non-real-estate related segment of corporate lending is usually followed by a surge in systemic stress, exuberance in the real-estate related segment of business lending does not.
    Keywords: credit cycle, sectoral decomposition, synchronicity, cyclical systemic risk
    JEL: E32 G01 G21 G28
    Date: 2019–06
  12. By: Piergiorgio Alessandri (Bank of Italy); Leonardo Del Vecchio (Bank of Italy); Arianna Miglietta (Bank of Italy)
    Abstract: This paper studies the relationship between financial conditions and economic activity in Italy using quantile regression techniques in the spirit of Adrian, Boryachenko and Giannone (2019). We exploit the volatility of the 2008-2012 period to assess the plausibility of ‘tail’ predictions obtained from a broad range of financial indicators. We find that, although spikes in financial distress are typically followed by economic contractions, using this relationship for out-of-sample forecasting is not trivial. To some extent, the models predict the slowdowns experienced by Italy after 2008, but the forecasts are volatile, their quality varies across indicators and horizons, and the predictions tend to overestimate the likelihood of an upcoming recession. As such, these tools represent a complement to, rather than a substitute for, an articulated and diversified systemic risk assessment framework.
    Keywords: financial conditions, quantile regression, growth risk
    JEL: C21 E37
    Date: 2019–10
  13. By: Sariev, Eduard; Germano, Guido
    Abstract: Artificial neural networks (ANN) have been extensively used for classification problems in many areas such as gene, text and image recognition. Although ANN are popular also to estimate the probability of default in credit risk, they have drawbacks; a major one is their tendency to overfit the data. Here we propose an improved Bayesian regularization approach to train ANN and compare it to the classical regularization that relies on the back-propagation algorithm for training feed-forward networks. We investigate different network architectures and test the classification accuracy on three data sets. Profitability, leverage and liquidity emerge as important financial default driver categories.
    Keywords: Artificial neural networks; Bayesian regularization; Credit risk; Probability of default; ES/K002309/1
    JEL: C11 C13
    Date: 2019–10–31
  14. By: Immanuel Lampe; Daniel Würtenberger
    Abstract: This work analyzes if reference dependence and loss aversion can explainthe puzzling low adoption rates of rainfall index insurance. We present a model that predicts the impact of loss aversion on index insurance demand to vary with different levels of insurance understanding. Index insurance demand of farmers who are unaware of the loss-hedging benefit that insurance provides decreases with loss aversion. In contrast, insurance demand of farmers who are aware of the loss-hedging benefit increases with loss aversion. The model further predicts that farmers who are unaware of the loss-hedging benefit will not demand an even highly subsidized index insurance. Using data from a randomized controlled trial involving a sample of Indian farmers we provide empirical support for our core conjecture that insurance understanding mitigates the negative impact of loss aversion on index insurance adoption.
    Keywords: Prospect Theory, Reference Dependence, Microinsurance, Farm Household
    JEL: D91 G22 Q12
    Date: 2019–06
  15. By: Anatoli Segura (Banca d’Italia); Javier Suarez (Center for Monetary and Financial Studies (Cemfi))
    Abstract: We characterize policy interventions directed to minimize the cost to the deposit guarantee scheme and the taxpayers of banks with legacy problems. Non-performing loans (NPLs) with low and risky returns create a debt overhang that induces bank owners to forego profitable lending opportunities. NPL disposal requirements can restore the incentives to undertake new lending but, as they force bank owners to absorb losses, can also make them prefer the bank being resolved. For severe legacy problems, combining NPL disposal requirements with positive transfers is optimal and involves no conflict between minimizing the cost to the authority and maximizing overall surplus.
    Keywords: non performing loans, deposit insurance, debt overhang, optimal intervention, state aid.
    JEL: G01 G20 G28
    Date: 2019–06
  16. By: Asen Ivanov (Queen Mary University of London)
    Abstract: What is the optimal default contribution rate or default asset allocation in pension plans? Could active decision (i.e., not setting a default and forcing employees to make a decision) be optimal? These questions are studied in a model in which each employee is biased regarding her optimal contribution rate or asset allocation. In this model, active decision is never optimal and the optimal default is, depending on parameter values, one of three defaults. The paper also explores how the parameters affect the optimal default and the total loss in the population at the optimal default.
    Keywords: optimal defaults, libertarian paternalism, nudging, pension plan design
    JEL: D14 D91 J26 J32
    Date: 2019–09–12
  17. By: Anne G. Balter (Tilburg University and Netspar); Malene Kallestrup-Lamb (Aarhus University, PeRCent and CREATES); Jesper Rangvid (Copenhagen Business School and PeRCent)
    Abstract: This paper models the impact of unanticipated changes in forecasted life expectancies on guaranteed and unguaranteed pension products. We study a unique data set containing individuals offered the opportunity to substitute a guaranteed pension product with relatively low levels of risk to an unguaranteed product with a higher degree of financial and longevity risk. The complexity of the products and the increase in the level of financial literacy required by the individual to make such a decision motivate the need to properly model the most important drivers that characterize the differences between guaranteed and unguaranteed pension products. This is done within the standard Merton, Black and Scholes framework and we find a clear tradeoff between financial risk and longevity risk in terms of their effect on future pension payments. We find that unguaranteed pension products allow for more financial risk-taking and thus higher expected returns. However, unexpected longevity shocks can reduce pension payments in unguaranteed pension products to a lower level relative to guaranteed products.
    Keywords: Macro longevity risk, Variable annuities, Guarantee, Unguarantee
    JEL: J32 J11 J17 G22
    Date: 2019–11–27
  18. By: Kilian R. Dinkelaker; Andreas-Walter Mattig; Stefan Morkoetter
    Abstract: We investigate the effect of credit analyst rotation in the context of long-term ratings of S&P 500 issuers between 2002 and 2015. We find that analyst rotation in the coverage of issuers is associated with higher rating activity and a lower credit risk assessment (e.g., rating downgrades) following the appointment of a new credit analyst. Our results provide empirical support for policies relating to mandatory credit analyst rotation programs.
    Keywords: Rating agencies, credit ratings, credit analysts, rotation policy, analyst bias
    JEL: G14 G24 G28
    Date: 2019–08
  19. By: Rolando Fuentes; Jorge Blazquez; Iqbal Adjali (King Abdullah Petroleum Studies and Research Center)
    Abstract: A market in which individuals pursue their own self-interest normally maximizes aggregate economic well-being. But households that install Distributed Energy Resources (DERs) in order to obtain savings in their electricity bill, impose an external cost on other customers. At scale, their actions can lead to higher electricity tariffs for utility customers and, in the extreme case, a utility death spiral. In this paper, we propose a market mechanism that may ameliorate this potential distortion based on the creation of a market for risk. Utilities would provide reliability insurance services to households to protect them against the failure of their own DER systems. Creating such an insurance market would allow customers to choose a premium according to their preference for reliability. It could also limit the potential utility death spiral efficiently, as the path would be driven by market mechanisms that arise after reassigning property rights and liabilities between utilities and their customers.
    Keywords: Distributed energy resources (DER), Electric power, Power markets, Utilities
    Date: 2018–11
  20. By: Manuel Ammann; Mathis Mörke
    Abstract: This paper studies variance risk premiums in the credit market. Using a novel data set of swaptions quotes on the CDX North America Investment Grade index, we find that returns of credit variance swaps are negative and economically large. Shorting variance swaps yields an annualized Sharpe ratio of almost six, eclipsing its counterpart in fixed income or equity markets. The returns remain highly statistically significant when accounting for transaction costs, cannot be explained by established risk-factors, and hold for various investment horizons. We also dissect the overall variance risk premium into payer and receiver variance risk premiums. We find that exposure to both parts is priced. However, the returns for payer variance, associated with bad economic states, are roughly twice as high in absolute terms.
    Keywords: Variance risk premium, CDS implied volatility, CDS variance swap
    JEL: G12 G13
    Date: 2019–06
  21. By: Lai, Audrey F.; Noymer, Andrew; Tai, Tsuio
    Abstract: We introduce convex hulls as a data visualization and analytic tool for demography. Convex hulls are widely used in computer science, and have been applied in fields such as ecology, but are heretofore underutilized in population studies. We briefly discuss convex hulls, then we show how they may profitably be applied to demography. We do this through three examples, drawn from the relationship between child mortality and adult survivorship (5q0 and 45p15 in life table notation). The three examples are: (i) sex differences in mortality; (ii) period and cohort differences and (iii) outlier identification. Convex hulls can be useful in robust compilation of demographic databases. Moreover, the gap/lag framework for sex differences or period/cohort differences is more complex when mortality data are arrayed by two components as opposed to a unidimensional measure such as life expectancy. Our examples show how, in certain cases, convex hulls can identify patterns in demographic data more readily than other techniques. The potential applicability of convex hulls in population studies goes beyond mortality.
    Date: 2019–04–01
  22. By: Priebe, Jan; Rink, Ute; Stemmler, Henry
    Abstract: This paper looks at individual risk behavior and disability in Vietnam, where many households live with a disabled family member. Due to the Vietnam war, disability is a common phenomenon and shapes individuals’ daily life and decision making. Using longitudinal data of 2200 households in Vietnam and an instrumental variable strategy, we show that individuals who live with a disabled family member are more risk averse than others. In addition we employ field experiments and psychological primes to elicit risk and loss behavior of individuals living in the Vietnam province Ha-Thinh. The experimental results, underpin our panel results. We show in addition that a negative recollection of health issues, leads to a lower risk attitude of individuals who do not live with a disabled family member and that individuals who live with a disabled family member are less loss averse. Our findings are causal and contribute to existing studies showing that households who are characterized by higher backward risks are more risk averse than others.
    Keywords: Risk, Disability, Vietnam
    JEL: D1 I14 Z1
    Date: 2019–08

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