nep-rmg New Economics Papers
on Risk Management
Issue of 2020‒05‒25
twelve papers chosen by

  1. Max Headroom: Discretionary Capital Buffers and Bank Risk By Lubberink, Martien
  2. Size does matter. A study on the required window size for optimal quality market risk models By Mateusz Buczyński; Marcin Chlebus
  3. Stressed Banks? Evidence from the Largest-Ever Supervisory Review By Abbassi, Puriya; Iyer, Rajkamal; Peydró, José-Luis; Soto, Paul
  4. The Informational Content of Default Risk in UK Insurance Firms By Mario Cerrato; Paolo Coccorese; Xuan Zhang
  5. The Variance Risk Premium in Equilibrium Models By Geert Bekaert; Eric Engstrom; Andrey Ermolov
  6. How should a points pension system be managed? By Antoine Bozio; Simon Rabaté; Audrey Rain; Maxime Tô
  7. Short-Term Investments and Indices of Risk By Yuval Heller; Amnon Schreiber
  8. The Potential Capital Requirement for a Minimum Prices Insurance Scheme for Wheat, Maize, and Rape Seed By Thomas Url; Serguei Kaniovski
  9. Buildings’ Energy Efficiency and the Probability of Mortgage Default: The Dutch Case By Monica Billio; Michele Costola; Loriana Pelizzon; Max Riedel
  10. A Multi-Risk SIR Model with Optimally Targeted Lockdown By Daron Acemoglu; Victor Chernozhukov; Iván Werning; Michael D. Whinston
  11. Can heterogeneous agent models explain the alleged mispricing of the S&P 500? By Lux, Thomas
  12. Continuous time mean-variance-utility portfolio problem and its equilibrium strategy By Ben-Zhang Yang; Xin-Jiang He; Song-Ping Zhu

  1. By: Lubberink, Martien
    Abstract: This paper examines the association between discretionary capital buffers, capital requirements, and risk for European banks. The discretionary buffers are banks' own buffers, or headroom: the difference between reported and required capital. I exploit capital requirements data that banks started to disclose since the release of a 2015 European Banking Authority opinion. Results using detailed SREP and Pillar 2 data of the largest 99 European banks over 2013-2019 show that less headroom is associated with increased bank risk. An additional examination reveals a positive association between headroom and stress test results for banks subjected to the Single Supervisory Mechanism, a result that runs against supervisory requirements.
    Keywords: Banking, European Banks, Pillar 2 requirements, SREP
    JEL: G21
    Date: 2020–05–17
  2. By: Mateusz Buczyński (Interdisciplinary Doctoral School, University of Warsaw); Marcin Chlebus (Faculty of Economic Sciences, University of Warsaw)
    Abstract: When it comes to market risk models, should we use full data that we possess or rather find a sufficient subsample? We have conducted a study of different fixed moving window’s lengths (from 300 to 2000 observations) for three Value-at-Risk models: historical simulation, GARCH and CAViaR model for three different indexes: WIG20, S&P500 and FTSE100. Testing samples contained 250 observations, each ending with the end of years 2015-2019. We have also addressed the subjectivity of choosing the window’s size by testing change points detection algorithms: binary segmentation and Pelt; to find the best matching cut-off point. Results indicate that the size of the training sample greater than 900-1000 observations doesn’t increase the quality of the model, while the lengths lower than such cut-off provide unsatisfactory results and decrease model’s conservatism. Change point detection methods provide more accurate models. Applying the algorithms with every model’s recalculation provides results better by on average 1 exceedance. Our recommendation is to use GARCH or CAViaR model with recalculated window size.
    Keywords: Value at Risk; historical simulation; CAViaR; GARCH; forecast comparison; sample size
    JEL: G32 C52 C53 C58
    Date: 2020
  3. By: Abbassi, Puriya; Iyer, Rajkamal; Peydró, José-Luis; Soto, Paul
    Abstract: Regulation needs effective supervision; but regulated entities may deviate with unobserved actions. For identification, we analyze banks, exploiting ECB’s asset-quality-review (AQR) and supervisory security and credit registers. After AQR announcement, reviewed banks reduce riskier securities and credit (also overall securities and credit supply), with largest impact on riskiest securities (not on riskiest credit), and immediate negative spillovers on asset prices and firm-level credit supply. Exposed (unregulated) nonbanks buy the shed risk. AQR drives the results, not the end-of-year. After AQR compliance, reviewed banks reload riskier securities, but not riskier credit, with medium-term negative firm-level real effects (costs of supervision/safe-assets increase).
    Keywords: asset quality review,stress tests,supervision,risk-masking,costs of safe assets
    JEL: E58 G21 G28 H63 L51
    Date: 2020
  4. By: Mario Cerrato; Paolo Coccorese; Xuan Zhang
    Abstract: “Historically, insurers have made money in two ways – returning an underwriting profit and investing premiums and making money on the investment returns.” By Nick Kitchen, Head of Technical Casualty and Motor Lines, Zurich Insurance plc. In this paper, we use a novel data-set of UK public and non-public insurance companies for the period 1985-2014 in order to investigate the empirical relationship between firms’ specific characteristics and default risk. We employ a portfolio approach, and after splitting firms’ returns into underwriting and investment returns, we find evidence that default risk is closely related to size and reinsurance activities, especially for small size firms, and that such firms are much less risky than large firms and earn the highest return when their default risk is low. Some policy implications are also provided.
    JEL: G23 G20 G28
    Date: 2020–02
  5. By: Geert Bekaert; Eric Engstrom; Andrey Ermolov
    Abstract: The equity variance risk premium is the expected compensation earned for selling variance risk in equity markets. The variance risk premium is positive and shows moderate persistence. High variance risk premiums coincide with the left tail of the consumption growth distribution shifting down. These facts, together with a positive, yet moderate, difference between the risk-neutral entropy and variance of the aggregate market return, refute the bulk of the extant consumption-based asset pricing models. We introduce a tractable habit model that does fit the data. In the model, the variance risk premium depends positively (negatively) on “bad” (“good”) consumption growth uncertainty.
    JEL: E44 G12 G13
    Date: 2020–05
  6. By: Antoine Bozio (IPP - Institut des politiques publiques, PJSE - Paris Jourdan Sciences Economiques - UP1 - Université Panthéon-Sorbonne - ENS Paris - École normale supérieure - Paris - INRA - Institut National de la Recherche Agronomique - EHESS - École des hautes études en sciences sociales - ENPC - École des Ponts ParisTech - CNRS - Centre National de la Recherche Scientifique, PSE - Paris School of Economics); Simon Rabaté (IPP - Institut des politiques publiques, Centraal Planbureau); Audrey Rain (IPP - Institut des politiques publiques); Maxime Tô (IPP - Institut des politiques publiques, UCL - University College of London [London], Institute for Fiscal Studies)
    Abstract: A points system, operating at defined yield, makes it possible to rethink how pension systems are managed. Instead of having to make repeated ad hoc changes to the parameters of the system, it is possible to define change rules that other guarantees to future pensioners, as regards not only their entitlements but also the long-term sustainability of the system. In this brief, and based on simulations of a variety of shocks to the pension system, we study what management rules deserve to be chosen. Two rules absolutely must be selected: firstly the growth in the value of the pension point should match the growth in salaries; and secondly converting the points into pension should take into account the life expectancy of each generation (cohort). A third rule that is important for the long term, is the relationship between the rules for index-linking claimed pensions and the amounts of the pensions when they start being claimed. This rule should serve as a guide to managers so that they can steer the system towards an equilibrium that is not based on too low an index-linking of the pensions. Such management implies high institutional autonomy for the system, whereby the managers need to be accountable for the finnancial equilibrium and for the risks to pension revaluation.
    Date: 2019–06
  7. By: Yuval Heller; Amnon Schreiber
    Abstract: We study various decision problems regarding short-term investments in risky assets whose returns evolve continuously in time. We show that in each problem, all risk-averse decision makers have the same (problem-dependent) ranking over short-term risky assets. Moreover, in each problem, the ranking is represented by the same risk index as in the case of CARA utility agents and normally distributed risky assets.
    Date: 2020–05
  8. By: Thomas Url (WIFO); Serguei Kaniovski
    Abstract: In 2005 the EU lowered the guaranteed minimum prices for crops in its Common Agricultural Policy and stopped market interventions. Consequently, prices started to fluctuate more intensively, and farmers' incomes are now subject to higher price volatility. A crop price insurance scheme could provide an interesting instrument to stabilise the income of European farmers. We analyse the premium level and capital requirement of a hypothetical insurance contract covering several combinations of minimum prices for a bundle of wheat, maize, and rape seed. The premium level is based on the Black option pricing model and a Bayesian autoregressive stochastic volatility model. Monte Carlo simulated forecasts provide estimates for expected variances and a profit-loss distribution for various combinations of minimum prices. The required solvency capital to keep the insurance business afloat at the 1 percent ruin probability creates capital costs exceeding the expected profit.
    Keywords: crop insurance program, option pricing, time varying volatility
    Date: 2020–05–12
  9. By: Monica Billio (Department of Economics, University Of Venice Cà Foscari); Michele Costola (Department of Economics, University Of Venice Cà Foscari); Loriana Pelizzon (Research Center SAFE, Goethe University Frankfurt); Max Riedel (Department of Economics, University Of Venice Cà Foscari; Research Center SAFE, Goethe University Frankfurt)
    Abstract: 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 provided 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. We also show that energy efficiency provides a further mitigation of default risk for borrowers with a lower income potentially because of the savings coming from lower utility bills, which have a major impact on the borrower with less disposable income. The results hold for a battery of robustness checks.
    Keywords: Mortgages, Energy Efficiency, Credit Risk
    JEL: G21
    Date: 2020
  10. By: Daron Acemoglu; Victor Chernozhukov; Iván Werning; Michael D. Whinston
    Abstract: We develop a multi-risk SIR model (MR-SIR) where infection, hospitalization and fatality rates vary between groups—in particular between the “young”, “the middle-aged” and the “old”. Our MR-SIR model enables a tractable quantitative analysis of optimal policy similar to those already developed in the context of the homogeneous-agent SIR models. For baseline parameter values for the COVID-19 pandemic applied to the US, we find that optimal policies differentially targeting risk/age groups significantly outperform optimal uniform policies and most of the gains can be realized by having stricter lockdown policies on the oldest group. For example, for the same economic cost (24.3% decline in GDP), optimal semi–targeted or fully-targeted policies reduce mortality from 1.83% to 0.71% (thus, saving 2.7 million lives) relative to optimal uniform policies. Intuitively, a strict and long lockdown for the most vulnerable group both reduces infections and enables less strict lockdowns for the lower-risk groups. We also study the impacts of social distancing, the matching technology, the expected arrival time of a vaccine, and testing with or without tracing on optimal policies. Overall, targeted policies that are combined with measures that reduce interactions between groups and increase testing and isolation of the infected can minimize both economic losses and deaths in our model.
    JEL: I18
    Date: 2020–05
  11. By: Lux, Thomas
    Abstract: Tests of excessive volatility along the lines of Shiller (1981) and Leroy and Porter (1981) count among the most convincing pieces of evidence against the validity of the time-honored efficient market hypothesis. Recently, using Shillers distinction between ex-ante rational (fundamental) price and ex-post rational price, Schmitt and Westerhoff (2017) have demonstrated that the difference between S&P 500 market prices and their ex-post counterparts exhibits a bi-modal distribution speaking for the prevalence of long periods of either undervaluation or overvaluation. Schmitt and Westerhoff (2017) also show that this new stylized fact is shared by a large set of nonlinear behavioral models of speculative interactions between heterogeneous market participants. Most of these models allow some form of chartist or fundamentalist strategy, and the more recent members of this family of models also allow for agents switching between both alternatives according to some fitness criterion. Here I go one step further exploring which (if any) of this legacy of behavioral models fits best the data. I discuss econometric issues in the estimation of these highly complex nonlinear models, and estimate the parameters of different versions of seven canonical models. As it turns out, most of these models perform not better than a linear chartist-fundamentalist model, and often their fit is worse than the fit of this benchmark. Among the models considered here, the one proposed by Franke and Westerhoff (2012) is the only exception. Estimation of the model confidence set indicates that this model is not outperformed by other candidates, and depending on the setting and the confidence level, it is often found to be the single member of the model confidence set.
    Keywords: Stock market dynamics,bubbles and crashes,nonlinear dynamics,chartists and fundamentalists,model confidence set
    JEL: G12 G14 G17
    Date: 2020
  12. By: Ben-Zhang Yang; Xin-Jiang He; Song-Ping Zhu
    Abstract: In this paper, we propose a new class of optimization problems, which maximize the terminal wealth and accumulated consumption utility subject to a mean variance criterion controlling the final risk of the portfolio. The multiple-objective optimization problem is firstly transformed into a single-objective one by introducing the concept of overall "happiness" of an investor defined as the aggregation of the terminal wealth under the mean-variance criterion and the expected accumulated utility, and then solved under a game theoretic framework. We have managed to maintain analytical tractability; the closed-form solutions found for a set of special utility functions enable us to discuss some interesting optimal investment strategies that have not been revealed before in literature.
    Date: 2020–05

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