nep-rmg New Economics Papers
on Risk Management
Issue of 2020‒09‒28
twenty-two papers chosen by
Stan Miles
Thompson Rivers University

  1. Simulation Methods for Robust Risk Assessment and the Distorted Mix Approach By Sojung Kim; Stefan Weber
  2. Factors affecting non-performing loans of commercial banks: The role of bank performance and credit growth By Dao, Kieu Oanh; Nguyen, Thi Yen; Hussain, Sarfraz; Nguyen, V.C.
  3. Forward looking loan provisions: Credit supply and risk-taking By Bernardo Morais; Gaizka Ormazabal; José-Luis Peydró; Mónica Roa; Miguel Sarmiento
  4. Systemic Banking Crises: The Relationship Between Concentration and Interbank Connections. By Andrea Calef
  5. Get beyond policy uncertainty: Evidence from political connections By Hua Cheng; Kishore Gawande; Steven Ongena; Shusen Qi
  6. Unskilled Fund Managers: Replicating Active Fund Performance With Few ETFs By Elias Cavalcante Junior; Fernando Moraes, Rodrigo De Losso
  8. High-Frequency Movements of the Term Structure of Interest Rates of the United States: The Role of Oil Market Uncertainty By Elie Bouri; Rangan Gupta; Clement Kweku Kyei; Sowmya Subramaniam
  9. Crisis Impact on the Diversity of Financial Portfolios - Evidence from European Citizens By Dorothea Schäfer; Michael Stöckel; Henriette Weser
  10. Skewing Quanto with Simplicity By George Hong
  11. Arbitrage and Beliefs By Paymon Khorrami; Alexander K. Zentefis
  12. Market Information in Banking Supervision: The Role of Stress Test Design By Ding, Haina; Guembel, Alexander
  13. Exact Computation of Maximum Rank Correlation Estimator By Youngki Shin; Zvezdomir Todorov
  14. Does higher business risk influence financial risk and induce savings among small agricultural operations? Findings from Tennessee By Adhikari, Sudip; Khanal, Aditya R.
  15. Price, Volatility and the Second-Order Economic Theory By Olkhov, Victor
  16. CEO Incentives and Bank Risk over the Business Cycle By Steven Ongena; Tanseli Savaser; Elif Sisli Ciamarra
  17. The Nexus between Natural disasters, Supply Chains and Trade – Revisiting the Role of FTAs in Disaster Risk Reduction By Permani, Risti; Xu, Xing
  18. Forecasting Low Frequency Macroeconomic Events with High Frequency Data By Ana B. Galvão; Michael T. Owyang
  19. Manager Uncertainty and Cross-Sectional Stock Returns By Tengfei Zhang
  20. Bequeathing in ambiguous times By Saito, Yuta
  21. Variance Gamma Model in Hedging Vanilla and Exotic Options By Bartłomiej Bollin; Robert Ślepaczuk
  22. Ambiguity and the Home Currency Bias By Urban Ulrych; Nikola Vasiljevic

  1. By: Sojung Kim; Stefan Weber
    Abstract: Uncertainty requires suitable techniques for risk assessment. Combining stochastic approximation and stochastic average approximation, we propose an efficient algorithm to compute the worst case average value at risk in the face of tail uncertainty. Dependence is modelled by the distorted mix method that flexibly assigns different copulas to different regions of multivariate distributions. We illustrate the application of our approach in the context of financial markets and cyber risk.
    Date: 2020–09
  2. By: Dao, Kieu Oanh; Nguyen, Thi Yen; Hussain, Sarfraz; Nguyen, V.C.
    Abstract: The recent crisis of non-performing loans in the banking system has hit the Vietnamese economy hard. The GDP has been fallen down, while the bad debt ratio in the banking system has risen dramatically to 17.2 percent, and it takes more time to restore the economy and banking system. This research aims to define aspects that impact non-performing commercial bank loans in Vietnam. It covers the period of 2008–2017 using 200 identified banks of Ho Chi Minh City Stock Exchange and Hanoi Stock Exchange, and applies methods based on the regression of pooled ordinary least squares, fixed and random effects models, in particular, generalized least squares to confirm the stability of the regression model. The results show that non-performing loans this year will positively affect those in the next year. In addition, a raise in bank performance and credit growth also leads to the reduction in non-performing loans from banks. Regarding macroeconomic factors, higher interest rates would have a major and beneficial influence on failed loans in terms of macroeconomic dynamics, and, therefore, little effect on economic activity and inflation. Therefore, Vietnamese banking system should reduce the systematic risk and improve monitoring processes, drawing on the experience of global banks with extensive experience in risk management.
    Date: 2020–08–12
  3. By: Bernardo Morais; Gaizka Ormazabal; José-Luis Peydró; Mónica Roa; Miguel Sarmiento
    Abstract: We show corporate-level real, financial, and (bank) risk-taking effects associated with calculating loan provisions based on expected-rather than incurred-credit losses. For identification, we exploit unique features of a Colombian reform and supervisory, matched loan-level data. The regulatory change induces a dramatic increase in provisions. Banks tighten all new lending conditions, adversely affecting borrowing-firms, with stronger effects for risky-firms. Moreover, to minimize provisioning, more affected (less-capitalized) banks cut credit supply to risky-firms- SMEs with shorter credit history, less tangible assets or more defaulted loans-but engage in "search-for-yield" within regulatory constraints and increase portfolio concentration, thereby decreasing risk diversification.
    Keywords: Loan provisions, IFRS9, ECL, corporate real and credit supply effects of accounting, bank risk-taking
    JEL: E31 G18 G21 G28
    Date: 2020–08
  4. By: Andrea Calef (University of East Anglia)
    Abstract: In this paper I study the extent to which the nexus between concentration and interbank linkages affects financial stability, using data for a sample of 19,689 banks in 69 countries from 1995 to 2014. I find that high levels of interbank exposures decrease the probability of observing a systemic banking crisis, when the banking system is either highly concentrated or fragmented. The relationship between concentration and stability is found to be non-monotonic, as predicted by Martinez-Miera & Repullo (2010), although not U-shaped.
    Keywords: banking crisis, systemic risk, market structure; interbank linkages, network, contagion.
    JEL: G01 G21 G28
    Date: 2020–01–15
  5. By: Hua Cheng (Nankai University - School of Finance; University of Texas at Austin); Kishore Gawande (University of Texas at Austin); Steven Ongena (University of Zurich - Department of Banking and Finance; Swiss Finance Institute; KU Leuven; Centre for Economic Policy Research (CEPR)); Shusen Qi (Xiamen University - School of Management)
    Abstract: Although policy uncertainty has drawn regulators’ attention in the aftermath of the global financial crisis, little is known on how to alleviate its adverse effects. In this paper, we examine the role of political connections in mitigating the detrimental impact of policy uncertainty on banks. Our estimates show that banks are more cautious when facing policy uncertainty, but that the effect is partially alleviated when banks are politically connected. For an increase of one standard deviation in policy uncertainty, connected banks maintain a loss provision to loan volume ratio that is almost seven percent lower compared to their unconnected peers. These findings are robust to a geographical regression discontinuity setting, as well as to a placebo test. Lastly, the mitigating role of political connections is driven mainly by smaller banks and periods of stricter banking regulations.
    Keywords: Policy uncertainty; Political connections; Bank risk-taking
    JEL: G21 G28 H70
    Date: 2020–05
  6. By: Elias Cavalcante Junior; Fernando Moraes, Rodrigo De Losso
    Abstract: This paper use Exchange Traded Funds (ETFs) instead of risk factors as benchmarks to examine active mutual fund performance distribution. While transaction costs are included in the ETF returns, that is not true regarding risk factors, making it more challenging to characterize extraordinary performances via alphas. Assessments are based on the proportion of skilled funds, defined as positive-alpha funds. Such a proportion is calculated taking into account potential false discoveries and employing the method devised by Barras et al. (2010). After evaluating several ETF combinations, we conclude that sets of 3 to 5 ETFs replicate most levels of active fund performance. Finally, we propose specific ETF selection algorithms, whereby we estimate that 95% of active management funds fail to generate value for their investors. Alphas calculated with ETFs are higher than those using risk factors, but the difference is similar to the transaction costs required for investing in risk factor portfolios (Frazzini et al., 2012).
    Keywords: Mutual funds; performance measures; ETF; risk factors
    JEL: G11 G2 G23
    Date: 2020–08–18
  7. By: fernos, jhon; Satifa, Oriza
    Abstract: This study aims to determine the application of credit risk management and criteria as well as efforts to minimize credit risk in Bank Nagari Simpang Haru Sub-Branch. In implementing credit risk management at Bank Nagari Simpang Haru Sub-Branch, it includes the identification, measurement, monitoring and control of credit risk. Credit risk is the risk of non-performing loans where the debtor must be under special surveillance while the credit measurement must be in accordance with the NPL, Non-perfoming loan (NPL) is very important for credit risk measurement at Bank Nagari Simpang Haru Sub-Branch, because it must be in accordance with the applicable provisions of the Bank Indonesia (BI), by using a non perfoming loan, it will be easy for the Bank to find out the criteria in analyzing credit risk where the Indonesian bank sets a maximum Npl of 5%. Credit collectability is the basis in calculating the level of NPL. Credit Risk Issues that appear at Bank Nagari Simpang Haru Sub-Branch, namely Problem Loans. In this case there are credit risk factors including internal banks, debtors and others. Thus the debtor becomes a factor that often arises and is of special concern.
    Date: 2020–07–31
  8. By: Elie Bouri (Adnan Kassar School of Business, Lebanese American University, Lebanon); Rangan Gupta (Department of Economics, University of Pretoria, Pretoria, 0002, South Africa); Clement Kweku Kyei (Department of Economics, University of Pretoria, Pretoria, 0002, South Africa); Sowmya Subramaniam (Indian Institute of Management Lucknow, Prabandh Nagar off Sitapur Road, Lucknow, Uttar Pradesh 226013, India)
    Abstract: Using daily data from 3rd January, 2001 to 17th July, 2020, we analyse the impact of oil market uncertainty, computed based on realized volatility of 5-minute intraday oil returns, on the level, slope and curvature factors derived from the term structure of interest rates of the United States (US) covering maturities of 1 to 30 years. The results of the linear Granger causality tests detect no evidence of predictability of oil uncertainty on the three latent factors. However, evidence of nonlinearity and structural breaks indicates misspecification of the linear model. Accordingly, we use a data-driven approach, the nonparametric causality in-quantiles test, which is robust to misspecification due to nonlinearity and regime change. Notably, this test allows us to model the entire conditional distribution of the level, slope and curvature factors, and hence accommodate, via the lower quantiles, the zero lower bound situation observed in our sample period. Using this robust test, we find overwhelming evidence of causality from oil uncertainty for the entire conditional distribution of the three factors, suggesting the predictability of the entire US term structure based on information contained in oil market volatility. Our results have important implications for academics, investors and policymakers.
    Keywords: US Term Structure of Interest Rates, Yield Curve Factors, Oil Market Uncertainty, Causality-in-Quantiles Test
    JEL: C22 C32 E43 Q41
    Date: 2020–09
  9. By: Dorothea Schäfer; Michael Stöckel; Henriette Weser
    Abstract: Since the 2008 Lehman bankruptcy, it is clearly shown that global economic and financial crises present major challenges to private households, requiring from them, a high level of shock absorption capacity. According to the old adage, “Do not put all the eggs in one basket”, resilience depends, to a large extent on financial diversification. So far, especially for Europe, little is known about whether and how the Great Financial Crisis (GFC) affected the diversity of private households’ investment portfolios. We tackle this research gap and explore the impact of the GFC on portfolio diversity of European private households. Our European focus complements Sierminska and Silber (2019) who explore the diversification behaviour of US households after the Lehman insolvency. Our study reveals a significant decrease in the diversity of financial portfolios. This finding is robust across distinct model specifications. In response to the GFC, evidence suggests that European households adjusted the diversity of their financial portfolio in the opposite directions to that of US households.
    Keywords: Financial and economic crisis, household finance, portfolio diversification, Shannon entropy index, Gini-Simpson diversity index, background risk, risk aversion
    JEL: D14 G11 G01
    Date: 2020
  10. By: George Hong
    Abstract: We present a simple and highly efficient analytical method for solving the Quanto Skew problem in Equities under a framework that accommodates both Equity and FX volatility skew consistently. Ease of implementation and extremely fast performance of this new approach should benefit a wide spectrum of market participants.
    Date: 2020–09
  11. By: Paymon Khorrami; Alexander K. Zentefis
    Abstract: We study a segmented-markets setting in which self-fulfilling volatility can arise. The only requirements are (i) asset price movements redistribute wealth across markets (e.g., equities rise as bonds fall) and (ii) some stabilizing force keeps valuation ratios stationary (e.g., cash flow growth rises when valuations rise). We prove that when self-fulfilling volatility exists, arbitrage opportunities must also exist. Conversely, at times when arbitrage profits exist, asset markets are susceptible to self-fulfilling fluctuations. The tight theoretical connection between price volatility and arbitrage is detectable in currency markets by studying deviations from covered interest parity.
    Keywords: limits to arbitrage, segmented markets, volatility, self-fulfilling prices, multiple equilibria, covered interest parity
    JEL: D84 G11 G12
    Date: 2020
  12. By: Ding, Haina; Guembel, Alexander
    Abstract: This paper studies the optimal degree of leniency in a bank stress test, when poorly capitalized banks engage in risk shifting and a banking supervisor can intervene to prevent it. The stress test directly provides the supervisor with noisy information about whether or not a bank is well capitalized. Furthermore, the stress test outcome a¤ects a speculator's incentives to acquire costly information about the bank and trade in its shares. This in turn a¤ects the amount of market information available to the supervisor when she takes her intervention decision. We show that a supervisor optimally distorts the stress test towards leniency for banks whose shares are relatively illiquid, and about whom the supervisor has little private information. When the supervisor has substantial private information about a bank whose shares are fairly liquid, it is optimal to apply a conservative stress test.
    Keywords: Stress test, leniency, monitoring, feedback, risk shifting
    JEL: G14 G28
    Date: 2020–09–10
  13. By: Youngki Shin; Zvezdomir Todorov
    Abstract: In this paper we provide an exact computation algorithm for the maximum rank correlation estimator using the mixed integer programming (MIP) approach. We construct a new constrained optimization problem by transforming all indicator functions into binary parameters to be estimated and show that it is equivalent to the original problem. Using a modern MIP solver, we apply the proposed method to an empirical example and Monte Carlo simulations. We also consider an application of the best subset rank prediction and show that the original optimization problem can be reformulated as MIP. We derive the non-asymptotic bound for the tail probability of the predictive performance measure.
    Date: 2020–09
  14. By: Adhikari, Sudip; Khanal, Aditya R.
    Keywords: Agribusiness, Agricultural Finance, Production Economics
    Date: 2020–07
  15. By: Olkhov, Victor
    Abstract: This paper considers price volatility as the reason for description of the second-degree economic variables, trades and expectations aggregated during certain time interval Δ. We call it - the second-order economic theory. The n-th degree products of costs and volumes of trades, performed by economic agents during interval Δ determine price n-th statistical moments. First two price statistical moments define volatility. To model volatility one needs description of the squares of trades aggregated during interval Δ. To describe price probability one needs all n-th statistical moments of price but that is almost impossible. We define squares of agent’s trades and macro expectations those approve the second-degree trades aggregated during interval Δ. We believe that agents perform trades under action of multiple expectations. We derive equations on the second-degree trades and expectations in economic space. As economic space we regard numerical continuous risk grades. Numerical risk grades are discussed at least for 80 years. We propose that econometrics permit accomplish risk assessment for almost all economic agents. Agents risk ratings distribute agents by economic space and define densities of macro second-degree trades and expectations. In the linear approximation we derive mean square price and volatility disturbances as functions of the first and second-degree trades disturbances. In simple approximation numerous expectations and their perturbations can cause small harmonic oscillations of the second-degree trades disturbances and induce harmonic oscillations of price and volatility perturbations.
    Keywords: volatility; economic theory; market trades; expectations; price probability
    JEL: C1 D4 E4 G1 G2
    Date: 2020–09–06
  16. By: Steven Ongena (University of Zurich - Department of Banking and Finance; Swiss Finance Institute; KU Leuven; Centre for Economic Policy Research (CEPR)); Tanseli Savaser (Vassar College - Department of Economics); Elif Sisli Ciamarra (Stonehill College)
    Abstract: We examine whether the relationship between managerial risk-taking incentives and bank risk is sensitive to the underlying macroeconomic conditions. We find that risk-taking incentives provided to bank executives are associated with higher bank riskiness during economic downturns. We attribute this finding to the increase in moral hazard during macroeconomic downturns when the perceived probability of future bailouts and government guarantees rises. This association is particularly strong for larger banks, banks that maintain lower capital ratios and banks that are managed by more powerful CEOs. Our findings highlight the importance of the interaction between managerial incentives and the macroeconomic environment. Boards and regulators may find it useful to consider the countercyclical nature of the relationship between risk-taking incentives and bank riskiness when designing managerial compensation.
    Keywords: bank risk; executive compensation; equity-based compensation; macroeconomy
    JEL: G01 G2 G3 M52
    Date: 2020–09
  17. By: Permani, Risti; Xu, Xing
    Keywords: International Relations/Trade, Agricultural and Food Policy, International Development
    Date: 2020–07
  18. By: Ana B. Galvão; Michael T. Owyang
    Abstract: High-frequency financial and economic activity indicators are usually time aggregated before forecasts of low-frequency macroeconomic events, such as recessions, are computed. We propose a mixed-frequency modelling alternative that delivers high-frequency probability forecasts (including their confidence bands) for these low-frequency events. The new approach is compared with single-frequency alternatives using loss functions adequate to rare event forecasting. We provide evidence that: (i) weekly-sampled spread improves over monthly-sampled to predict NBER recessions, (ii) the predictive content of the spread and the Chicago Fed Financial Condition Index (NFCI) is supplementary to economic activity for one-year-ahead forecasts of contractions, and (iii) a weekly activity index can date the 2020 business cycle peak two months in advance using a mixed-frequency filtering.
    Keywords: mixed frequency models; recession; financial indicators; weekly activity index; event probability forecasting
    JEL: C25 C53 E32
    Date: 2020–09
  19. By: Tengfei Zhang
    Abstract: This paper evidences the explanatory power of managersâ uncertainty for cross-sectional stock returns. I introduce a novel measure of the degree of managersâ uncertain beliefs about future states: manager uncertainty (MU), defined as the count of the word âuncertaintyâ over the sum of the count of the word âuncertaintyâ and the count of the word âriskâ in filings and conference calls. I find that managerâs level of uncertainty reveals valuation information about real options and thereby has significantly negative explanatory power for cross-sectional stock returns. Beyond existing market-based uncertainty measures, the manager uncertainty measure has incremental pricing power by capturing information frictions between managersâ reported uncertainty and investorsâ perception of uncertainty. Moreover, a short-long portfolio sorted by manager uncertainty has a significantly positive premium and cannot be spanned by existing factor models. An application on COVID-19 uncertainty shows consistent results.
    JEL: G11 G12 D81
    Date: 2020–09–18
  20. By: Saito, Yuta
    Abstract: This paper studies a model of altruistic bequest in times of ambiguity. The parent is ambiguous about future economic conditions, which affects the probability of the child’s economic success. We show that an increase in the degree of ambiguity makes the parent leave more transfer. Our model implies that the amount of parental transfer grows during a pandemic or recession.
    Keywords: Bequest; Parental Transfer; Robust Control; Ambiguity
    JEL: D1 D8 E21
    Date: 2020–04–01
  21. By: Bartłomiej Bollin (Quantitative Finance Research Group; Faculty of Economic Sciences, University of Warsaw); Robert Ślepaczuk (Quantitative Finance Research Group; Faculty of Economic Sciences, University of Warsaw)
    Abstract: The aim of this research is to explore the performance of different option pricing models in hedging the exotic options using the FX data. We analyze the narrow class of Lévy processes - the Variance Gamma process in hedging vanilla, Asian and lookback options. We pose a question of whether or not using additional level of complexity, by introducing more sophisticated models, improves the effectiveness of hedging options, assuming that hedging errors are measured as the differences between portfolio values according to the model and not real market data (which we don’t have). We compare this model with its special case and the Black-Scholes model. We use the data for EURUSD currency pair assuming that option prices change according to the model (as we don’t observe them directly). We use Monte Carlo methods in fitting the model’s parameters. Our results are not in line with the previous literature as there are no signs of the Variance Gamma process being better than the Black-Scholes and it seems that all three models perform equally well.
    Keywords: Monte Carlo, option pricing, Variance Gamma, BSM model, Lévy processes, FX market, hedging, Asian and lookback options
    JEL: C02 C4 C14 C15 C22 C45 C53 C58 C63 G12 G13
    Date: 2020
  22. By: Urban Ulrych (University of Zurich - Department of Banking and Finance; Swiss Finance Institute); Nikola Vasiljevic (University of Zurich, Department of Banking and Finance)
    Abstract: This paper addresses the question of optimal currency exposure for a risk-and-ambiguity-avers international investor. A robust mean-variance model with smooth ambiguity preferences is used to derive the optimal currency exposure. In the theoretical part, we show that the sample-efficient currency demand can be calculated as the solution to a generalized ridge regression. Through the lens of these results, we demonstrate that our ambiguity-based model offers a new explanation of the home currency bias. The investor's dislike for model uncertainty induces a disproportionately high currency hedging demand. The empirical analysis of currency overlay strategies employs the foreign exchange, equity, and bond returns over the period from 1999 to 2018. Our out-of-sample back-tests illustrate that accounting for ambiguity enhances the stability of estimated optimal currency exposures and significantly improves the portfolio performance net of transaction costs.
    Keywords: Ambiguity aversion, model uncertainty, optimal currency overlay, generalized ridge regression, international asset allocation
    JEL: D81 D83 F31 G11 G15
    Date: 2020–08

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