nep-rmg New Economics Papers
on Risk Management
Issue of 2021‒08‒23
fifteen papers chosen by
Stan Miles
Thompson Rivers University

  1. Dynamic Currency Hedging with Ambiguity By Pawel Polak; Urban Ulrych
  2. Distributionally robust goal-reaching optimization in the presence of background risk By Yichun Chi; Zuo Quan Xu; Sheng Chao Zhuang
  3. Predicting Credit Default Probabilities Using Bayesian Statistics and Monte Carlo Simulations By Dominic Joseph
  4. Does the market believe in loss-absorbing bank debt? By Martin Indergand; Gabriela Hrasko
  5. Reduced-form framework for multiple default times under model uncertainty By Francesca Biagini; Andrea Mazzon; Katharina Oberpriller
  6. The Evolution from Life Insurance to Financial Engineering By Ralph S. J. Koijen; Motohiro Yogo
  7. Currency Management by International Fixed Income Mutual Funds By Clemens Sialm; Qifei Zhu
  8. InfoGram and Admissible Machine Learning By Subhadeep Mukhopadhyay
  9. Rare Disaster Risks and Volatility of the Term-Structure of US Treasury Securities: The Role of El Nino and La Nina Events By Renee van Eyden; Rangan Gupta; Jacobus Nel; Elie Bouri
  10. Modeling ex-ante risk premia in the oil market By Georges Prat; Remzi Uctum
  11. Sharing asymmetric tail risk smoothing, asset pricing and terms of trade By Giancarlo Corsetti; Anna Lipínska; Giovanni Lombardo
  12. Inverse Options in a Black-Scholes World By Carol Alexander; Arben Imeraj
  13. Term structure of interest rates: modelling the risk premium using a two horizons framework By Georges Prat; Remzi Uctum
  14. Wealth and Insurance Choices: Evidence from US Households By Michael J. Gropper; Camelia M. Kuhnen
  15. Risk Preferences in Time Lotteries By Yonatan Berman; Mark Kirstein

  1. By: Pawel Polak (Stony Brook University); Urban Ulrych (University of Zurich - Department of Banking and Finance; Swiss Finance Institute)
    Abstract: This paper establishes a general relation between investor's ambiguity and non-Gaussianity of financial asset returns. Based on that relation and utilizing a flexible non-Gaussian returns model for the joint distribution of portfolio and currency returns, we develop an ambiguity-adjusted dynamic currency hedging strategy for international investors. We propose an extended filtered historical simulation that combines Monte Carlo simulation based on volatility clustering patterns with the semi-parametric non-normal return distribution from historical data. This simulation allows us to incorporate investor's ambiguity into the dynamic currency hedging strategy algorithm that can numerically optimize an arbitrary risk measure, such as volatility, value-at-risk, or expected shortfall. The out-of-sample back-test results show that, for globally diversified investors, the derived dynamic currency hedging strategy with ambiguity is stable, robust, and highly risk reductive. It outperforms the benchmarks of constant hedging as well as dynamic approaches without ambiguity in terms of lower maximum drawdown and higher Sharpe and Sortino ratios in gross terms and net of transaction costs.
    Keywords: Currency Hedging, Ambiguity, Filtered Historical Simulation, Expected Shortfall, Non- Gaussianity, International Asset Allocation, Currency Risk Management
    JEL: C53 C58 F31 G11 G15
    Date: 2021–08
  2. By: Yichun Chi; Zuo Quan Xu; Sheng Chao Zhuang
    Abstract: In this paper, we examine the effect of background risk on portfolio selection and optimal reinsurance design under the criterion of maximizing the probability of reaching a goal. Following the literature, we adopt dependence uncertainty to model the dependence ambiguity between financial risk (or insurable risk) and background risk. Because the goal-reaching objective function is non-concave, these two problems bring highly unconventional and challenging issues for which classical optimization techniques often fail. Using quantile formulation method, we derive the optimal solutions explicitly. The results show that the presence of background risk does not alter the shape of the solution but instead changes the parameter value of the solution. Finally, numerical examples are given to illustrate the results and verify the robustness of our solutions.
    Date: 2021–08
  3. By: Dominic Joseph
    Abstract: Banks and financial institutions all over the world manage portfolios containing tens of thousands of customers. Not all customers are high credit-worthy, and many possess varying degrees of risk to the Bank or financial institutions that lend money to these customers. Hence assessment of credit risk is paramount in the field of credit risk management. This paper discusses the use of Bayesian principles and simulation-techniques to estimate and calibrate the default probability of credit ratings. The methodology is a two-phase approach where, in the first phase, a posterior density of default rate parameter is estimated based the default history data. In the second phase of the approach, an estimate of true default rate parameter is obtained through simulations
    Date: 2021–08
  4. By: Martin Indergand; Gabriela Hrasko
    Abstract: We propose a simple model to estimate the risk-neutral loss distribution from the credit spreads of long-term debt instruments with different seniorities. We apply our model to a sample of global systemically important banks that have issued bail-in debt in order to meet the total loss-absorbing capacity (TLAC) requirements established after the global financial crisis. Bail-in debt is a new debt category that absorbs losses in a gone-concern situation and that ranks between subordinated debt and non-eligible senior debt. With a structural model for these three debt layers, we calibrate the tail of the risk-neutral loss distribution such that it is consistent with the observed market prices. Based on this loss distribution, we find that the expected loss in a gone-concern situation exceeds TLAC for most banks and that the risk-neutral probability that TLAC will not be sufficient to cover the losses in such a situation is approximately 50%. The large expected losses that we find with our model are a consequence of the similar pricing of bail-in debt relative to other senior debt. We argue that regulators should promote further clarity about the subordination and the conversion mechanism of bail-in debt to achieve a more differentiated pricing that is more in line with regulatory expectations.
    Keywords: Financial stability, bank regulation, loss-absorbing capacity, creditor hierarchy, bail-in debt, bank resolution
    JEL: G12 G28 G32
    Date: 2021
  5. By: Francesca Biagini; Andrea Mazzon; Katharina Oberpriller
    Abstract: In this paper we introduce a sublinear conditional operator with respect to a family of possibly nondominated probability measures in presence of multiple ordered default times. In this way we generalize the results of [5], where a reduced-form framework under model uncertainty for a single default time is developed. Moreover, we use this operator for the valuation of credit portfolio derivatives under model uncertainty.
    Date: 2021–08
  6. By: Ralph S. J. Koijen; Motohiro Yogo
    Abstract: Since the mid-1980s, the share of household net worth intermediated by US financial institutions has shifted from defined benefit plans to life insurers and defined contribution plans. Life insurers have primarily grown through variable annuities, which are mutual funds with longevity insurance, a potential tax advantage, and minimum return guarantees. The minimum return guarantees change the primary function of life insurers from traditional insurance to financial engineering. Variable annuity insurers are exposed to interest and equity risk mismatch and suffered especially low stock returns during the COVID-19 crisis. We consider regulatory changes, such as more detailed financial disclosure and standardized stress tests, to monitor potential risk mismatch and to ensure stability of the insurance sector.
    JEL: G22 G32
    Date: 2021–07
  7. By: Clemens Sialm; Qifei Zhu
    Abstract: Investments in international fixed income securities are exposed to significant currency risks. We collect novel data on mutual fund currency derivatives and document that around 90% of U.S. international fixed income funds use currency forwards to manage their foreign exchange exposure. Funds' currency forward positions differ substantially based on risk management demands related to portfolio currency exposures, return-enhancement motives such as currency momentum and carry trade, and strategic considerations related to past performance and fund clienteles. Funds that hedge their currency risk exhibit lower return variability, but do not generate inferior abnormal returns.
    JEL: F21 F31 F34 G11 G12 G13 G15 G23 G32
    Date: 2021–07
  8. By: Subhadeep Mukhopadhyay
    Abstract: We have entered a new era of machine learning (ML), where the most accurate algorithm with superior predictive power may not even be deployable, unless it is admissible under the regulatory constraints. This has led to great interest in developing fair, transparent and trustworthy ML methods. The purpose of this article is to introduce a new information-theoretic learning framework (admissible machine learning) and algorithmic risk-management tools (InfoGram, L-features, ALFA-testing) that can guide an analyst to redesign off-the-shelf ML methods to be regulatory compliant, while maintaining good prediction accuracy. We have illustrated our approach using several real-data examples from financial sectors, biomedical research, marketing campaigns, and the criminal justice system.
    Date: 2021–08
  9. By: Renee van Eyden (Department of Economics, University of Pretoria, Private Bag X20, Hatfield 0028, South Africa); Rangan Gupta (Department of Economics, University of Pretoria, Private Bag X20, Hatfield 0028, South Africa); Jacobus Nel (Department of Economics, University of Pretoria, Private Bag X20, Hatfield 0028, South Africa); Elie Bouri (School of Business, Lebanese American University, Lebanon)
    Abstract: The purpose of this paper is to determine the impact of rare disaster risks, captured by the El Nino-Southern Oscillation (ENSO) cycle, on the volatility of Treasury securities of the United States (US) involving 1- to 360-month maturities. We use a random coefficients panel-data-based heterogeneous autoregressive-realized variance (HAR-RV) model over the monthly period of 1961:06 to 2019:12, with the RV derived from the sum of squared daily changes in yield over a month. Our results show a positive and statistically significant (at the 1% level) impact of the ENSO cycle on RV, with the results being robust to alternative metrics of the ENSO, consideration of lagged impact, and decomposition of the ENSO cycle into El Nino and La Nina phases, with the former having a relatively stronger effect. With our panel estimation method using heterogeneous slope coefficients, we find that the effect on the entire term structure is positive, with higher impacts observed at the two-ends and the middle-part of the term-structure. Our results have important implications for investors in US Treasury securities.
    Keywords: Rare Disaster Risks, ENSO Cycle, Term-Structure Volatility, US Treasury Securities, Panel HAR-RV Model
    JEL: C33 E43 Q54
    Date: 2021–08
  10. By: Georges Prat (EconomiX - UPN - Université Paris Nanterre - CNRS - Centre National de la Recherche Scientifique); Remzi Uctum (EconomiX - UPN - Université Paris Nanterre - CNRS - Centre National de la Recherche Scientifique)
    Abstract: Using survey-based data we show that oil price expectations are not rational, implying that the ex-ante premium is a more relevant concept than the widely popular expost premium. We propose for the 3-and 12-month horizons a portfolio choice model with risky oil assets and a risk-free asset. At the maximized expected utility the risk premium is defined as the risk price times the expected oil return volatility. A state-space model, where the risk prices are represented as stochastic unobservable components and where expected volatilities depend on historical squared returns, is estimated using Kalman filtering. We find that the representative investor is risk seeking at short horizons and risk averse at longer horizons. We examine the economic factors driving risk prices whose signs are shown to be consistent with the predictions of the prospect theory. An upward sloped term structure of oil risk premia prevails in average over the period.
    Keywords: oil market,oil price expectations,ex-ante risk premium JEL classification : D81
    Date: 2021–06–03
  11. By: Giancarlo Corsetti; Anna Lipínska; Giovanni Lombardo
    Abstract: Crises and tail events have asymmetric effects across borders, raising the value of arrangements improving insurance of macroeconomic risk. Using a two-country DSGE model, we provide an analytical and quantitative analysis of the channels through which countries gain from sharing (tail) risk. Riskier countries gain in smoother consumption but lose in relative wealth and average consumption. Safer countries benefit from higher wealth and better average terms of trade. Calibrated using the empirical distribution of moments of GDP-growth across countries, the model suggests significant quantitative effects. We offer an algorithm for the correct solution of the equilibrium using DSGE models under complete markets, at higher order of approximation.
    Keywords: international risk sharing, asymmetry, fat tails, welfare
    JEL: F15 F41 G15
    Date: 2021–08
  12. By: Carol Alexander; Arben Imeraj
    Abstract: Most trading in cryptocurrency options is on inverse products, so called because the contract size is denominated in US dollars and they are margined and settled in crypto, typically bitcoin or ether. Their popularity stems from allowing professional traders in bitcoin or ether options to avoid transferring fiat currency to and from the exchanges. We derive new analytic pricing and hedging formulae for inverse options under the assumption that the underlying follows a geometric Brownian motion. The boundary conditions and hedge ratios exhibit relatively complex but very important new features which warrant further analysis and explanation. We also illustrate some inconsistencies, exhibited in time series of Deribit bitcoin option implied volatilities, which indicate that traders may be applying direct option hedging and valuation methods erroneously. This could be because they are unaware of the correct, inverse option characteristics which are derived in this paper.
    Date: 2021–07
  13. By: Georges Prat (EconomiX - UPN - Université Paris Nanterre - CNRS - Centre National de la Recherche Scientifique); Remzi Uctum (EconomiX - UPN - Université Paris Nanterre - CNRS - Centre National de la Recherche Scientifique)
    Abstract: We propose a two-horizon interest rate term structure model where the maturity of the riskless rate is the one of the debt security whose duration equals investor's desired horizon. Our framework thus relaxes the usual assumptions of the literature that the riskless rate is unchangingly the short period rate. A representative investor compares at each of the 3and the 6-month horizons the risk premium offered by the market and the one they require to take a risky position, the latter premium being determined by the portfolio choice theory. Due to market frictions, the deviation between the offered and required risk premium evolves according to a mean-reverting process. Using 3-month ahead survey-based expectations of the US 3-month Treasury Bill rate, we employ Kalman filtering to estimate the market risk premium where the preference parameter of investors for alternative horizons is time-varying. We find that the market comprises both a group of agents with 3-month preferred horizon and a group of agents with 6-month preferred horizon with a weigh of two-thirds for the first group.
    Keywords: interest rates,term structure,risk premium
    Date: 2021
  14. By: Michael J. Gropper; Camelia M. Kuhnen
    Abstract: Theoretically, wealthier people should buy less insurance, and should self-insure through saving instead, as insurance entails monitoring costs. Here, we use administrative data for 63,000 individuals and, contrary to theory, find that the wealthier have better life and property insurance coverage. Wealth-related differences in background risk, legal risk, liquidity constraints, financial literacy, and pricing explain only a small fraction of the positive wealth-insurance correlation. This puzzling correlation persists in individual fixed-effects models estimated using 2,500,000 person-month observations. The fact that the less wealthy have less coverage, though intuitively they benefit more from insurance, might increase financial health disparities among households.
    JEL: D14 G22 G51 G52
    Date: 2021–07
  15. By: Yonatan Berman; Mark Kirstein
    Abstract: An important but understudied question in economics is how people choose when facing uncertainty in the timing of events. Here we study preferences over time lotteries, in which the payment amount is certain but the payment time is uncertain. Expected discounted utility theory (EDUT) predicts decision makers to be risk-seeking over time lotteries. We explore a normative model of growth-optimality, in which decision makers maximise the long-term growth rate of their wealth. Revisiting experimental evidence on time lotteries, we find that growth-optimality accords better with the evidence than EDUT. We outline future experiments to scrutinise further the plausibility of growth-optimality.
    Date: 2021–08

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