nep-rmg New Economics Papers
on Risk Management
Issue of 2022‒02‒07
twenty-one papers chosen by
Stan Miles
Thompson Rivers University

  1. How People React to Pension Risk By Nicolás Salamanca; Andries de Grip; Olaf Sleijpen
  2. Temporal Risk Resolution: Utility vs. Probability Weighting Approaches By Mohammed Abdellaoui; Enrico Diecidue; Emmanuel Kemel; Ayse Onculer
  3. Forecasting Stock Market Volatility with Regime-Switching GARCH-MIDAS: The Role of Geopolitical Risks By Mawuli Segnon; Rangan Gupta
  4. Robust Portfolio Optimization: A Stochastic Evaluation of Worst-Case Scenarios By Paulo Rotella Junior; Luiz Celio Souza Rocha; Rogerio Santana Peruchi; Giancarlo Aquila; Karel Janda; Edson de Oliveira Pamplona
  5. What drives the risk of European banks during crises? New evidence and insights By Ion LAPTEACRU
  6. Dynamic Portfolio Optimization with Inverse Covariance Clustering By Yuanrong Wang; Tomaso Aste
  7. Board Gender Diversity and Firm Risk By Zyed Achour
  8. Debt as Safe Asset By Markus K. Brunnermeier; Sebastian A. Merkel; Yuliy Sannikov
  9. Some connections between higher moments portfolio optimization methods By Farshad Noravesh; Kristiaan Kerstens
  10. Optimal Risk Sharing in Society By Aase, Knut K.
  11. Sparse Non-Convex Optimization For Higher Moment Portfolio Management By Farshad Noravesh; Kristiaan Kerstens
  12. Intermediation via Credit Chains By Zhiguo He; Jian Li
  13. LSTM Architecture for Oil Stocks Prices Prediction By Javad T. Firouzjaee; Pouriya Khaliliyan
  14. Does a Change in an Accounting Standard Affect the Risk-Pricing of a Firm? By Itay Kedmi
  15. Variation margins, fire-sales and information-constrained optimality By Biais, Bruno; Heider, Florian; Hoerova, Marie
  16. Defining an intrinsic "stickiness" parameter of stock price returns By Naji Massad; Jørgen Vitting Andersen
  17. Personality Traits Across the Life Cycle: Disentangling Age, Period, and Cohort Effects By Bernd Fitzenberger; Gary Mena; Jan Nimczik; Uwe Sunde
  18. The Role for Deposit Insurance Funds in Dealing with Failing Banks in the European Union By Mr. Marc C Dobler; Mr. Atilla Arda
  19. You can’t always get what you want—An experiment on finance professionals' decisions for others By Matthias Stefan; Martin Holmén; Felix Holzmeister; Michael Kirchler; Erik Wengström
  20. Evolutionary correlation, regime switching, spectral dynamics and optimal trading strategies for cryptocurrencies and equities By Nick James
  21. Do REITs Hedge against Inflation? Evidence from an African Emerging Market By Daniel Ibrahim Dabara; Job Taiwo Gbadegesin; Abdul-Rasheed Amidu; Tunbosun Biodun Oyedokun; Augustina Chiwuzie

  1. By: Nicolás Salamanca (Melbourne Institute: Applied Economic & Social Research, The University of Melbourne | ARC Centre of Excellence for Children and Families over the Life Course Institute of Labor Economics); Andries de Grip (Research Centre for Education and the Labour Market, Institute of Labor Economics; Netspar); Olaf Sleijpen (Department of Economics, Maastricht University; De Nederlandsche Bank)
    Abstract: We show that people exposed to greater pension risk are less likely to invest in risky assets. We exploit a reform that links people’s future pension benefits to their pension funds’ funding ratio—a measure of the fund’s financial health—making funding ratios a fund-specific measure of pension risk. The effect of pension risk is stronger for people who are better informed about their pensions, for retirees and pension-age non-retirees, and for wealthier people. The funding ratio does not affect investments in a pre-reform period, nor does it affect bequest intentions, (expected) retirement, or the motivations for saving.
    Keywords: Individual portfolio choice; background risk; retirement planning; pension reform; The Netherlands
    JEL: D14 J22
    Date: 2020–04
  2. By: Mohammed Abdellaoui; Enrico Diecidue (INSEAD - Institut Européen d'administration des Affaires); Emmanuel Kemel; Ayse Onculer
    Date: 2022
  3. By: Mawuli Segnon (Department of Economics, Institute for Econometric and Economic Statistics and Chair of Empirical Economics, University of Munster, Germany); Rangan Gupta (Department of Economics, University of Pretoria, Private Bag X20, Hatfield 0028, South Africa)
    Abstract: We investigate the role of geopolitical risks (GPR) in forecasting stock market volatility in a robust autoregressive Markov-switching GARCH mixed data sampling (ARMSGARCH-MIDAS) framework that accounts for structural breaks through regime switching and allows us to disentangle short- and long-run volatility components driven by geopolitical risks. An empirical out-of-sample forecasting exercise is conducted using unique data sets on Dow Jones Industrial Average (DJIA) index and geopolitical risks that cover the time period from January 3, 1899 to December 31, 2020. We find that geopolitical risks as explanatory variables can help to improve the accuracy of stock market volatility forecasts. Furthermore, our empirical results show that the macroeconomic variables such as output measured by recessions, inflation and interest rates contain information that is complementary to the one included in the geopolitical risks.
    Keywords: Geopolitical risks, Volatility forecasts, Markov-switching GARCH-MIDAS
    JEL: C52 C53 C58
    Date: 2022–01
  4. By: Paulo Rotella Junior (Department of Production Engineering, Federal University of Paraiba, Brazil & Department of Management, Federal Institute of Education, Science and Technology - North of Minas Gerais, Brazil & Faculty of Finance and Accounting, Prague University of Economics and Business, Czech Republic & Faculty of Social Sciences, Charles University, Czech Republic); Luiz Celio Souza Rocha (Department of Management, Federal Institute of Education, Science and Technology - North of Minas Gerais, Brazil); Rogerio Santana Peruchi (Department of Production Engineering, Federal University of Paraiba, Brazil); Giancarlo Aquila (IEPG, Federal University of Itajuba, Brazil); Karel Janda (Faculty of Finance and Accounting, Prague University of Economics and Business, Czech Republic & Faculty of Social Sciences, Charles University, Czech Republic); Edson de Oliveira Pamplona (Institute of Production and Management Engineering, Federal University of Itajuba, Brazil)
    Abstract: This article presents a new approach for building robust portfolios based on stochastic efficiency analysis and periods of market downturn. The empirical analysis is done on assets traded on the Brazil Stock Exchange, B3 (Brasil, Bolsa, Balcao). We start with information on the assets from periods of market downturn (worst-case) and we group them using hierarchical clustering. Then we do stochastic efficiency analysis on these data using the Chance Constrained Data Envelopment Analysis (CCDEA) model. Finally, we use a classical model of capital allocation to obtain the optimal share of each asset. Our model is able to accommodate investors who exhibit different risk behaviors (from conservatives to risky investors) by varying the level of probability in fulfilling the constraints (1-αi) of the CCDEA model. We show that the optimal portfolios constructed with the use of information from periods of market downturns perform better for the Sharpe ratio (SR) in the validation period. The combined use of these approaches, using also fundamentalist variables and information on market downturns, allows us to build robust portfolios, with higher cumulative returns in the validation period, and portfolios with lower beta values.
    Keywords: Robust optimization, Stochastic evaluation, Chance Constrained DEA, Worst-case markets, Portfolios
    JEL: G11 G14 C38 C61
    Date: 2022–03
  5. By: Ion LAPTEACRU
    Abstract: Based on an extensive dataset of 1,156 European banks over the 1995-2015 period, we aim to provide new insights on the determinants of European banks’ risk-taking during crisis events, employing a novel asymmetric Z-score. Our results suggest that more capital, lower ratios of loans to deposits and of liquid assets to total assets and lower share of non-deposit and short-term funding in total funding are associated with lower bank risk and this relationship is stronger during the crises. Moreover, having low costs compared to their revenues reduces the risk of European banks in normal times and has the same impact during the crises. Being involved in non-interest-generating activities makes banks riskier. Finally, being large and having higher net interest margin make banks more stable, but this positive effect is diminished for the size and vanished for the profitability during crisis times. And some differences are observed between Western and Eastern European countries. countries exhibit less regulatory intensity than developed countries. This result suggests that it will require more technical and financial resources for developing countries to comply with measures imposed by developed countries that adopt more stringent technical measures than they do.
    Keywords: European banking; bank risk; financial crisis; Z-score
    JEL: G21
    Date: 2022
  6. By: Yuanrong Wang; Tomaso Aste
    Abstract: Market conditions change continuously. However, in portfolio's investment strategies, it is hard to account for this intrinsic non-stationarity. In this paper, we propose to address this issue by using the Inverse Covariance Clustering (ICC) method to identify inherent market states and then integrate such states into a dynamic portfolio optimization process. Extensive experiments across three different markets, NASDAQ, FTSE and HS300, over a period of ten years, demonstrate the advantages of our proposed algorithm, termed Inverse Covariance Clustering-Portfolio Optimization (ICC-PO). The core of the ICC-PO methodology concerns the identification and clustering of market states from the analytics of past data and the forecasting of the future market state. It is therefore agnostic to the specific portfolio optimization method of choice. By applying the same portfolio optimization technique on a ICC temporal cluster, instead of the whole train period, we show that one can generate portfolios with substantially higher Sharpe Ratios, which are statistically more robust and resilient with great reductions in maximum loss in extreme situations. This is shown to be consistent across markets, periods, optimization methods and selection of portfolio assets.
    Date: 2021–12
  7. By: Zyed Achour (INTES - Institut national du travail et des études sociales - Université de Carthage - University of Carthage)
    Abstract: In this chapter, we address the following question: Does board gender diversity affect global risk? Drawing on agency theory, upper echelon theory, and human capital theory, we hypothesize that gender diversity on the board of directors will decrease the volatility of firm risk. Applying fixed effect estimation on a panel data of listed French companies (SBF120) for the years 2011–2018, the results show a negative link between the percentage of female directors on the board and the standard deviation of monthly stock return as firm risk proxy suggesting that the inclusion of more women on corporate boards could improve financial stability. Our findings contribute to the literature by providing empirical evidence from France occupying the first place at the European level with the most female presence on the boards of directors.1
    Keywords: board gender diversity,board of directors,corporate governance,firm risk,SBF 120
    Date: 2021–11–15
  8. By: Markus K. Brunnermeier; Sebastian A. Merkel; Yuliy Sannikov
    Abstract: The price of a safe asset reflects not only the expected discounted future cash flows but also future service flows, since retrading allows partial insurance of idiosyncratic risk in an incomplete markets setting. This lowers the issuers' interest burden and allows the government to run a permanent (primary) deficit without ever paying back its debt. As idiosyncratic risk rises during recessions, so does the value of the service flows bestowing the safe asset with a negative beta. This resolves government debt valuation puzzles. Nevertheless, the government faces a “Debt Laffer Curve”. The paper also has important implications for fiscal debt sustainability.
    JEL: E44 G11 G12
    Date: 2022–01
  9. By: Farshad Noravesh; Kristiaan Kerstens
    Abstract: In this paper, different approaches to portfolio optimization having higher moments such as skewness and kurtosis are classified so that the reader can observe different paradigms and approaches in this field of research which is essential for practitioners in Hedge Funds in particular. Several methods based on different paradigms such as utility approach and multi-objective optimization are reviewed and the advantage and disadvantageous of these ideas are explained. Keywords: multi-objective optimization, portfolio optimization, scalarization, utility
    Date: 2022–01
  10. By: Aase, Knut K. (Dept. of Business and Management Science, Norwegian School of Economics)
    Abstract: We consider risk sharing among individuals in a one-period setting under uncertainty, that will result in payoffs to be shared among the members. We start with optimal risk sharing in an Arrow-Debreu economy, or equivalently, in a Borch-style reinsurance market. From the results of this model we can infer how risk is optimally distributed between individuals according to their preferences and initial endow ments, under some idealized conditions. A main message in this theory is the mutuality principle, of interest related to the economic effects of pandemics. From this we point out some elements of a more gen eral theory of syndicates, where in addition, the group of people is to make a common decision under uncertainty. We extend to a compet itive market as a special case of such a syndicate.
    Keywords: Optimal risk sharing; Syndicates; Savage expected utility; Evaluation measures; No-arbitrage pricing; State prices
    JEL: D51 D53 D90 E21 G10 G12
    Date: 2021–12–30
  11. By: Farshad Noravesh; Kristiaan Kerstens
    Abstract: One of the reasons that higher order moment portfolio optimization methods are not fully used by practitioners in investment decisions is the complexity that these higher moments create by making the optimization problem nonconvex. Many few methods and theoretical results exists in the literature, but the present paper uses the method of successive convex approximation for the mean-variance-skewness problem.
    Date: 2022–01
  12. By: Zhiguo He; Jian Li
    Abstract: The modern financial system features complicated financial intermediation chains, with each layer performing a certain degree of credit/maturity transformation. We develop a dynamic model in which an entrepreneur borrows from overlapping-generation households via layers of funds, forming a credit chain. Each intermediary fund in the chain faces rollover risks from its lenders, and the optimal debt contracts among layers are time invariant and layer independent. The model delivers new insights regarding the benefits of intermediation via layers: the chain structure insulates interim negative fundamental shocks and protects the underlying cash flows from being discounted heavily during bad times, resulting in a greater borrowing capacity. We show that the equilibrium chain length minimizes the run risk for any given contract and find that restricting credit chain length can improve total welfare once the available funding from households has been endogenized.
    JEL: D85 E44 E51 G21 G23 G33
    Date: 2022–01
  13. By: Javad T. Firouzjaee; Pouriya Khaliliyan
    Abstract: Oil companies are among the largest companies in the world whose economic indicators in the global stock market have a great impact on the world economy and market due to their relation to gold, crude oil, and the dollar. To quantify these relations we use the correlation feature and the relationships between stocks with the dollar, crude oil, gold, and major oil company stock indices, we create datasets and compare the results of forecasts with real data. To predict the stocks of different companies, we use Recurrent Neural Networks (RNNs) and LSTM, because these stocks change in time series. We carry on empirical experiments and perform on the stock indices dataset to evaluate the prediction performance in terms of several common error metrics such as Mean Square Error (MSE), Mean Absolute Error (MAE), Root Mean Square Error (RMSE), and Mean Absolute Percentage Error (MAPE). The received results are promising and present a reasonably accurate prediction for the price of oil companies' stocks in the near future. The results show that RNNs do not have the interpretability, and we cannot improve the model by adding any correlated data.
    Date: 2022–01
  14. By: Itay Kedmi (Bank of Israel)
    Abstract: In 2016, a new accounting standard for Leases (IFRS 16) was issued, which substantially changes the accounting treatment of operating leases. As a result, financial ratios of firms might change dramatically, especially the leverage ratio. Using the difference-in-differences approach, this paper examines the impact of the disclosure regarding this standard, and its implementation, on the risk-pricing of firms, as measured by the yield spreads of their bonds. The results indicate that the yield spreads of the treated firms rise in the first disclosure date, compared to the control group. Thereafter, in the implementation date, there is no impact. The results are stronger in firms that are expected to violate financial covenants following the new standard
    Date: 2021–08
  15. By: Biais, Bruno; Heider, Florian; Hoerova, Marie
    Abstract: In order to share risk, protection buyers trade derivatives with protection sellers. Protection sellers’ actions affect the riskiness of their assets, which can create counter-party risk. Because these actions are unobservable, moral hazard limits risk sharing. To mitigate this problem, privately optimal derivative contracts involve variation mar-gins. When margins are called, protection sellers must liquidate some assets, depressing asset prices. This tightens the incentive constraints of other protection sellers and re-duces their ability to provide insurance. Despite this fire-sale externality, equilibrium is information-constrained efficient. Investors, who benefit from buying assets at fire-sale prices, optimally supply insurance against the risk of fire sales.
    Keywords: variation margins; fire sales; pecuniary externality; moral hazard, con-strained efficiency; regulation
    JEL: G18 D62 G13 D82
    Date: 2022–01–27
  16. By: Naji Massad (CES - Centre d'économie de la Sorbonne - UP1 - Université Paris 1 Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique); Jørgen Vitting Andersen (CES - Centre d'économie de la Sorbonne - UP1 - Université Paris 1 Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique, CNRS - Centre National de la Recherche Scientifique)
    Abstract: We introduce a non-linear pricing model of individual stock returns that defines a "stickiness" parameter of the returns. The pricing model resembles the capital asset pricing model (CAPM) used in finance but has a non-linear component inspired from models of earth quake tectonic plate movements. The link to tectonic plate movements happens, since price movements of a given stock index is seen adding "stress" to its components of individual stock returns, in order to follow the index. How closely individual stocks follow the index's price movements, can then be used to define their "stickiness".
    Keywords: stickiness of stock returns,non-linear CAPM
    Date: 2020–06
  17. By: Bernd Fitzenberger; Gary Mena; Jan Nimczik; Uwe Sunde
    Abstract: Economists increasingly recognise the importance of personality traits for socio-economic outcomes, but little is known about the stability of these traits over the life cycle. Existing empirical contributions typically focus on age patterns and disregard cohort and period influences. This paper contributes novel evidence for the separability of age, period, and cohort effects for a broad range of personality traits based on systematic specification tests for disentangling age, period and cohort influences. Our estimates document that for different cohorts, the evolution of personality traits across the life cycle follows a stable, though non-constant, age profile, while there are sizeable differences across time periods.
    Keywords: Big Five Personality Traits, Locus of Control, Risk Attitudes, Age-Period-Cohort Decomposition, Life Cycle
    JEL: D8 J1
    Date: 2021
  18. By: Mr. Marc C Dobler; Mr. Atilla Arda
    Abstract: This paper argues that in the European Union (EU) deposit insurance funds are too difficult to use in bank resolution and too easy to use outside resolution. The paper proposes reforms in three areas for the effective management of bank failures of small and medium-sized banks in the European Union: making resolution the norm for dealing with failing banks; establishing a common DIS for the European Union; and increasing funding and backstops for deposit insurance while removing constraints on their use for resolution measures. Without these changes, the European Union will continue to be challenged by banks that are too small for resolution and too large for liquidation.
    Keywords: Deposit Insurance, Bank Resolution, Banking Union, Crisis Preparedness, Crisis Management, Euro Area, European Union, Financial Crisis, Financial Stability
    Date: 2022–01–07
  19. By: Matthias Stefan; Martin Holmén; Felix Holzmeister; Michael Kirchler; Erik Wengström
    Abstract: To study whether clients benefit from delegating financial investment decisions to an agent, we run an investment allocation experiment with 408 finance professionals (agents) and 550 participants from the general population (clients). In several between-subjects treatments, we vary the mode of decision-making (investment on one's own account vs. investments on behalf of clients) and the agents' incentives (aligned vs. fixed). We find that finance professionals show higher decision-making quality than participants from the general population when investing on their own account. However, when deciding on behalf of clients, professionals' decision-making quality does not significantly differ from their clients', neither when compensated with a fixed payment nor when facing aligned incentives. Our results further identify a considerable challenge in risk communication between agents and clients: While finance professionals tend to take into account principals' desired risk levels, the constructed portfolios by professionals show considerable overlaps in portfolio risk across different risk levels requested by principals. We argue that this result is due to differences in risk perception.
    Keywords: Experimental finance, finance professionals, delegated decision-making, risk communication
    JEL: C93 G11 G41
    Date: 2022–02
  20. By: Nick James
    Abstract: This paper uses new and recently established methodologies to study the evolutionary dynamics of the cryptocurrency market, and compares the findings with that of the equity market. We begin by applying random matrix theory and principal components analysis (PCA) to correlation matrices of both collections, highlighting clear differences in the eigenspectra exhibited. We then explore the heterogeneity of both asset classes, studying the time-varying dynamics of underlying sector behaviours, and determine the collective similarity within each collection. We then turn to a study of structural break dynamics and evolutionary power spectra, where we quantify the collective affinity in structural breaks and evolutionary behaviours of underlying sector time series. Finally, we implement two algorithms simulating `portfolio choice' dynamics to compare the effectiveness of stock selection and sector allocation in cryptocurrency portfolios. There, we highlight the importance of both endeavours and comment on noteworthy implications for cryptocurrency portfolio management.
    Date: 2021–12
  21. By: Daniel Ibrahim Dabara; Job Taiwo Gbadegesin; Abdul-Rasheed Amidu; Tunbosun Biodun Oyedokun; Augustina Chiwuzie
    Abstract: Purpose: This study examines how returns on Nigerian REIT (N-REIT) behave in relation to inflation changes from 2008 to 2019 to provide information for investment decisions.Design/Methodology/Approach: Eleven years monthly return data from 2008 to 2019 were collected from databases and annual reports of the three active REITs in Nigeria. Inflation rates covering the study period were collected from the Central Bank of Nigeria’s database. The authors adopt the Fama and Schwert model, an extension of the Fisher hypothesis, to test N- REIT's inflation-hedging capability.Findings: The empirical results suggest that N-REIT has perverse hedging-characteristics (poor inflation hedges) across all inflation exposures (actual, expected, and unexpected). The Engle- Granger causality tests conducted corroborates these results.Practical Implication: This study reveals the peculiar nature of Nigerian REITs in relation to inflation, which could have profound investment implication for domestic and foreign investors.Originality/Value: This study is one of the first to empirically analyse the inflation-hedging characteristics of REITs in the second-largest African REIT market (N-REIT).
    Keywords: emerging economies; Inflation-Hedge; Investment; real estate; Returns; risk.
    JEL: R3
    Date: 2021–09–01

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