nep-rmg New Economics Papers
on Risk Management
Issue of 2023‒01‒23
eighteen papers chosen by

  1. International banking regulation and Tier 1 capital ratios. On the robustness of the critical average risk weight framework By Renaud Beaupain; Yann Braouezec
  2. Prediction of Auto Insurance Risk Based on t-SNE Dimensionality Reduction By Joseph Levitas; Konstantin Yavilberg; Oleg Korol; Genadi Man
  3. Economic Scenario Generators: a risk management tool for insurance By Pierre-Edouard Arrouy; Alexandre Boumezoued; Bernard Lapeyre; Sophian Mehalla
  4. Voluntary Equity, Project Risk, and Capital Requirements By Haufler, Andreas; Lülfesmann, Christoph
  5. A Stackelberg reinsurance-investment game under $\alpha$-maxmin mean-variance criterion and stochastic volatility By Guohui Guan; Zongxia Liang; Yilun Song
  6. Risk Theory and Pricing of "Pay-for-Performance" Business Models By Roger Knecktys; Henrik Bette; R\"udiger Kiesel; Thomas Guhr
  7. Trade Credit Default By Xavier Mateos-Planas; Giulio Seccia
  8. Peer-reviewed theory does not help predict the cross-section of stock returns By Andrew Y. Chen; Alejandro Lopez-Lira; Tom Zimmermann
  9. DeFi Risk Transfer: Towards A Fully Decentralized Insurance Protocol By Matthias Nadler; Felix Bekemeier; Fabian Sch\"ar
  10. Capital regulation, market-making, and liquidity By Haselmann, Rainer; Kick, Thomas; Singla, Shikhar; Vig, Vikrant
  11. Risk Management and the Autonomy of Labor By Andreas J. Dambaur; Keith Marzilli Ericson; Johannes G. Jaspersen; Sandra Zoller
  12. Superstar Returns By Francisco Amaral; Martin Dohmen; Sebastian Kohl; Moritz Schularick
  13. "Multi-Agent Model Based Proactive Risk Management For Equity Investment" By Daiya Mita; Akihiko Takahashi
  14. Efficient Sampling for Realized Variance Estimation in Time-Changed Diffusion Models By Timo Dimitriadis; Roxana Halbleib; Jeannine Polivka; Sina Streicher
  15. Explicit Caplet Implied Volatilities for Quadratic Term-Structure Models By Matthew Lorig; Natchanon Suaysom
  16. Intertemporal Hedging and Trade in Repeated Games with Recursive Utility By Kochov, Asen; Song, Yangwei
  17. On the determinants of corporate default in the EU-27: Evidence from a large sample of companies By FATICA Serena; OLIVIERO Tommaso; RANCAN Michela
  18. Performance Pay in Insurance Markets: Evidence from Medicare By Michele Fioretti; Hongming Wang

  1. By: Renaud Beaupain (IESEG School of Management, Univ. Lille, CNRS, UMR 9221 - LEM - Lille Economie Management, F-59000 Lille, France); Yann Braouezec (IESEG School of Management, Univ. Lille, CNRS, UMR 9221 - LEM - Lille Economie Management, F-59000 Lille, France)
    Abstract: Under Basel III, the new international banking regulation, banks must maintain two Tier 1 capital ratios that treat risky assets dierently. The Basel Committee uses the critical average risk weight (CARW) framework, developed by the Bank of England to determine which ratio is the binding constraint. This methodology, which implicitly assumes that each asset is subject to a uniform shock, consists in comparing the implied average risk weight of a bank to a regulatory critical threshold. Using a stress test approach, we examine whether, and under which conditions, the CARW framework identies the correct binding capital ratio. We nd important errors, that are attributable to incorrect data but surprisingly not to the CARW framework. We nally generalize the methodology used by the Basel Committee and show how our stress-test approach can be used to determine which ratio is binding when only a (single class of) asset(s) is shocked.
    Keywords: : International banking regulation, Leverage ratio, Risk-based capital ratio, Critical average risk weight framework, Stress-test framework
    Date: 2022–11
  2. By: Joseph Levitas; Konstantin Yavilberg; Oleg Korol; Genadi Man
    Abstract: Correct scoring of a driver's risk is of great significance to auto insurance companies. While the current tools used in this field have been proven in practice to be quite efficient and beneficial, we argue that there is still a lot of room for development and improvement in the auto insurance risk estimation process. To this end, we develop a framework based on a combination of a neural network together with a dimensionality reduction technique t-SNE (t-distributed stochastic neighbour embedding). This enables us to visually represent the complex structure of the risk as a two-dimensional surface, while still preserving the properties of the local region in the features space. The obtained results, which are based on real insurance data, reveal a clear contrast between the high and low risk policy holders, and indeed improve upon the actual risk estimation performed by the insurer. Due to the visual accessibility of the portfolio in this approach, we argue that this framework could be advantageous to the auto insurer, both as a main risk prediction tool and as an additional validation stage in other approaches.
    Date: 2022–12
  3. By: Pierre-Edouard Arrouy (Recherche et Développement, Milliman Paris - Milliman France); Alexandre Boumezoued (Recherche et Développement, Milliman Paris - Milliman France); Bernard Lapeyre (ENPC - École des Ponts ParisTech, MATHRISK - Mathematical Risk Handling - UPEM - Université Paris-Est Marne-la-Vallée - ENPC - École des Ponts ParisTech - Inria de Paris - Inria - Institut National de Recherche en Informatique et en Automatique); Sophian Mehalla (Recherche et Développement, Milliman Paris - Milliman France, CERMICS - Centre d'Enseignement et de Recherche en Mathématiques et Calcul Scientifique - ENPC - École des Ponts ParisTech, MATHRISK - Mathematical Risk Handling - UPEM - Université Paris-Est Marne-la-Vallée - ENPC - École des Ponts ParisTech - Inria de Paris - Inria - Institut National de Recherche en Informatique et en Automatique)
    Abstract: We present a risk management tool, named Economic Scenario Generator (ESG), used by insurance companies for simulating the global state of one or several economies described by key financial risk drivers. This tool is of particular use within the Solvency II framework, since insurance companies are required to value their balance-sheet from a market-consistent viewpoint. However, there is no observable price of insurance contracts hence the necessity of relying on ESGs to perform Monte Carlo simulations useful for valuation. As such, the calibration of Risk-Neutral models underlying this valuation is of particular interest as there is a strong requirement to match observable market prices. Furthermore, for a variety of applications, the insurance company has to value its balance-sheet over a set of different economic conditions, leading to the need of intensive re-calibrations of such models. In this paper, we first provide an overview of the key requirements from Solvency II and their practical implications for insurance valuation. We then describe the different use cases of ESGs. A particular attention is paid to Risk-Neutral interest rates models, specifically the Libor Market Model with a stochastic volatility. We discuss the complexity of its calibration and describe fast calibration methods based on approximations and expansions of the probability density function. Comparisons with more common method highlight the reduction in calibration time.
    Keywords: Insurance,Libor Market Model,interest rate,stochastic volatility
    Date: 2022
  4. By: Haufler, Andreas (LMU Munich); Lülfesmann, Christoph (Simon Fraser University)
    Abstract: We introduce a model of the banking sector that formally incorporates a buffer function of capital. Heterogeneous banks choose their portfolio risk, bank size, and capital holdings. Banks voluntarily hold equity when the buffer effect against the risk of default outweighs the cost advantages of debt financing. In this setting, banks with lower monitoring costs are larger, choose riskier portfolios, and have less equity. Moreover, binding capital requirements or levies on bank borrowing are shown to make higher-risk portfolios more attractive. Accounting for banks' interior capital choices can thus explain why higher capital ratios incentivize banks to undertake riskier projects.
    Keywords: voluntary equity; capital requirements; bank heterogeneity;
    JEL: G28 G38 H32
    Date: 2022–12–27
  5. By: Guohui Guan; Zongxia Liang; Yilun Song
    Abstract: This paper investigates a Stackelberg game between an insurer and a reinsurer under the $\alpha$-maxmin mean-variance criterion. The insurer can purchase per-loss reinsurance from the reinsurer. With the insurer's feedback reinsurance strategy, the reinsurer optimizes the reinsurance premium in the Stackelberg game. The financial market consists of cash and stock with Heston's stochastic volatility. Both the insurer and reinsurer maximize their respective $\alpha$-maxmin mean-variance preferences in the market. The criterion is time-inconsistent and we derive the equilibrium strategies by the extended Hamilton-Jacobi-Bellman equations. Similar to the non-robust case in Li and Young (2022), excess-of-loss reinsurance is the optimal form of reinsurance strategy for the insurer. The equilibrium investment strategy is determined by a system of Riccati differential equations. Besides, the equations determining the equilibrium reinsurance strategy and reinsurance premium rate are given semi-explicitly, which is simplified to an algebraic equation in a specific example. Numerical examples illustrate that the game between the insurer and reinsurer makes the insurance more radical when the agents become more ambiguity aversion or risk aversion. Furthermore, the level of ambiguity, ambiguity attitude, and risk attitude of the insurer (reinsurer) have similar effects on the equilibrium reinsurance strategy, reinsurance premium, and investment strategy.
    Date: 2022–12
  6. By: Roger Knecktys; Henrik Bette; R\"udiger Kiesel; Thomas Guhr
    Abstract: Technology trends as digitalization and Industry 4.0 initiate a growing demand for new business models. Most of this models requires a fundamental shift of operational and financial risks between seller and buyer. A key question is therefore how to include additional risk pricing and hedging. In this paper we propose a new approach for a risk theory of innovative performance based business models as "Pay-for-Performance" or "Product as a Service". A new model and calculation method for determination the risk premium is presented. It contains beside financial price fluctuations also operational failure behaviour of products. We apply the model for a typical industrial application and simulate the pricing dependency for different cost distributions.
    Date: 2022–12
  7. By: Xavier Mateos-Planas (Queen Mary University of London; Centre for Macroeconomics (CFM)); Giulio Seccia (Nazarbayev University)
    Abstract: Recent micro evidence shows that default on trade credit repayments is substantial. What is the role of trade credit default in the transmission of macroeconomic shocks? We build a heterogeneous-firms quantitative model where an intermediate input is purchased by final-goods producers partly on trade credit before observing the realisation of their productivity. A bad productivity shock may ex-post induce final good producers to skip payment to suppliers or, alternatively, liquidate via bankruptcy. Aggregate trade credit delinquency and liquidation are taken into account by input suppliers; the individual liquidation risk is priced in by lenders supplying bank credit. The response of trade-credit delinquency and bankruptcy, via their effect on intermediate input supplier’s markups, provides an amplification mechanism of aggregate shocks. We consider productivity, financial and volatility shocks. In a calibrated version of the model, the surge in trade credit default that follows a negative shock accounts for a large portion of the fall in output and employment, and feeds into further firm liquidation and delinquency. For instance, trade-credit default accounts for about one third of the impact of a volatility shock.
    Keywords: trade credit, default, delinquency and bankruptcy, heterogeneous firms, amplification of macroeconomic shocks, markups
    JEL: D21 D25 E32 E44 G33
    Date: 2021–11
  8. By: Andrew Y. Chen; Alejandro Lopez-Lira; Tom Zimmermann
    Abstract: To examine whether theory helps predict the cross-section of returns, we combine text analysis of publications with out-of-sample tests. Based on the original texts, only 18% predictors are attributed to risk-based theory. 58% are attributed to mispricing and 24% have uncertain origins. Post-publication, risk-based predictability decays by 65%, compared to 50% for non-risk predictors. Out-of-sample, risk-based predictors fail to outperform data-mined accounting predictors that are matched on in-sample summary statistics. Published and data-mined returns rise before in-sample periods end and fall out-of-sample at similar rates. Overall, peer-reviewed research adds little information about future mean returns above naive back testing.
    Date: 2022–12
  9. By: Matthias Nadler; Felix Bekemeier; Fabian Sch\"ar
    Abstract: In this paper, we propose a fully decentralized and smart contract-based insurance protocol. We identify various issues in the Decentralized Finance (DeFi) insurance context and propose a solution to overcome these shortcomings. We introduce an economic model that allows for risk transfer without any external dependencies or centralized intermediaries. In particular, our proposal does not need any sort of subjective claim assessment, community voting or external data providers (oracles). Moreover, it solves the problem of over-insurance and proposes various ways to mitigate the capital inefficiencies usually seen with DeFi collateral. The work takes inspiration from peer-to-peer (P2P) insurance and collateralized debt obligations (CDO). We formally describe the protocol, assess its efficiency and key properties and present a reference implementation. Finally, we address limitations, extensions and ideas for further research.
    Date: 2022–12
  10. By: Haselmann, Rainer; Kick, Thomas; Singla, Shikhar; Vig, Vikrant
    Abstract: We employ a proprietary transaction-level dataset in Germany to examine how capital requirements affect the liquidity of corporate bonds. Using the 2011 European Banking Authority capital exercise that mandated certain banks to increase regulatory capital, we find that affected banks reduce their inventory holdings, pre-arrange more trades, and have smaller average trade size. While non-bank affiliated dealers increase their market-making activity, they are unable to bridge this gap - aggregate liquidity declines. Our results are stronger for banks with a higher capital shortfall, for noninvestment grade bonds, and for bonds where the affected banks were the dominant market-maker.
    Keywords: market-making, capital regulation, bond market liquidity
    JEL: G01 G21 G28
    Date: 2022
  11. By: Andreas J. Dambaur; Keith Marzilli Ericson; Johannes G. Jaspersen; Sandra Zoller
    Abstract: Foresightful workers can take actions to reduce their exposure to risk in labor markets, but existing evidence on narrow bracketing suggests that individuals might not optimally integrate risk reduction decisions with subsequent labor decisions. In an online labor market, we vary the level of worker autonomy when transcribing a set of documents and measure the willingness to do preventative tasks to reduce the expected total task length. If workers integrate their risk management decisions with subsequent labor effort, the high-autonomy group should be more likely to engage in prevention, since they can adjust their work to accommodate the preventative effort. In contrast, if workers narrowly bracket the decision, it should not be affected by autonomy. We find that workers in the high autonomy condition are more likely to undertake prevention, consistent with an integrated view of risk management and later labor decisions. Our results have implications for designing effective incentive systems, particularly in times of the gig-economy and rising popularity of working from home.
    JEL: D90 J24 M54
    Date: 2022–12
  12. By: Francisco Amaral (University of Bonn); Martin Dohmen (University of Bonn); Sebastian Kohl (Max Planck Institute for the Study of Societies - Max-Planck-Gesellschaft); Moritz Schularick (University of Bonn, ECON - Département d'économie (Sciences Po) - Sciences Po - Sciences Po - CNRS - Centre National de la Recherche Scientifique, Federal Reserve Bank of New York)
    Abstract: We study long-term returns on residential real estate in twenty-seven "superstar" cities in fifteen countries over 150 years. We find that total returns in superstar cities are close to 100 basis points lower per year than in the rest of the country. House prices tend to grow faster in the superstars, but rent returns are substantially greater outside the big agglomerations, resulting in higher long-run total returns. The excess returns outside the superstars can be rationalized as a compensation for risk, especially for higher covariance with income growth and lower liquidity. Superstar real estate is comparatively safe.
    Keywords: Housing returns, Housing risk, Superstar cities, Regional housing markets
    Date: 2021–12
  13. By: Daiya Mita (Nomura Asset Management Co., Ltd.); Akihiko Takahashi (Faculty of Economics, The University of Tokyo)
    Abstract: This paper develops a new multi-agent model to create a novel warning signal for equity investment, which well replicates actual stock and bond futures price dynamics through estimating fund flows of typical trading agents. Particularly, our model contains four types of agents taking equity/bond strategies such as (i) trend-follow, (ii) contrarian, (iii) yield-curve, and (iv) valuation strategies, each of which is effectively modeled by fuzzy logic with technical indicators. Moreover, to reveal the effects of their trading activities on the price changes, we develop a state space model which represents how the agents’ portfolio rebalances drive the price dynamics. Concretely, the model sets each agent’s fund size as an unobservable state variable, and supposes its proportion to all agents’ total fund size as a market impact of the agent’s rebalance. As an estimation result, the price dynamics of popular stock index futures and bond futures in Japan and the United States are well explained by the trading activities. Finally, we provide a warning signal for proactive risk management utilizing the multiagent model and show its validity on trading performance in Japanese and the United States equity markets. The results demonstrate that the estimated fund flow of each agent helps us to avoid a market crash, which reduces the risk and improves the return.
    Date: 2022–12
  14. By: Timo Dimitriadis; Roxana Halbleib; Jeannine Polivka; Sina Streicher
    Abstract: This paper illustrates the benefits of sampling intraday returns in intrinsic time for the estimation of integrated variance through the realized variance (RV) estimator. The intrinsic time transforms the clock time in accordance with the market's activity, which we measure by trading intensity (transaction time) or spot variance (business time). We theoretically show that the RV estimator is unbiased for all sampling schemes, but most efficient under business time, also under independent market microstructure noise. Our analysis builds on the flexible assumption that asset prices follow a diffusion process that is time-changed with a doubly stochastic Poisson process. This provides a flexible stochastic model for the prices together with their transaction times that allows for separate and stochastically varying trading intensity and tick variance processes that jointly govern the spot variance. These separate model components are particularly advantageous over e.g., standard diffusion models, as they allow to exploit and disentangle the effects of the two different sources of intraday information on the theoretical properties of RV. Extensive simulations confirm our theoretical results and show that business time remains superior under different noise specifications and for noise-corrected RV estimators. An empirical application to stock data provides further evidence for the benefits of using intrinsic sampling to get efficient RV estimators.
    Date: 2022–12
  15. By: Matthew Lorig; Natchanon Suaysom
    Abstract: We derive an explicit asymptotic approximation for implied volatilities of caplets under the assumption that the short-rate is described by a generic quadratic term-structure model. In addition to providing an asymptotic accuracy result, we perform experiments in order to gauge the numerical accuracy of our approximation.
    Date: 2022–12
  16. By: Kochov, Asen (University of Rochester); Song, Yangwei (HU Berlin)
    Abstract: Recursive preferences have found widespread application in representative-agent asset-pricing models and general equilibrium. A majority of these applications exploit two decision-theoretic properties not shared by the standard model of intertemporal choice: (i) agents care about the intertemporal distribution of risk and (ii) rates of time preference, rather than being exogenously fixed, may vary with the level of consumption. We investigate what these features imply in the context of a repeated strategic interaction. Specifically, we identify novel opportunities for the players to manage risk and trade intertemporally, and characterize when such opportunities lead to an expansion of the feasible set of payoffs. Sharp implications for equilibrium behavior and the folk theorem are also deduced.
    Keywords: recursive utility; repeated games; correlation aversion; endogenous discounting; intertemporal trade; intertemporal hedging;
    Date: 2022–12–28
  17. By: FATICA Serena (European Commission - JRC); OLIVIERO Tommaso; RANCAN Michela
    Abstract: We analyze a large sample of companies operating in the EU-27 in the period 2007-2018 to gain new insights on the determinants of corporate defaults. The sample includes micro, small, medium and large enterprises, both active and defaulting. We document significant differences in the drivers of insolvency across firm size categories. Micro and small firms are significantly more vulnerable to sectoral shocks and to disruptions along the supply chain than larger companies. Instead, the default probability for all firms is significantly larger when companies experience in the previous year negative end-of-the year equity, that is a measure of prolonged financial distress. By exploiting institutional differences in judicial efficiency among EU-27 countries, we find financial distress is more likely to predict default in jurisdictions with more efficient insolvency procedures. Finally, we derive potential implications of our findings, especially with regard to the recent crises hitting European firms and the harmonisation of national insolvency regimes in the EU-27 towards most efficient legal practices, as foreseen under the Capital Markets Union Action Plan.
    Keywords: bankruptcy, financial distress, SMEs, EU-27, judicial efficiency
    Date: 2022–12
  18. By: Michele Fioretti (ECON - Département d'économie (Sciences Po) - Sciences Po - Sciences Po - CNRS - Centre National de la Recherche Scientifique); Hongming Wang
    Abstract: Public procurement bodies increasingly resort to pay-for-performance contracts to promote efficient spending. We show that firm responses to pay-for-performance can widen the inequality in accessing social services. Focusing on the quality bonus payment initiative in Medicare Advantage, we find that higher quality-rated insurers responded to bonus payments by selecting healthier enrollees with premium differences across counties. Selection is profitable because the quality rating fails to adjust for differences in enrollee health. Selection inflated the bonus payments and shifted the supply of highrated insurance to the healthiest counties, reducing access to lower-priced, higher-rated insurance in the riskiest counties.
    Keywords: pay-for-performance, Medicare Advantage, risk selection, quality ratings, health insurance access
    Date: 2021–10–15

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