nep-rmg New Economics Papers
on Risk Management
Issue of 2023‒04‒24
eleven papers chosen by
Stan Miles
Thompson Rivers University

  1. An axiomatic approach to default risk and model uncertainty in rating systems By Max Nendel; Jan Streicher
  2. A Multilevel Stochastic Approximation Algorithm for Value-at-Risk and Expected Shortfall Estimation By Stéphane Crépey; Noufel Frikha; Azar Louzi
  3. CCP initial margin models in Europe By Boudiaf, Ismael Alexander; Scheicher, Martin; Vacirca, Francesco
  4. Asset allocation and risk taking under different interest rate regimes By Hermans, Lieven; Kostka, Thomas; Vassallo, Danilo
  5. Portfolio Optimization with Relative Tail Risk By Young Shin Kim
  6. Pricing Transition Risk with a Jump-Diffusion Credit Risk Model: Evidences from the CDS market By Giulia Livieri; Davide Radi; Elia Smaniotto
  7. Real Options Technique as a Tool of Strategic Risk Management By Volodymyr Savchuk
  8. Optimal Loan Portfolio under Regulatory and Internal Constraints By Makoto Okawara; Akihiko Takahashi
  9. Longevity, Health and Housing Risks Management in Retirement By Pierre-Carl Michaud; Pascal St-Amour
  10. Real Exchange Rate Risk and FDI flows: stylized facts and theory By Jacek Rothert; Alexander McQuoid; Katherine Smith
  11. Bankruptcy regime change and credit risk premium on corporate bonds: Evidence from the Indian economy By Rajeswari Sengupta; Harsh Vardhan

  1. By: Max Nendel; Jan Streicher
    Abstract: In this paper, we deal with an axiomatic approach to default risk. We introduce the notion of a default risk measure, which generalizes the classical probability of default (PD), and allows to incorporate model risk in various forms. We discuss different properties and representations of default risk measures via monetary risk measures, families of related tail risk measures, and Choquet capacities. In a second step, we turn our focus on default risk measures, which are given as worst-case PDs and distorted PDs. The latter are frequently used in order to take into account model risk for the computation of capital requirements through risk-weighted assets (RWAs), as demanded by the Capital Requirement Regulation (CRR). In this context, we discuss the impact of different default risk measures and margins of conservatism on the amount of risk-weighted assets.
    Date: 2023–03
  2. By: Stéphane Crépey (LPSM (UMR_8001) - Laboratoire de Probabilités, Statistique et Modélisation - SU - Sorbonne Université - CNRS - Centre National de la Recherche Scientifique - UPCité - Université Paris Cité); Noufel Frikha (CES - Centre d'économie de la Sorbonne - UP1 - Université Paris 1 Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique); Azar Louzi (LPSM (UMR_8001) - Laboratoire de Probabilités, Statistique et Modélisation - SU - Sorbonne Université - CNRS - Centre National de la Recherche Scientifique - UPCité - Université Paris Cité)
    Abstract: We propose a multilevel stochastic approximation (MLSA) scheme for the computation of the Value-at-Risk (VaR) and the Expected Shortfall (ES) of a financial loss, which can only be computed via simulations conditional on the realization of future risk factors. Thus, the problem of estimating its VaR and ES is nested in nature and can be viewed as an instance of a stochastic approximation problem with biased innovation. In this framework, for a prescribed accuracy ε, the optimal complexity of a standard stochastic approximation algorithm is shown to be of order ε −3. To estimate the VaR, our MLSA algorithm attains an optimal complexity of order ε −2−δ , where δ
    Keywords: Value-at-Risk, Expected Shortfall, stochastic approximation algorithm, Nested Monte Carlo, Multilevel Monte Carlo
    Date: 2023–03–22
  3. By: Boudiaf, Ismael Alexander; Scheicher, Martin; Vacirca, Francesco
    Abstract: In this paper we aim to provide a holistic understanding of the Initial Margin (IM) models used by Central Counterparties (CCPs) in Europe. In addition to discussing their relevance in terms of CCP risk management and their importance for the functioning of financial markets, we provide an overview of the main modelling frameworks used, including Standard Portfolio Analysis of Risk (SPAN) and Value at Risk (VaR) models.By leveraging on publicly available data, we provide an up-to-date picture of current modelling practices for specific cleared product classes, as well as various trends in IM modelling practices in Europe. We show how IM model frameworks vary materially, depending on the CCP’s past choices and the products it clears. Despite a propensity to switch to VaR models, idiosyncrasies and differences across CCPs are likely to persist.We conclude by highlighting current and upcoming challenges and risks to CCP IM model frameworks and linking the current status quo with ongoing and upcoming regulatory work at European and international level. JEL Classification: G15, G18, G19, G23, G28, G32
    Keywords: Central Counterparties, initial margin models, model governance and validation., risk management
    Date: 2023–04
  4. By: Hermans, Lieven; Kostka, Thomas; Vassallo, Danilo
    Abstract: We study the effects of low short-term interest rates on the optimal portfolio allocation in Markowitz portfolios and Risk parity portfolios. We propose a measure of Portfolio Instabil-ity, gauging the amount of optimal portfolio shifts needed to respond to exogenous shocks to the expected risk and return of the risky portfolio assets. Portfolio Instability, i.e. the selling pressure on riskier asset holdings, is found to be stronger the lower the risk-free interest rate. Heightened portfolio instability in the presence of low rates is found to emerge through two channels both of which incentivise the build-up of large and leveraged risky asset shares during calm periods which need to be unwound in the event of higher market volatility: first, low rates (mechanically) augment the excess return to be gained by investing in riskier assets and second, they are found to dampen volatility of riskier assets in the portfolio. The inverse relationship between portfolio instability and the risk-free rates is found to increase the closer the risk-free rate approaches the effective lower bound. Counterfactual analyses of the behaviour of optimal multi-asset portfolios demonstrate that the sell-off in riskier asset classes during the Covid crisis in March 2020 was more severe than would have been in the presence of higher short-term interest rates. JEL Classification: C58, E52, G11, G12
    Keywords: CAPM, Counterfactual analysis, portfolio optimization
    Date: 2023–03
  5. By: Young Shin Kim
    Abstract: This paper proposes analytic forms of portfolio CoVaR and CoCVaR on the normal tempered stable market model. Since CoCVaR captures the relative risk of the portfolio with respect to a benchmark return, we apply it to the relative portfolio optimization. Moreover, we derive analytic forms for the marginal contribution to CoVaR and the marginal contribution to CoCVaR. We discuss the Monte-Carlo simulation method to calculate CoCVaR and the marginal contributions of CoVaR and CoCVaR. As the empirical illustration, we show relative portfolio optimization with thirty stocks under the distress condition of the Dow Jones Industrial Average. Finally, we perform the risk budgeting method to reduce the CoVaR and CoCVaR of the portfolio based on the marginal contributions to CoVaR and CoCVaR.
    Date: 2023–03
  6. By: Giulia Livieri; Davide Radi; Elia Smaniotto
    Abstract: Transition risk can be defined as the business-risk related to the enactment of green policies, aimed at driving the society towards a sustainable and low-carbon economy. In particular, the value of certain firms' assets can be lower because they need to transition to a less carbon-intensive business model. In this paper we derive formulas for the pricing of defaultable coupon bonds and Credit Default Swaps to empirically demonstrate that a jump-diffusion credit risk model in which the downward jumps in the firm value are due to tighter green laws can capture, at least partially, the transition risk. The empirical investigation consists in the model calibration on the CDS term-structure, performing a quantile regression to assess the relationship between implied prices and a proxy of the transition risk. Additionally, we show that a model without jumps lacks this property, confirming the jump-like nature of the transition risk.
    Date: 2023–03
  7. By: Volodymyr Savchuk
    Abstract: The real options approach is now considered an effective alternative to the corporate DCF model for a feasibility study. The current paper offers a practical methodology employing binomial trees and real options techniques for evaluating investment projects. A general computation procedure is suggested for the decision tree with two active stages of real options, which correspond to additional investments. The suggested technique can be used for most real options, which are practically essential regarding enterprise strategy. The special case named Binomial-Random-Cash-Flow Real Options Model with random outcomes is developed as the next step of real options modelling. Project Value at Risk is introduced and used as a criterion of investment project feasibility under the assumption regarding random outcomes. In particular, the Gaussian probability distribution is used for modelling option outcomes uncertainty. The choice of the Gaussian distribution is caused by the desire to obtain estimates in the final analytical form. Choosing another distribution for random outcomes leads to using Monte Carlo simulation, for which a general framework is developed by demonstrating some instances. The author could avoid the computational complexity that makes these solutions feasible for business practice.
    Date: 2023–03
  8. By: Makoto Okawara (Graduate School of Economics, The University of Tokyo); Akihiko Takahashi (Graduate School of Economics, The University of Tokyo)
    Abstract: This paper considers an optimization problem for a typical loan portfolio of international banks. In particular, after taking collateral for a loan portfolio into account, we obtain a capital allocation that achieves the maximum profit under Basel regulatory capital and credit market constraints, as well as risk limits against business units and industrial sectors. To the best of our knowledge, the current work derives optimal loan portfolios to analyze the effects of different risk constraints from multiple perspectives more realistically and comprehensively than existing research. As a result, we propose to unify internal risk constraints against the business units and industrial sectors based on economic capital-based credit risk amounts.
    Date: 2023–04
  9. By: Pierre-Carl Michaud; Pascal St-Amour
    Abstract: Annuities, long-term care insurance and reverse mortgages remain unpopular to manage longevity, medical and housing price risks after retirement. We analyze low demand using a life-cycle model structurally estimated with a unique stated-preference survey experiment of Canadian households. Low risk aversion, substitution between housing and consumption and low marginal utility when in poor health explain most of the reduced demand. Bequests motives are found to be a luxury good and play a limited role. The remaining disinterest is explained by information frictions and behavioural status-quo biases. We find evidence of strong spousal co-insurance motives motivating LTCI and of responsiveness to bundling with a near doubling of demand for annuities when reverse mortgages can be used to annuitize, instead of consuming home equity. Les rentes, l'assurance soins de longue durée (ASLD) et les prêts hypothécaires inversés restent impopulaires pour gérer les risques de longévité, les risques médicaux et les risques liés au prix du logement après la retraite. Nous analysons la faible demande à l'aide d'un modèle de cycle de vie estimé de manière structurelle avec une expérience par enquête unique de préférences déclarées auprès de ménages canadiens. Une faible aversion pour le risque, la substitution entre le logement et la consommation et une faible utilité marginale en cas de mauvaise santé expliquent principalement la faible demande. Les motifs de legs s'avèrent être un bien de luxe et ne jouent qu'un rôle limité. Le désintérêt restant s'explique par des frictions informationnelles et des biais comportementaux (inertie). Nous trouvons des preuves de l'existence d'une forte motivation de coassurance entre conjoints, qui motive l'achat d'ASLD; et de réactivité à l'offre groupée, avec un quasi-doublement de la demande de rentes lorsque les prêts hypothécaires inversés peuvent être utilisés pour constituer des rentes, au lieu de consommer la valeur nette du logement.
    Keywords: retirement wealth, insurance, health risk, housing risk, patrimoine retraite, assurance, risque santé, risque logement
    JEL: J14 G52 G53
    Date: 2023–03–13
  10. By: Jacek Rothert (United States Naval Academy; Group for Research in Applied Economics (GRAPE)); Alexander McQuoid (United States Naval Academy); Katherine Smith (United States Naval Academy)
    Abstract: We document a robust negative relationship between bilateral RER volatility and bilateral FDI flows in the European Union. We then extend the standard international business cycle model to allow for domestic and foreign ownership of physical capital stock to be less than perfect substitutes. This allows the model to have meaningful predictions about the behavior of gross FDI flows. We characterize the conditions under which lower RER volatility coincides with larger bilateral FDI flows. We also show, both theoretically, and using numerical simulations, that the magnitude of the relationship between the RER volatility and FDI flows depends crucially on one parameter: the elasticity of substitution between domestic and foreign ownership of capital stock used in production. Our results suggest the existence of a new channel through which a reduction in RER volatility can be welfare improving: more efficient allocation of capital across countries (capital diversity).
    Keywords: FDI, real exchange rates, international financial integration, exchange rate risk
    JEL: E F
    Date: 2023
  11. By: Rajeswari Sengupta (Indira Gandhi Institute of Development Research); Harsh Vardhan
    Abstract: Enactment of the Insolvency and Bankruptcy Code (IBC) in 2016 marked a watershed event in the commercial credit landscape in India, and represented a major enhancement in the rights of creditors. In this paper we hypothesise that in the new regime, creditors would demand a lower price for credit now that the IBC has strengthened their rights in the event of a borrower defaulting. We focus on one class of creditors--investors in the bond market. We consider IBC as a quasi-natural experiment and empirically investigate its impact on credit spreads in the corporate bond market in India. We find that post IBC, credit spreads declined for the non-financial firms in the private corporate sector. However, even for these firms, bond investors seem to assign greater importance to firm-specific characteristics such as firm size and firm financial health compared to the impact of the new bankruptcy regime. It is plausible that a few years after IBC was implemented, the general discontentment in the financial markets regarding the effectiveness of the bankruptcy law may have dampened the effect on credit spreads. Ours is the first study to analyse the influence of the IBC on the cost of credit in the bond market. Currently, the bond market in India is skewed towards high rated bonds which account for the bulk of all issuances. In order to develop a deep and liquid market for lower rated bonds, investor confidence in effective bankruptcy resolution will be crucial. This study provides us with valuable insights about the reaction of the bond investors to the IBC.
    Keywords: Bond pricing, Credit spreads, Bankruptcy law, Creditor rights, Credit rating, Maturity, Liquidity, Risk perception
    JEL: G12 G32 G34
    Date: 2023–02

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