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on Risk Management |
| By: | Ruipeng Liu (Department of Finance, Deakin Business School, Deakin University, Australia); Mawuli Segnon (Department of Economics, University of Munster, Germany); Oguzhan Cepni (Department of Economics, Copenhagen Business School, Denmark; Ostim Technical University, Ankara, Turkiye); Rangan Gupta (Department of Economics, University of Pretoria, Private Bag X20, Hatfield 0028, South Africa) |
| Abstract: | This paper adopts a bivariate Markov switching multifractal (MSM) model to reexamine co-movement in stochastic volatility between commodity, foreign exchange (FX) and stock markets. After the 2007-2008 global financial crisis understanding volatility linkages and the correlation structure between these markets becomes very important for risk analysts, portfolio managers, traders, and governments. Using daily data on stock indices and FX rates from developed and emerging countries and a range of commodities such crude oil, natural gas, aluminum, copper, gold, silver, platinum, wheat, corn, soybean and soybean oil we find evidence of (re)correlation between commodity, FX and stock markets. The bivariate MSM model compares favorably to a bivariate DCC-GARCH and univariate MSM model, especially at short (1, 5 and 10 days) forecasting horizons. Furthermore, we discuss its implications for risk and portfolio management. |
| Keywords: | Multifractal processes, Volatility co-movement, Commodity returns, Foreign exchange returns, Stock returns |
| JEL: | C53 C58 G15 |
| Date: | 2023–12 |
| URL: | http://d.repec.org/n?u=RePEc:pre:wpaper:202340&r=rmg |
| By: | Herv\'e Andr\`es (CERMICS); Alexandre Boumezoued (CERMICS, MATHRISK); Benjamin Jourdain (CERMICS, MATHRISK) |
| Abstract: | We propose a new model for the coherent forecasting of both the implied volatility surfaces and the underlying asset returns.In the spirit of Guyon and Lekeufack (2023) who are interested in the dependence of volatility indices (e.g. the VIX) on the paths of the associated equity indices (e.g. the S\&P 500), we first study how implied volatility can be predicted using the past trajectory of the underlying asset price. Our empirical study reveals that a large part of the movements of the at-the-money-forward implied volatility for up to two years maturities can be explained using the past returns and their squares. Moreover, we show that up to four years of the past evolution of the underlying price should be used for the prediction and that this feedback effect gets weaker when the maturity increases. Building on this new stylized fact, we fit to historical data a parsimonious version of the SSVI parameterization (Gatheral and Jacquier, 2014) of the implied volatility surface relying on only four parameters and show that the two parameters ruling the at-the-money-forward implied volatility as a function of the maturity exhibit a path-dependent behavior with respect to the underlying asset price. Finally, we propose a model for the joint dynamics of the implied volatility surface and the underlying asset price. The latter is modelled using a variant of the path-dependent volatility model of Guyon and Lekeufack and the former is obtained by adding a feedback effect of the underlying asset price onto the two parameters ruling the at-the-money-forward implied volatility in the parsimonious SSVI parameterization and by specifying a hidden semi-Markov diffusion model for the residuals of these two parameters and the two other parameters. Thanks to this model, we are able to simulate highly realistic paths of implied volatility surfaces that are arbitrage-free. |
| Date: | 2023–12 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2312.15950&r=rmg |
| By: | Tim J. Boonen; Xia Han |
| Abstract: | This paper studies an optimal insurance contracting problem in which the preferences of the decision maker given by the sum of the expected loss and a convex, increasing function of a deviation measure. As for the deviation measure, our focus is on convex signed Choquet integrals (such as the Gini coefficient and a convex distortion risk measure minus the expected value) and on the standard deviation. We find that if the expected value premium principle is used, then stop-loss indemnities are optimal, and we provide a precise characterization of the corresponding deductible. Moreover, if the premium principle is based on Value-at-Risk or Expected Shortfall, then a particular layer-type indemnity is optimal, in which there is coverage for small losses up to a limit, and additionally for losses beyond another deductible. The structure of these optimal indemnities remains unchanged if there is a limit on the insurance premium budget. If the unconstrained solution is not feasible, then the deductible is increased to make the budget constraint binding. We provide several examples of these results based on the Gini coefficient and the standard deviation. |
| Date: | 2023–12 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2312.01813&r=rmg |
| By: | B. Bruno; I. Marino; G. Nocera (Audencia Business School) |
| Keywords: | Transparency, Credit risk, Bank regulation, Disclosure |
| Date: | 2023–10 |
| URL: | http://d.repec.org/n?u=RePEc:hal:journl:hal-04322520&r=rmg |
| By: | Xia Han; Ruodu Wang; Qinyu Wu |
| Abstract: | Mean-deviation models, along with the existing theory of coherent risk measures, are well studied in the literature. In this paper, we characterize monotonic mean-deviation (risk) measures from a general mean-deviation model by applying a risk-weighting function to the deviation part. The form is a combination of the deviation-related functional and the expectation, and such measures belong to the class of consistent risk measures. The monotonic mean-deviation measures admit an axiomatic foundation via preference relations. By further assuming the convexity and linearity of the risk-weighting function, the characterizations for convex and coherent risk measures are obtained, giving rise to many new explicit examples of convex and nonconvex consistent risk measures. Further, we specialize in the convex case of the monotonic mean-deviation measure and obtain its dual representation. The worst-case values of the monotonic mean-deviation measures are analyzed under two popular settings of model uncertainty. Finally, we establish asymptotic consistency and normality of the natural estimators of the monotonic mean-deviation measures. |
| Date: | 2023–12 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2312.01034&r=rmg |
| By: | Beatrice Acciaio; Antonio Marini; Gudmund Pammer |
| Abstract: | The Bass local volatility model introduced by Backhoff-Veraguas--Beiglb\"ock--Huesmann--K\"allblad is a Markov model perfectly calibrated to vanilla options at finitely many maturities, that approximates the Dupire local volatility model. Conze and Henry-Labord\`ere show that its calibration can be achieved by solving a fixed-point equation. In this paper we complement the analysis and show existence and uniqueness of the solution to this equation, and that the fixed-point iteration scheme converges at a linear rate. |
| Date: | 2023–11 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2311.14567&r=rmg |
| By: | Allen N. Berger; Filippo Curti; Nika Lazaryan; Atanas Mihov; Raluca A. Roman |
| Abstract: | Using supervisory data from large U.S. bank holding companies (BHCs), we document that BHCs suffer more operational losses during episodes of extreme storms. Among different operational loss types, losses due to external fraud, BHCs’ failure to meet obligations to clients and faulty business practices, damage to physical assets, and business disruption drive this relation. Event study estimations corroborate our baseline findings. We further show that BHCs with past exposure to extreme storms reduce operational losses from future exposure to storms. Overall, our findings provide new evidence regarding U.S. banking organizations’ exposure to climate risks with implications for risk management practices and supervisory policy. |
| Keywords: | Operational Losses; Banking; Bank Holding Companies; Natural Disasters; Climate Risk; Hurricanes; Tornadoes; Severe Thunderstorms |
| JEL: | G20 G21 G32 Q54 |
| Date: | 2023–12–19 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedpwp:97489&r=rmg |
| By: | Roger J. A. Laeven; Mitja Stadje |
| Abstract: | This paper axiomatizes, in a two-stage setup, a new theory for decision under risk and ambiguity. The axiomatized preference relation $\succeq$ on the space $\tilde{V}$ of random variables induces an ambiguity index $c$ on the space $\Delta$ of probabilities, a probability weighting function $\psi$, generating the measure $\nu_{\psi}$ by transforming an objective probability measure, and a utility function $\phi$, such that, for all $\tilde{v}, \tilde{u}\in\tilde{V}$, \begin{align*} \tilde{v}\succeq\tilde{u} \Leftrightarrow \min_{Q \in \Delta} \left\{\mathbb{E}_Q\left[\int\phi\left(\tilde{v}^{\centerdot}\right)\, \mathrm{d}\nu_{\psi}\right]+c(Q)\right\} \geq \min_{Q \in \Delta} \left\{\mathbb{E}_Q\left[\int\phi\left(\tilde{u}^{\centerdot}\right)\, \mathrm{d}\nu_{\psi}\right]+c(Q)\right\}. \end{align*} Our theory extends the rank-dependent utility model of Quiggin (1982) for decision under risk to risk and ambiguity, reduces to the variational preferences model when $\psi$ is the identity, and is dual to variational preferences when $\phi$ is affine in the same way as the theory of Yaari (1987) is dual to expected utility. As a special case, we obtain a preference axiomatization of a decision theory that is a rank-dependent generalization of the popular maxmin expected utility theory. We characterize ambiguity aversion in our theory. |
| Date: | 2023–12 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2312.05977&r=rmg |
| By: | An Chen; Giorgio Ferrari; Shihao Zhu |
| Abstract: | This paper investigates the consumption and investment decisions of an individual facing uncertain lifespan and stochastic labor income within a Black-Scholes market framework. A key aspect of our study involves the agent's option to choose when to acquire life insurance for bequest purposes. We examine two scenarios: one with a fixed bequest amount and another with a controlled bequest amount. Applying duality theory and addressing free-boundary problems, we analytically solve both cases, and provide explicit expressions for value functions and optimal strategies in both cases. In the first scenario, where the bequest amount is fixed, distinct outcomes emerge based on different levels of risk aversion parameter $\gamma$: (i) the optimal time for life insurance purchase occurs when the agent's wealth surpasses a critical threshold if $\gamma \in (0, 1)$, or (ii) life insurance should be acquired immediately if $\gamma>1$. In contrast, in the second scenario with a controlled bequest amount, regardless of $\gamma$ values, immediate life insurance purchase proves to be optimal. |
| Date: | 2023–12 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2312.02943&r=rmg |
| By: | Yu-Jui Huang; Li-Hsien Sun |
| Abstract: | This paper considers finitely many investors who perform mean-variance portfolio selection under a relative performance criterion. That is, each investor is concerned about not only her terminal wealth, but how it compares to the average terminal wealth of all investors (i.e., the mean field). At the inter-personal level, each investor selects a trading strategy in response to others' strategies (which affect the mean field). The selected strategy additionally needs to yield an equilibrium intra-personally, so as to resolve time inconsistency among the investor's current and future selves (triggered by the mean-variance objective). A Nash equilibrium we look for is thus a tuple of trading strategies under which every investor achieves her intra-personal equilibrium simultaneously. We derive such a Nash equilibrium explicitly in the idealized case of full information (i.e., the dynamics of the underlying stock is perfectly known), and semi-explicitly in the realistic case of partial information (i.e., the stock evolution is observed, but the expected return of the stock is not precisely known). The formula under partial information involves an additional state process that serves to filter the true state of the expected return. Its effect on trading is captured by two degenerate Cauchy problems, one of which depends on the other, whose solutions are constructed by elliptic regularization and a stability analysis of the state process. Our results indicate that partial information alone can reduce investors' wealth significantly, thereby causing or aggravating systemic risk. Intriguingly, in two different scenarios of the expected return (i.e., it is constant or alternating between two values), our Nash equilibrium formula spells out two distinct manners systemic risk materializes. |
| Date: | 2023–12 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2312.04045&r=rmg |
| By: | Turan G. Bali (Georgetown University); Heiner Beckmeyer (University of Münster); Amit Goyal (University of Lausanne; Swiss Finance Institute) |
| Abstract: | Motivated by structural credit risk models, we propose a parsimonious reduced-form joint factor model for bonds, options, and stocks. By extending the instrumented principal component analysis to accommodate heterogeneity in how firm characteristics instrument the sensitivity of bonds, options, and stocks, we find that our model is able to jointly explain the risk-return tradeoff for the three asset classes. Just six factors are sufficient to explain 31% of the total variation of bond, option, and stock returns; these six factors leave the returns of only 7 out of 169 characteristic-managed portfolios unexplained. Finally, we investigate the patterns of commonality in return predictability. |
| Keywords: | factor model, IPCA, corporate bond, option returns |
| JEL: | G10 G11 G12 |
| Date: | 2023–11 |
| URL: | http://d.repec.org/n?u=RePEc:chf:rpseri:rp23106&r=rmg |
| By: | Mishari Al-Foraih; Jan Posp\'i\v{s}il; Josep Vives |
| Abstract: | Using Malliavin calculus techniques we obtain formulas for computing Greeks under different rough Volterra stochastic volatility models. In particular we obtain formulas for rough versions of Stein-Stein, SABR and Bergomi models and numerically demonstrate the convergence. |
| Date: | 2023–12 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2312.00405&r=rmg |
| By: | Denitsa Angelova (Institute for Sustainable Resources, Bartlett School of Environment Energy & Resources, University College London); Andrea Bigano (Euro-Mediterranean Center on Climate Change (CMCC); RFF-CMCC European Institute on Economics and the Environment (EIEE)); Francesco Bosello (Euro-Mediterranean Center on Climate Change (CMCC); Department of Environmental Sciences, Informatics and Statistics, Ca' Foscari University of Venice); Shouro Dasgupta (Euro-Mediterranean Center on Climate Change (CMCC)); Silvio Giove (Department of Economics, Ca' Foscari University of Venice) |
| Abstract: | This paper proposes a transparent and replicable methodology to rank countries according to climate change risk through a composite indicator approach. We show that adherence to the IPCC definition of risk easily leads to a dominance of the exposure component in risk determination. This, on its turn, produces a country risk ranking that can differ also substantively from that of other indicators used for similar purposes, especially by rating agencies. These last indicators are, in fact, closer to the concept of vulnerability to climate change, than risk. Our major conclusion is that by accounting for all the components of risk, the dichotomy "high-climate-change-risk developing countries" vs "low climate-change-risk developed countries" blurs substantively, while climate risk becomes relatively higher than commonly considered in the latter group. |
| Keywords: | climate risk, physical climate risk, climate risk index, composite indicator |
| JEL: | Q5 Q54 |
| Date: | 2023 |
| URL: | http://d.repec.org/n?u=RePEc:ven:wpaper:2023:28&r=rmg |
| By: | 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); Roy Cerqueti (UNIROMA - Università degli Studi di Roma "La Sapienza" = Sapienza University [Rome], LSBU - London South Bank University); Jessica Riccioni (UNIROMA - Università degli Studi di Roma "La Sapienza" = Sapienza University [Rome]) |
| Abstract: | Here we introduce the idea of using rational expectations, a core concept in economics and finance, as a tool to predict the optimal failure time for a wide class of weighted k-out-of-n reliability systems. We illustrate the concept by applying it to systems which have components with heterogeneous failure times. Depending on the heterogeneous distributions of component failure, we find different measures to be optimal for predicting the failure time of the total system. We give examples of how, as a given system deteriorates over time, one can issue different optimal predictions of system failure by choosing among a set of time-dependent measures. |
| Keywords: | Physics and Society, Data Analysis, Statistics and Probability, General Finance, Physical sciences, Economics and business, Rational expectations, weighted k-out-of-n reliability systems, failure prediction, statistical measures |
| Date: | 2023–04–17 |
| URL: | http://d.repec.org/n?u=RePEc:hal:cesptp:hal-03634370&r=rmg |
| By: | Alexis Anagnostakis |
| Abstract: | We consider a financial market model featuring a risky asset with a sticky geometric Brownian motion price dynamic and a constant interest rate $r \in \mathbb R$. We prove that the model is arbitrage-free if and only if $r =0 $. In this instance, we find the unique riskless replication strategy and derive the associated pricing equation. Last, we numerically evaluate discrete-time hedging error and error from model mismatch. |
| Date: | 2023–11 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2311.17011&r=rmg |
| By: | Maarten Meeuwis; Dimitris Papanikolaou; Jonathan L. Rothbaum; Lawrence D.W. Schmidt |
| Abstract: | We show that time variation in risk premia leads to time-varying idiosyncratic income risk for workers. Using US administrative data on worker earnings, we show that increases in risk premia lead to lower earnings for low-wage workers; these declines are primarily driven by job separations. By contrast, productivity shocks affect the earnings mainly of highly paid workers. We build an equilibrium model of labor market search that quantitatively replicates these facts. The model generates endogenous time-varying income risk in response to changes in risk premia and matches several stylized features of the data regarding unemployment and income risk over the business cycle. |
| JEL: | E3 E40 G1 J20 J30 |
| Date: | 2023–12 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:31968&r=rmg |