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on Risk Management |
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Issue of 2024‒04‒29
seventeen papers chosen by |
| By: | Ofelia Bonesini; Antoine Jacquier; Aitor Muguruza |
| Abstract: | One the one hand, rough volatility has been shown to provide a consistent framework to capture the properties of stock price dynamics both under the historical measure and for pricing purposes. On the other hand, market price of volatility risk is a well-studied object in Financial Economics, and empirical estimates show it to be stochastic rather than deterministic. Starting from a rough volatility model under the historical measure, we take up this challenge and provide an analysis of the impact of such a non-deterministic risk for pricing purposes. |
| Date: | 2024–03 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2403.11897&r=rmg |
| By: | Killian Pluzanski; Jean-Luc Prigent (Université de Cergy-Pontoise, THEMA) |
| Abstract: | We extend the standard Constant Proportion Portfolio Insurance (CPPI) by introducing simultaneously margin based dynamic strategies and constraints on minimum market expo- sure. This leads us to introduce specific conditional floors, allowing the portfolio of not being monetized (to avoid the cash-lock risk) while ensuring better participation in potential market increases. To control the risk of such strategies, we introduce risk measures based both on quantile conditions. Our empirical analysis is mainly conducted on S&P 500 and Euro Stoxx 50, by using Monte-Carlo experiments based on circular block boostrap method. This allows us to analyze the impact of the different parameters that define our CPPI strategies (i.e. CPPI multiple, successive margins, level of the minimum market exposure). We estimate and compare the cumulative distribution functions of the portfolio returns corresponding to the various insur- ance strategies that we investigate. We provide also their first four moments and measure their respective performances using both the Sharpe and the Omega ratios. Our results highlight the benefits of introducing time-varying floors associated to a decreasing sequence of margins while keeping the market exposure above a minimum level. |
| Keywords: | Portfolio insurance; CPPI strategy; time vaying floor; margin based strategy; market exposure |
| JEL: | C22 C61 G11 |
| Date: | 2023 |
| URL: | http://d.repec.org/n?u=RePEc:ema:worpap:2023-22&r=rmg |
| By: | Christopher Chambers; Alan Miller; Ruodu Wang; Qinyu Wu |
| Abstract: | Max-stability is the property that taking a maximum between two inputs results in a maximum between two outputs. We investigate max-stability with respect to first-order stochastic dominance, the most fundamental notion of stochastic dominance in decision theory. Under two additional standard axioms of monotonicity and lower semicontinuity, we establish a representation theorem for functionals satisfying max-stability, which turns out to be represented by the supremum of a bivariate function. Our characterized functionals encompass special classes of functionals in the literature of risk measures, such as benchmark-loss Value at Risk (VaR) and $\Lambda$-quantile. |
| Date: | 2024–03 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2403.13138&r=rmg |
| By: | Yuyu Chen; Paul Embrechts; Ruodu Wang |
| Abstract: | We study the optimal decisions of agents who aim to minimize their risks by allocating their positions over extremely heavy-tailed (i.e., infinite-mean) and possibly dependent losses. The loss distributions of our focus are super-Pareto distributions which include the class of extremely heavy-tailed Pareto distributions. For a portfolio of super-Pareto losses, non-diversification is preferred by decision makers equipped with well-defined and monotone risk measures. The phenomenon that diversification is not beneficial in the presence of super-Pareto losses is further illustrated by an equilibrium analysis in a risk exchange market. First, agents with super-Pareto losses will not share risks in a market equilibrium. Second, transferring losses from agents bearing super-Pareto losses to external parties without any losses may arrive at an equilibrium which benefits every party involved. The empirical studies show that extremely heavy tails exist in real datasets. |
| Date: | 2024–03 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2403.20171&r=rmg |
| By: | Gasparini, Tommaso; Lewis, Vivien; Moyen, Stéphane; Villa, Stefania |
| Abstract: | Increases in firm default risk raise the default probability of banks while decreasing output and inflation in US data. To rationalize the empirical evidence, we analyse firm risk shocks in a New Keynesian model where entrepreneurs and banks engage in a loan contract and both are subject to default risk. In the model, a wave of corporate defaults leads to losses on banks' balance sheets; banks respond by selling assets and reducing credit provision. A highly leveraged banking sector exacerbates the contractionary effects of firm defaults. We show that high minimum capital requirements jointly implemented with a countercyclical capital buffer are effective in dampening the adverse consequences of firm risk shocks. |
| Keywords: | bank default, capital buffer, firm risk, macroprudential policy |
| JEL: | E44 E52 E58 E61 G28 |
| Date: | 2024 |
| URL: | http://d.repec.org/n?u=RePEc:zbw:bubdps:287761&r=rmg |
| By: | João Granja; Erica Xuewei Jiang; Gregor Matvos; Tomasz Piskorski; Amit Seru |
| Abstract: | In the face of rising interest rates in 2022, banks mitigated interest rate exposure of the accounting value of their assets but left the vast majority of their long-duration assets exposed to interest rate risk. Data from call reports and SEC filings shows that only 6% of U.S. banking assets used derivatives to hedge their interest rate risk, and even heavy users of derivatives left most assets unhedged. The banks most vulnerable to asset declines and solvency runs decreased existing hedges, focusing on short-term gains but risking further losses if rates rose. Instead of hedging the market value risk of bank asset declines, banks used accounting reclassification to diminish the impact of interest rate increases on book capital. Banks reclassified $1 trillion in securities as held-to-maturity (HTM) which insulated these assets book values from interest rate fluctuations. More vulnerable banks were more likely to reclassify. Extending Jiang et al.’s (2023) solvency bank run model, we show that capital regulation could address run risk by encouraging capital raising, but its effectiveness depends on the regulatory capital definitions and can by eroded by the use of HTM accounting. Including deposit franchise value in regulatory capital calculations without considering run risk could weaken capital regulation’s ability to prevent runs. Our findings have implications for regulatory capital accounting and risk management practices in the banking sector. |
| JEL: | G2 G21 G28 |
| Date: | 2024–03 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:32293&r=rmg |
| By: | Boyi Li; Weixuan Xia |
| Abstract: | Recent empirical evidence has highlighted the crucial role of jumps in both price and volatility within the cryptocurrency market. In this paper, we introduce an analytical model framework featuring fractional stochastic volatility, accommodating price--volatility co-jumps and volatility short-term dependency concurrently. We particularly focus on inverse options, including the emerging Quanto inverse options and their power-type generalizations, aimed at mitigating cryptocurrency exchange rate risk and adjusting inherent risk exposure. Characteristic function-based pricing--hedging formulas are derived for these inverse options. The general model framework is then applied to asymmetric Laplace jump-diffusions and Gaussian-mixed tempered stable-type processes, employing three types of fractional kernels, for an extensive empirical analysis involving model calibration on two independent Bitcoin options data sets, during and after the COVID-19 pandemic. Key insights from our theoretical analysis and empirical findings include: (1) the superior performance of fractional stochastic-volatility models compared to various benchmark models, including those incorporating jumps and stochastic volatility, (2) the practical necessity of jumps in both price and volatility, along with their co-jumps and rough volatility, in the cryptocurrency market, (3) stability of calibrated parameter values in line with stylized facts, and (4) the suggestion that a piecewise kernel offers much higher computational efficiency relative to the commonly used Riemann--Liouville kernel in constructing fractional models, yet maintaining the same accuracy level, thanks to its potential for obtaining explicit model characteristic functions. |
| Date: | 2024–03 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2403.16006&r=rmg |
| By: | Shige Peng; Shuzhen Yang; Wenqing Zhang |
| Abstract: | The integration and innovation of finance and technology have gradually transformed the financial system into a complex one. Analyses of the causesd of abnormal fluctuations in the financial market to extract early warning indicators revealed that most early warning systems are qualitative and causal. However, these models cannot be used to forecast the risk of the financial market benchmark. Therefore, from a quantitative analysis perspective, we focus on the mean and volatility uncertainties of the stock index (benchmark) and then construct three early warning indicators: mean uncertainty, volatility uncertainty, and ALM-G-value at risk. Based on the novel warning indicators, we establish a new abnormal fluctuations warning model, which will provide a short-term warning for the country, society, and individuals to reflect in advance. |
| Date: | 2024–03 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2403.12647&r=rmg |
| By: | Yun-Shi Dai; Peng-Fei Dai; Wei-Xing Zhou |
| Abstract: | The current international landscape is turbulent and unstable, with frequent outbreaks of geopolitical conflicts worldwide. Geopolitical risk has emerged as a significant threat to regional and global peace, stability, and economic prosperity, causing serious disruptions to the global food system and food security. Focusing on the international food market, this paper builds different dimensions of geopolitical risk measures based on the random matrix theory and constructs single- and two-factor GJR-GARCH-MIDAS models with fixed time span and rolling window, respectively, to investigate the impact of geopolitical risk on food market volatility. The findings indicate that modeling based on rolling window performs better in describing the overall volatility of the wheat, maize, soybean, and rice markets, and the two-factor models generally exhibit stronger explanatory power in most cases. In terms of short-term fluctuations, all four staple food markets demonstrate obvious volatility clustering and high volatility persistence, without significant asymmetry. Regarding long-term volatility, the realized volatility of wheat, maize, and soybean significantly exacerbates their long-run market volatility. Additionally, geopolitical risks of different dimensions show varying directions and degrees of effects in explaining the long-term market volatility of the four staple food commodities. This study contributes to the understanding of the macro-drivers of food market fluctuations, provides useful information for investment using agricultural futures, and offers valuable insights into maintaining the stable operation of food markets and safeguarding global food security. |
| Date: | 2024–04 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2404.01641&r=rmg |
| By: | Muzi Chen; Nan Li; Lifen Zheng; Difang Huang; Boyao Wu |
| Abstract: | The connectivity of stock markets reflects the information efficiency of capital markets and contributes to interior risk contagion and spillover effects. We compare Shanghai Stock Exchange A-shares (SSE A-shares) during tranquil periods, with high leverage periods associated with the 2015 subprime mortgage crisis. We use Pearson correlations of returns, the maximum strongly connected subgraph, and $3\sigma$ principle to iteratively determine the threshold value for building a dynamic correlation network of SSE A-shares. Analyses are carried out based on the networking structure, intra-sector connectivity, and node status, identifying several contributions. First, compared with tranquil periods, the SSE A-shares network experiences a more significant small-world and connective effect during the subprime mortgage crisis and the high leverage period in 2015. Second, the finance, energy and utilities sectors have a stronger intra-industry connectivity than other sectors. Third, HUB nodes drive the growth of the SSE A-shares market during bull periods, while stocks have a think-tail degree distribution in bear periods and show distinct characteristics in terms of market value and finance. Granger linear and non-linear causality networks are also considered for the comparison purpose. Studies on the evolution of inter-cycle connectivity in the SSE A-share market may help investors improve portfolios and develop more robust risk management policies. |
| Date: | 2024–03 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2403.19363&r=rmg |
| By: | Guohui Guan; Lin He; Zongxia Liang; Litian Zhang |
| Abstract: | This paper studies a variable proportion portfolio insurance (VPPI) strategy. The objective is to determine the risk multiplier by maximizing the extended Omega ratio of the investor's cushion, using a binary stochastic benchmark. When the stock index declines, investors aim to maintain the minimum guarantee. Conversely, when the stock index rises, investors seek to track some excess returns. The optimization problem involves the combination of a non-concave objective function with a stochastic benchmark, which is effectively solved based on the stochastic version of concavification technique. We derive semi-analytical solutions for the optimal risk multiplier, and the value functions are categorized into three distinct cases. Intriguingly, the classification criteria are determined by the relationship between the optimal risky multiplier in Zieling et al. (2014 and the value of 1. Simulation results confirm the effectiveness of the VPPI strategy when applied to real market data calibrations. |
| Date: | 2024–03 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2403.13388&r=rmg |
| By: | Mikkel Bennedsen; Kim Christensen; Peter Christensen |
| Abstract: | We develop a framework for composite likelihood inference of parametric continuous-time stationary Gaussian processes. We derive the asymptotic theory of the associated maximum composite likelihood estimator. We implement our approach on a pair of models that has been proposed to describe the random log-spot variance of financial asset returns. A simulation study shows that it delivers good performance in these settings and improves upon a method-of-moments estimation. In an application, we inspect the dynamic of an intraday measure of spot variance computed with high-frequency data from the cryptocurrency market. The empirical evidence supports a mechanism, where the short- and long-term correlation structure of stochastic volatility are decoupled in order to capture its properties at different time scales. |
| Date: | 2024–03 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2403.12653&r=rmg |
| By: | Yaacov Kopeliovich; Michael Pokojovy |
| Abstract: | Consider a stock market following a geometric Brownian motion and a riskless asset continuously compounded at a constant rate. Assuming the stock can go bankrupt, i.e., lose all of its value, at some exogenous random time (independent of the stock price) modeled as the first arrival time of a homogeneous Poisson process, we study the Merton's optimal portfolio problem consisting of maximizing the expected logarithmic utility of the total wealth at a preselected finite maturity time. First, we present a heuristic derivation based on a new type of Hamilton-Jacobi-Bellman equation. Then, we formally reduce the problem to a classical controlled Markovian diffusion with a new type of terminal and running costs. A new version of Merton's ratio is rigorously derived using Bellman's dynamic programming principle and validated with a suitable type of verification theorem. A real-world example comparing the latter ratio to the classical Merton's ratio is given. |
| Date: | 2024–03 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2403.15923&r=rmg |
| By: | Takuma Kunieda; Akihisa Shibata |
| Abstract: | Although many studies in macroeconomics have examined the role of insurance in the presence of income risk, whether aggregate shocks are insurable has not been sufficiently investigated. We present a simple two-period general equilibrium model to show the conditions under which insurance against aggregate shocks works in an economy with constant-elasticity-substitution (CES) production technology and the Greenwood- Hercowitz-Huffman (GHH) utility function (Greenwood et al., 1988). Our theoretical investigation clarifies that only when agents are heterogeneous in their ability or initial wealth can aggregate shocks be insurable. From our quantitative investigation, we find that (i) agents with lower ability enjoy greater welfare improvement from insurance, and as agents’ ability increases, the welfare improvement diminishes, (ii) agents enjoy greater welfare improvement when the damage from disasters is more severe and when the frequency of disasters is greater, and (iii) although the welfare improvement increases as agents’ initial wealth increases, the impact of a difference in agents’ initial wealth on the difference in the contribution of insurance is very moderate. |
| Date: | 2024–04 |
| URL: | http://d.repec.org/n?u=RePEc:dpr:wpaper:1239&r=rmg |
| By: | Takuma Kunieda (School of Economics, Kwansei Gakuin University); Akihisa Shibata (Institute of Economic Research, Kyoto University) |
| Abstract: | Although many studies in macroeconomics have examined the role of insurance in the presence of income risk, whether aggregate shocks are insurable has not been sufficiently investigated. We present a simple two-period general equilibrium model to show the conditions under which insurance against aggregate shocks works in an economy with constant-elasticity-substitution (CES) production technology and the Greenwood- Hercowitz-Huffman (GHH) utility function (Greenwood et al., 1988). Our theoretical investigation clarifies that only when agents are heterogeneous in their ability or initial wealth can aggregate shocks be insurable. From our quantitative investigation, we find that (i) agents with lower ability enjoy greater welfare improvement from insurance, and as agents' ability increases, the welfare improvement diminishes, (ii) agents enjoy greater welfare improvement when the damage from disasters is more severe and when the frequency of disasters is greater, and (iii) although the welfare improvement increases as agents' initial wealth increases, the impact of a difference in agents' initial wealth on the difference in the contribution of insurance is very moderate. |
| Keywords: | aggregate shocks, heterogeneous agents, state-contingent claims, incomplete market. |
| JEL: | D52 G12 |
| Date: | 2024–04 |
| URL: | http://d.repec.org/n?u=RePEc:kgu:wpaper:267&r=rmg |
| By: | T. van der Zwaard; L. A. Grzelak; C. W. Oosterlee |
| Abstract: | Affine Diffusion dynamics are frequently used for Valuation Adjustments (xVA) calculations due to their analytic tractability. However, these models cannot capture the market-implied skew and smile, which are relevant when computing xVA metrics. Hence, additional degrees of freedom are required to capture these market features. In this paper, we address this through an SDE with state-dependent coefficients. The SDE is consistent with the convex combination of a finite number of different AD dynamics. We combine Hull-White one-factor models where one model parameter is varied. We use the Randomized AD (RAnD) technique to parameterize the combination of dynamics. We refer to our SDE with state-dependent coefficients and the RAnD parametrization of the original models as the rHW model. The rHW model allows for efficient semi-analytic calibration to European swaptions through the analytic tractability of the Hull-White dynamics. We use a regression-based Monte-Carlo simulation to calculate exposures. In this setting, we demonstrate the significant effect of skew and smile on exposures and xVAs of linear and early-exercise interest rate derivatives. |
| Date: | 2024–03 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2403.14841&r=rmg |
| By: | Jose-Miguel Benavente; Claudio Bravo-Ortega; Pablo Egaña-delSol; Bronwyn H. Hall |
| Abstract: | We analyze how expropriation risk reduces incentives for innovation and reallocates resources from the innovative sector, building on Romer’s(1990) model. Our framework predicts the R&D expenditure, the share of human capital in R&D, the number of patents, technical progress, and economic growth are all lower due to lower expected profits and patent devaluation in the presence of expropriation risks. Empirical analyses, based on a LASSO Instrumental Variable approach and a novel comprehensive dataset spanning nearly two decades, confirm our theoretical predictions. We find robust evidence that expropriation risk, such as corruption, negatively impacts innovation by reducing R&D expenditure, human capital in R&D, number of patents, scientific publications, and the Economic Complexity Index, which is our proxy for technical progress. These findings highlight the detrimental effects of expropriation risk on innovation and economic development at the country level. |
| JEL: | O17 O30 O50 |
| Date: | 2024–03 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:32288&r=rmg |