Showing papers in "The Journal of Risk Finance in 2006"

Determinants of dividend payout ratios in Ghana

Abstract: Purpose – This study seeks to examine the determinants of dividend payout ratios of listed companies in Ghana.Design/methodology/approach – The analyses are performed using data derived from the financial statements of firms listed on the Ghana Stock Exchange during a six‐year period. Ordinary Least Squares model is used to estimate the regression equation. Institutional holding is used as a proxy for agency cost. Growth in sales and market‐to‐book value are also used as proxies for investment opportunities.Findings – The results show positive relationships between dividend payout ratios and profitability, cash flow, and tax. The results also show negative associations between dividend payout and risk, institutional holding, growth and market‐to‐book value. However, the significant variables in the results are profitability, cash flow, sale growth and market‐to‐book value.Originality/value – The main value of this study is the identification of the factors that influence the dividend payout policy decisio...

Predicting probability of default of Indian corporate bonds: logistic and Z‐score model approaches

Abstract: Purpose – This paper aims at developing an early warning signal model for predicting corporate default in emerging market economy like India. At the same time, it also aims to present methods for directly estimating corporate probability of default (PD) using financial as well as non‐financial variables.Design/methodology/approach – Multiple Discriminate Analysis (MAD) is used for developing Z‐score models for predicting corporate bond default in India. Logistic regression model is employed to directly estimate the probability of default.Findings – The new Z‐score model developed in this paper depicted not only a high classification power on the estimated sample, but also exhibited a high predictive power in terms of its ability to detect bad firms in the holdout sample. The model clearly outperforms the other two contesting models comprising of Altman's original and emerging market set of ratios respectively in the Indian context. In the logit analysis, the empirical results reveal that inclusion of fina...

Business cycles in insurance and reinsurance: the case of France, Germany and Switzerland

Abstract: Purpose – This article aims to examine the existence of an underwriting cycle in property‐liability insurance for France, Germany and Switzerland (primary markets) and for the European reinsurance industry. It is also aimed to test how the two markets are related with each other in each country and how they influence each other.Design/methodology/approach – Loss ratio data for France, Germany and Switzerland are used for the recent period 1982‐2001 in connection with the price of reinsurance in Europe as well as the money market rate. To test for the existence of cycles and calculate their length auto‐regressive processes of second order are applied.Findings – There are cross‐country differences for the primary markets of the three countries. The reinsurance price index is highly cyclical with a calculated cycle length of almost nine years. It is shown that the reinsurance price index has a strong influence on the primary market loss ratios of the three countries studied.Originality/value – With the excep...

Empirical study of value‐at‐risk and expected shortfall models with heavy tails

Abstract: Purpose – This paper aims to test empirically the performance of different models in measuring VaR and ES in the presence of heavy tails in returns using historical data.Design/methodology/approach – Daily returns of popular indices (S&P500, DAX, CAC, Nikkei, TSE, and FTSE) and currencies (US dollar vs Euro, Yen, Pound, and Canadian dollar) for over ten years are modeled with empirical (or historical), Gaussian, Generalized Pareto (peak over threshold (POT) technique of extreme value theory (EVT)) and Stable Paretian distribution (both symmetric and non‐symmetric). Experimentation on different factors that affect modeling, e.g. rolling window size and confidence level, has been conducted.Findings – In estimating VaR, the results show that models that capture rare events can predict risk more accurately than non‐fat‐tailed models. For ES estimation, the historical model (as expected) and POT method are proved to give more accurate estimations. Gaussian model underestimates ES, while Stable Paretian framewo...

Analysis of multinational underwriting cycles in property‐liability insurance

Abstract: Purpose – The paper sets out to use the loss ratio series of Switzerland, Germany, the USA and Japan, to test whether underwriting cycles still exist internationally and to identify possible structural changes.Design/methodology/approach – Based on financial theory and insurance pricing theory, co‐integration analysis was performed to check possible causes of structural changes.Findings – All four countries have breaks in different years. This result leads to the hypothesis that the factors affecting underwriting cycles are mainly country‐specific, such as economic environment and regulations, rather than global/international. Although the financial theory and the insurance pricing theory suggest that the loss ratio series should be co‐integrated with the interest rate series with co‐integrating coefficient −1, the empirical results do not support the theories.Originality/value – More detailed analysis for the time series characteristics for countries other than the USA is presented to investigate the pos...

Can the student‐t distribution provide accurate value at risk?

Abstract: Purpose – This paper aims to investigate how effectively the value at risk (VaR) estimated using the student‐t distribution captures the market risk.Design/methodology/approach – Two alternative VaR models, VaR‐t and VaR‐x models, are presented and compared with the benchmark model (VaR‐n model). In this study, we consider the Student‐t distribution as a fit to the empirical distribution for estimating the VaR measure, namely, VaR‐t method. Since the Student‐t distribution is criticized for its inability to capture the asymmetry of distribution of asset returns, we use the extreme value theory (EVT)‐based model, VaR‐x model, to take into account the asymmetry of distribution of asset returns. In addition, two different approaches, excess‐kurtosis and tail‐index techniques, for determining the degrees of freedom of the Student‐t distribution in VaR estimation are introduced.Findings – The main finding of the study is that using the student‐t distribution for estimating VaR can improve the VaR estimation an...

Approximating the growth optimal portfolio with a diversified world stock index

Abstract: Purpose – This paper aims to construct and compare various total‐return world stock indices based on daily data.Design/methodology/approach – Because of diversification, these indices are noticeably similar. A diversification theorem identifies any diversified portfolio as a proxy for the growth optimal portfolio.Findings – The paper constructs a diversified world stock index that outperforms a number of other indices and argues that it is a good proxy for the growth optimal portfolio.Originality/value – The diversified world stock index has applications to derivative pricing and investment management.

Multi‐national underwriting cycles in property‐liability insurance

Abstract: Purpose – The purpose of this article is to examine the existence of underwriting cycles in property‐liability insurance for Switzerland, the USA, and Japan over a period of 40 years (1957‐1997), it aims to overcome some of the limitations of a pure autoregressive process of second order (AR(2)).Design/methodology/approach – Loss‐ratio data for the three countries are used for the recent period 1957‐1997. To test for the existence of cycles and calculate their length, we start with autoregressive processes of second order and include more variables that should be taken into account. We also estimate a cointegration model in order to separate long‐term and short‐term dynamics.Findings – The hypothesis of cycles of six years in length no longer holds globally and it is necessary to go further than estimating simple AR(2) processes. Different models or specifications seem adequate for different countries because of the varying structure of the insurance markets. Cycles are still found for the USA and most es...

Credit‐default swap rates and equity volatility: a nonlinear relationship

Abstract: Purpose – The aim of this paper is to study the impact of equity returns volatility of reference entities on credit‐default swap rates using a new dataset from the Japanese market.Design/methodology/approach – Using a copula approach, the paper models the different relationships that can exist in different ranges of behavior. It studies the bivariate distributions of credit‐default swap rates and equity return volatility estimated with GARCH (1,1) and focus on one parameter Archimedean copula.Findings – First, the paper emphasizes the finding that pairs with higher rating present a weaker dependence coefficient and then, the impact of equity returns volatility on credit‐default swap rates is higher for the lowest rating class. Second, the dependence structure is positive and asymmetric indicating that protection sellers ask for higher credit‐default swap returns to compensate the higher credit risk incurred by low rating class.Practical implications – The paper has several practical implications that are ...

Multi‐national underwriting cycles in property‐liability insurance: Part I – some theory and empirical results

Abstract: Purpose – The purpose of this article is to examine the existence of underwriting cycles in property‐liability insurance for Switzerland, the USA, Japan, and West Germany over a period of 40 years (1957‐1997), i.e. it looks at the question of whether the unit price of insurance coverage (given by the inverse of the loss ratio) fluctuates cyclically over time. The article serves as basis and starting point for Part II, where some of the limitations of the model presented here are dealt with. Design/methodology/approach – Loss ratio data for the four countries are used for the recent period 1957‐1997. To test for the existence of cycles and calculate their length, the article applies autoregressive processes of second order, which were brought to a broader audience by a paper by Cummins and Outreville in 1987. The article also conducts a spectral analysis of the series. Findings – For West Germany, much longer cycles than in earlier studies were found for the basic model. In general, the cycles get longer for the longer period, 1957‐1997. The article concludes that the hypothesis of cycles of six years in length no longer holds globally. It also finds cross‐country differences for the primary markets of the four countries. Originality/value – Most empirical work on underwriting cycles has so far been carried out on US data. This study replicates a previous study for four countries on three continents and discusses the results and some limitations. It serves as the basis for Part II of this work.

Foreign‐exchange trading risk management with value at risk

Abstract: Purpose – The aim of this paper is to fill a gap in the foreign‐exchange trading risk‐management literature and particularly from the perspective of emerging and illiquid markets, such as in the context of the Moroccan foreign‐exchange market.Design/methodology/approach – This paper, demonstrates a constructive approach, for the management of trading risk exposure of foreign‐exchange securities, which takes into account proper adjustments for the illiquidity of both long and short trading positions. The approach is based on the renowned concept of value at risk (VaR) along with the innovation of a software tool utilizing matrix‐algebra and other optimization techniques.Findings – Several case studies, on the Moroccan Dirham, were achieved with the objective of setting‐up a practical framework of trading risk measurement, management and control reports, in addition to the inception of a practical procedure for the calculation of optimum VaR limits structure.Practical implications – In this work, the risk‐m...

Stationarity and stability of underwriting profits in property‐liability insurance

Abstract: Purpose – To examine whether the properties of the combined‐ratio series, an indicator of underwriting profitability in property‐liability insurance, have changed over time.Design/methodology/approach – Using the autocorrelation function (ACF) and partial autocorrelation function (PACF), we check whether combined ratios are stationary.Findings – Underwriting profit has worsened in recent years, and combined ratios are non‐stationary. This characteristic of combined ratios needs further analysis for its impact on underwriting cycles.Practical implications – Traditional concepts of underwriting cycles, such as predictable cycle lengths and trends, may have changed.Originality/value – The possibility of a non‐stationary combined‐ratio series is recognized, and the possible existence of non‐stationarity and breaks in combined ratios is introduced.

When does cross‐border acquisition of insurance firms lead to value creation?

Abstract: Purpose – The purpose of this paper is to focus on international acquisitions that took place in the insurance sector by US‐based firms in the years 1997‐2003 and their impact on shareholder wealth.Design/methodology/approach – The study sample is based on 52 international acquisitions in 24 countries undertaken by US firms in the insurance industry during the years 1997‐2003. The event‐study methodology is used to verify the impact of international acquisition announcements on an insurance firm's shareholder wealth. Cross‐sectional regression analysis is used to determine the importance of host country factors.Findings – Overall results of this study show that firms undertaking overseas acquisitions face statistically insignificant negative market returns, indicating the market neither rewards nor penalizes such firms. The market returns faced by firms during such acquisitions tend to vary by the degree of wealth of the host country, amount of bilateral trade between host and home country, extent of pote...

Option pricing for some stochastic volatility models

Abstract: Purpose – To study stochastic volatility in the pricing of options.Design/methodology/approach – Random‐coefficient autoregressive and generalized autoregressive conditional heteroscedastic models are studied. The option‐pricing formula is viewed as a moment of a truncated normal distribution.Findings – Kurtosis for RCA and for GARCH process is derived. Application of random coefficient GARCH kurtosis in analytical approximation of option pricing is discussed.Originality/value – Findings are useful in financial modeling.

Financial applications of ARMA models with GARCH errors

Abstract: Purpose – Financial returns are often modeled as stationary time series with innovations having heteroscedastic conditional variances. This paper seeks to derive the kurtosis of stationary processes with GARCH errors. The problem of hypothesis testing for stationary ARMA(p, q) processes with GARCH errors is studied. Forecasting of ARMA(p, q) processes with GARCH errors is also discussed in some detail.Design/methodology/approach – Estimating‐function methodology was the principal method used for the research. The results were also illustrated using examples and simulation studies. Volatility modeling is the subject of the paper.Findings – The kurtosis of stationary processes with GARCH errors is derived in terms of the model parameters (ψ), Ψ‐weights, and the kurtosis of the innovation process. Hypothesis testing for stationary ARMA(p, q) processes with GARCH errors based on the estimating‐function approach is shown to be superior to the least‐squares approach. The fourth moment of the l‐steps‐ahead forec...

Application of spectral and ARIMA analysis to combined‐ratio patterns

Abstract: Purpose – This paper seeks to use spectral analysis as an alternative method to analyze whether underwriting results exhibit a cyclical behavior for the property‐liability insurance industry and by lines of business In addition, aims to use the AR(2) process to obtain information about cyclical behavior and cycle lengths Then, the results from the two methods are to be closely examined and comparedDesign/methodology/approach – Spectral analysis and ARIMA are used to obtain cycle lengths, then to compare them to check the consistency of the two methodsFindings – The AR(2) produced more significant results than spectral analysisOriginality/value – This is the first article in insurance using significant levels for spectral analysis to decide appropriate cycle lengths In addition, the consideration of multiple comparisons to get critical values for significance levels reduces false positive and produces more reliable results

Fuzzy random‐coefficient volatility models with financial applications

Abstract: Purpose – The purpose of this research is to introduce a class of FRC (fuzzy random coefficient) volatility models and to study their moment properties. Fuzzy option values and the superiority of fuzzy forecasts over minimum mean‐square forecasts are also discussed in some detail.Design/methodology/approach – Fuzzy components are assumed to be triangular fuzzy numbers. Buckley's data‐driven method is used to determine the spread of the triangular fuzzy numbers by using standard errors of the estimated parameters.Findings – The fuzzy kurtosis of various volatility models is obtained in terms of fuzzy coefficients. Fuzzy option values and fuzzy forecasts are illustrated with examples. Fuzzy forecast intervals are narrower than the corresponding MMSE forecast intervals.Originality/value – This paper will be of value to econometricians and to anyone with an interest in financial volatility models.

The use of spectral analysis in insurance cycle research

Abstract: Purpose – Aims to address a number of issues related to the use of spectral analysis in the study of insurance cycles.Design/methodology/approach – Spectral analysis has seldom been used in the study of insurance cycles. This may be due to the fact that no statistical test is readily available for rejecting the hypothesis that a spectrum is significantly different from random uncorrelated noise in a context in which the period of the alternative is not known. This article suggests one such test.Findings – In evaluating the proposed test, the relevant critical points, when the number of observations is small, and provided the power of the test is also explored to identify three cyclical processes: a sine process with noise, a second‐order autoregressive process, and the rational expectations process suggested by Cummins and Outreville.Originality/value – The article provides the first comprehensive analysis and discussion of spectral analysis in the context of insurance‐cycle research.

An insurance paradox

Abstract: Purpose – To consider why the law of large numbers does not play a more significant role in determining an insurer's financial leverage.Design/methodology/approach – Insurer‐group data show that there is little relationship between an insurer's premium volume and its overall leverage (i.e. net written premium‐to‐surplus ratio). An explanation is sought for the lack of a positive scale effect by considering concomitant negative scale effects.Findings – It is argued that insurers frequently convert the benefits of the law of large numbers into economic subsidies for expanded writings that include poorer risks.Originality/value – The editorial identifies and explores a significant scale phenomenon in the insurance sector that is generally overlooked.

Effects of maturity choices on loan‐guarantee portfolios1

Abstract: Purpose – The purpose of this paper is to analyse the effects of the maturities of credit‐enhanced debt contracts on the value of an insurer's loan‐guarantee portfolios.Design/methodology/approach – The paper proposes a contingent‐claims model and uses as measure of credit insurance risk, the market value of the private guarantee, which accounts for projects' and guarantor's specific risks, correlations as well as financial leverage.Findings – The results indicate that in the case of insuring the debts of two parallel projects with different specific risks, one high‐risk and the other low‐risk, the tradeoff between maturities of the guarantees increases with the projects' expected losses, hence the maturity choice decision is crucial for portfolios subject to high expected losses. For a two sequential projects loan‐guarantee portfolio, the paper finds that, regardless of the order of execution of the projects, it is the maturity of the debt supporting the high‐risk project that drives the risk exposure of...

The estimation of nominal and real yield curves from government bonds in Israel

Abstract: Purpose – The purpose of this research is to develop and test a mathematical method of deriving zero yield curve from market prices of government bonds.Design/methodology/approach – The method is based on a forward curve approximated by a linear (or piecewise constant) spline and should be applicable even for markets with low liquidity. The best fitting curve is derived by minimizing the penalty function. The penalty is defined as a sum of squared price discrepancies (theoretical curve based price minus market closing price) weighted by trade volume and an additional penalty for non‐smoothness of the yield curve.Findings – This method is applied to both nominal and CPI linked bonds traded in Israel (some segments of these markets have low liquidity). The resulting two yield curves are used for derivation of market expected inflation rate.Research limitations/implications – The main problems are low liquidity of some bonds and imperfect linkage to inflation in the CPI linked market.Practical implications –...

Dynamic monitoring of financial intermediaries with subordinated debt

Abstract: Purpose – The purpose of this paper is to show that subordinated debt regulatory proposals assume that transactions in the secondary market of subordinated debt can attenuate moral hazard on the part of management if secondary market prices are informative signals of the risk of the institution Owing to the proprietary nature of dealer prices and the liquidity of secondary transactions, the practical value of information provided by subordinated debt issues in isolation is questionableDesign/methodology/approach – A multivariate dynamic risk signal is proposed that combines fluctuations in equity prices, subordinated debt and senior debt yields The signal is constructed as a coincident indicator that is based in a time series model of yield fluctuations and equity returns The extracted signal monitors idiosyncratic risk of the intermediary because yields and equity returns are filtered from market conditions It is also predictable because it is possible to construct a leading indicator based almost e

Best execution compliance: new techniques for managing compliance risk

Abstract: Purpose – New regulatory initiatives, principally MiFID and RegNMS, challenge wholesale financial firms to prove that they can provide best execution for their clients. This article aims to outline the background to the problem and suggest that current research into SVM/DAPR applications may provide a practical approach.Design/methodology/approach – The article presents a desk review of current issues in “best execution” based on work with European brokers and others, followed by initial, promising trial of SVM/DAPR.Findings – The article finds that brokers need automated tools, e.g. “sifting engines” that help them to focus compliance efforts on anomalous trades.Research limitations/implications – Although brokers appear to need assistance in identifying anomalous trades, whether they place significant effort in compliance depends on regulatory enforcement.Originality/value – MiFID and RegNMS will require changes in current practice. SVM/DAPR approaches appear to be worth further investigation.

Pure vs speculative risk: False choice; sham marriage

Abstract: Purpose – The purpose of this editorial is to study the relationship between the pure risks of insurance and the speculative risks of other financial markets in the context of financial services “convergence”.Design/methodology/approach – The editorial recasts the difference between pure risks and speculative risks as a distinction between empirical risks (which arise from observable natural processes largely insulated against behavioral effects) and market risks (which contain substantial non‐empirical or behavioral components).Findings – Using the empirical risk/market risk dichotomy, it is argued that there is little reason to anticipate a dramatic convergence of insurance and other financial markets.Originality/value – The editorial challenges conventional distinctions between insurance and other financial risks, as well as conventional expectations regarding financial services convergence.

Catastrophe forecasting: seeing “gray” among the “black boxes”

Abstract: Purpose – The purpose of this paper is to consider the problem of using “black‐box” methods to forecast catastrophe events, and illustrate the value of independent peer review.Design/methodology/approach – The problem with black‐box catastrophe forecasts is the absence of both extensive validation data and impartial peer review. These issues may be addressed by comparing black‐box forecasts with a set of naive alternative forecasts provided by an independent party. To illustrate this approach, the historical hurricane forecasts of Dr William M. Gray, professor at Colorado State University, are considered and a simple ARIMA analysis is offered as a naive alternative.Findings – The analysis shows that Dr Gray's complex forecasting methodology does in fact provide reasonable forecasts, and may indeed offer value beyond a naive alternative model.Originality/value – The editorial identifies a major problem in catastrophe forecasting, and suggests one way to address this problem.

The fund of hedge funds reporting puzzle: Reconciling investors' expectations and fund managers' constraints

Abstract: Purpose – The development of alternative investment has not yet been accompanied by genuine consideration of the specific characteristics of the risks and returns of hedge funds with regard to the provision of information to investors. To fill the gap, in 2004 EDHEC launched an international consultation process, seeking to implement a new framework for funds of hedge funds reporting.Design/methodology/approach – The consultation process was based on a series of recommendations proposed by EDHEC with regard to the academic state‐of‐the‐art on risk measurement in the alternative universe. The findings of the survey, which brought together the opinions of 98 institutional investors and fund managers, allow a consensus to be established on the information required for the implementation of a relevant reporting method in the field of alternative investment.Findings – Interestingly, despite somewhat conflicting goals, investors and fund managers, except for slight discrepancies, globally agree on the definitio...

Parsimonious principle of GARCH models: a Monte‐Carlo approach

Abstract: Purpose – This paper is intended to test the robustness of the fitness of nested GARCH modelsDesign/methodology/approach – Both Monte‐Carlo simulation data and real‐world data are used in the paper Likelihood‐family tests are used to test in‐sample fitness, while mean‐squared prediction error is employed for out‐sample prediction testsFindings – The paper finds that, generally, the parsimonious principle is found to work well for both criteria However, it is found that conflict exists between the two criteria: in‐sample likelihood‐family tests pay more attention to conditional distributions or are more sensitive to fat tail effects; while the out‐sample criteria focus more on the accuracy of parameter estimationOriginality/value – The paper shows that complexity does not necessarily mean good fitness; sometimes, the simpler model can fit better, especially for real‐world data