Showing papers on "Financial risk published in 1996"

Rethinking risk management

Abstract: This paper presents a theory of corporate risk management that attempts to go beyond the “variance-minimization” model that dominates most academic discussions of the subject. It argues that the primary goal of risk management is not to dampen swings in corporate cash flows or value, but rather to provide protection against the possibility of costly lower-tail outcomes–situations that would cause financial distress or make a company unable to carry out its investment strategy. (In the jargon of finance specialists, risk management can be viewed as the purchase of well-out-of-the-money put options designed to limit downside risk.) By eliminating downside risk and reducing the expected costs of financial trouble, risk management can also help a company to achieve both its optimal capital structure and its optimal ownership structure. For, besides increasing corporate debt capacity, the reduction of downside risk also encourages larger equity stakes for managers by shielding their investments from “uncontrollables.” The paper also departs from standard finance theory in suggesting that some companies may have a comparative advantage in bearing certain financial market risks–an advantage that derives from information acquired through their normal business activities. Although such specialized information may lead some companies to take speculative positions in commodities or currencies, it is more likely to encourage “selective” hedging, a practice in which the risk manager's “view” of future price movements influences the percentage of the exposure that is hedged. But, to the extent that such view-taking becomes an accepted part of a company's risk management program, it is important to evaluate managers' bets on a risk-adjusted basis and relative to the market. If risk managers want to behave like money managers, they should be evaluated like money managers.

Estimating the Price of Default Risk

Abstract: The risk of default affects virtually every financial contract. Therefore the pricing of default risk has received much attention; both from traders, who have a strong interest in pricing transactions accurately, and from financial economists, who have much to learn from the way such risks are priced in markets. The standard theoretical paradigm for modeling credit risks is the contingent claims approach pioneered by Black and Scholes. Much of the literature follows Merton (1974) by explicitly linking the risk of a firm’s default to the variability in the firm’s asset value. Although this line of research has proven very useful in addressing the qualitatively important aspects of

Political Risk, Economic Risk, and Financial Risk

Abstract: Given the increasingly global nature of investment portfolios, an understanding of country risk is very important. This article addresses the economic content of five different measures of country risk: four measures from the International Country Risk Guide's political-, financial-, economic-, and composite-risk indexes and one from Institutional Investor's country credit ratings. We explored whether any of these measures contain information about future expected stock returns. We conducted time-series/cross-sectional analysis linking these risk measures to future expected returns. Finally, we analyzed the links between fundamental attributes such as book-to-price ratios within each economy and the risk measures. The results suggest that the country-risk measures are correlated with future equity returns. In addition, such measures are highly correlated with equity valuation measures. This finding provides some insight into the reason that value-oriented strategies generate high average returns.

Pricing the Risks of Default

Abstract: This paper models default risk as composed of arrival and magnitude risks. In our model the two default components are explicitly priced as if they were traded in the futures market and the spot price of risky debt is derived as a consequence. We develop estimation strategies to evaluate the magnitude risks which are then employed to construct implicit prices of pure arrival risk contingent securities. The latter prices are used to estimate the structure of arrival risks. The models are estimated on monthly data for rates on certificates of deposit offered by institutions in the Savings and Loan Industry, during the 1987-1991 period. Empirical results support market expectations of lower likelihoods of default after 1989. This paper was presented at the Wharton Financial Institutions Center's conference on Risk Management in Banking, October 13-15, 1996.

Political Risk, Economic Risk and Financial Risk

Abstract: How important is an understanding of country risk for investors? Given the increasingly global nature of investment portfolios, we believe it is very important. Our paper measures the economic content of five different measures of country risk: The International Country Risk Guide is political risk, the financial risk, economic risk and composite risk indices and Institutional Investoris country credit ratings. First, we explore whether any of these measures contain information about future expected stock returns by conducting trading simulations. Next, we conduct time-series-cross-sectional analysis linking these risk measures to future expected returns. Second, we investigate the relation between these measures and other, more standard, approaches to risk exposures. Finally, we analyze the linkages between fundamental attributes within each economy, such as book-to-price ratios, and the risk measures. Our results suggest that the country risk measures are correlated future equity returns. We find that the country risk measures are correlated with each other, however, financial risk measures contain the most information about future equity returns. Finally, we find that country risk measures are highly correlated with country equity valuation measures. This provides some insight into the reason why value-oriented strategies generate higher returns.

Risk2: Measuring the Risk in Value at Risk

Abstract: The recent derivatives disasters have focused the attention of the finance industry on the need to control financial risks better. This search has led to a uniform measure of risk called value at risk (VAR), which is the expected worst loss over a given horizon at a given confidence level. VAR numbers, however, are themselves affected by sampling variation, or “estimation risk”—thus, the risk in value at risk itself. Nevertheless, given these limitations, VAR is an indispensable tool to control financial risks. This article lays out the statistical methodology for analyzing estimation error in VAR and shows how to improve the accuracy of VAR estimates.

The impact of prior firm financial performance on subsequent corporate reputation

Abstract: This study links corporate reputation, as measured byFortune magazine's Most Admired list, with firm financial performance. Seven measures of financial risk and return were collected for a sample of 149 firms from two time periods, 1981 and 1986. The mean score of four attributes from the 1993Fortune Most Admired list for the sample was then analyzed with the financial data through regression analysis. Two financial variables, Standard Deviation of the Market Return of the Firm and Return on Sales, explained between 0.12 and 0.14 of subsequent reputation. The implication for management is that they can affect a firm's subsequent reputation by lowering financial risk and controlling costs.

Measuring organizational downside risk

Abstract: Despite widespread incorporation of risk measures in strategy research, there is little consensus regarding the meaning and measurement of risk. In contrast to the variability measures widely used in strategy studies, this paper draws from behavioral decision theory, finance, and management theory to present an alternative perspective on organizational risk-downside risk. The paper explains three categories of organizational downside risk measures based on the concept of lower partial moments. The latter sections of the paper present considerations involved in specifying operational measures of downside risk and an empirical comparison of alternative downside risk measures.

Financial Risk and the Need for Superior Knowledge Management

Abstract: Three recent failures of risk management—at Barings Bank, Kidder Peabody, and Metallgesellschaft—appear to be due to three underlying causes: dysfunctional culture, unmanaged organizational knowledge, and ineffective controls. The first and the last of these have been extensively discussed in the media. This article explores the importance of the second: knowledge management. It demonstrates the need for a more structured approach to transferring knowledge to decision makers before it is needed, enabling the access of information as it is needed, and finally generating and testing new knowledge about the firm's changing risk management requirements.

Financial Markets, Instruments, and Institutions

Abstract: Part 1:GROUND RULES and REASONS FOR STUDYChapter 1: Introduction: Function Performed by Financial Markets Chapter 2: The Flow of Funds in the MarketsPart II:PRICING CASH FLOWSChapter 3: Fundamentals of Interest Rate DeterminationChapter 4: The Behavior of Nominal Interest RatesChapter 5: The Term Structure of Interest RatesChapter 6: Valuing Cash FlowsChapter 7: Recognizing the Uncertainty of Future Interest RatesChapter 8: Interest Rate Risk and the Value of Cash FlowsChapter 9: Default Risk and Other Risk to Cash FlowPART III:INSTRUMENTS IN THE MARKETChapter 10: Valuing Cash Flows in Foreign CurrenciesChapter 11: Understanding the Money MarketChapter 12: Understanding the Bond MarketChapter 13: Understanding the Mortgage and Other Asset-Backed Debt MarketsChapter 14: Understanding EquitiesChapter 15: Understanding Futures and OptionsChapter 16: Understanding Derivatives SecuritiesPart IV:MARKETS and INSTITUTIONSChapter 17: The Structure of Financial MarketsChapter 18: Primary Market StructureChapter 19: Secondary Market StructureChapter 20: The Changing Institutional Structure of the Financial MarketsChapter 21: The Investment Banking IndustryChapter 22: The Commercial Banking IndustryChapter 23: Other Depository InstitutionsChapter 24: Nonbank Financial InstitutionsChapter 25: Managing Financial InstitutionsPart V:THE IMPORTANT ROLE of BANKSChapter 26: The Money Supply Process and BanksChapter 27: The Federal Reserve and the Money Supply Process

Financial crises, payment system problems, and discount window lending

Abstract: In a developed economy, financial crises are rapidly conveyed to the payment system, which tends to rely on private credit extensions in most countries. While many authors recommend that the central bank do no more than provide adequate aggregate liquidity during a crisis, this policy requires well-functioning private credit markets to channel liquidity to solvent, but illiquid, firms. This paper presents a model of private lending which defines a crisis as a time when lenders become uncertain about how to assess financial risks and, therefore, rationally withdraw from making new loans. In such an environment, a government lender of last resort can improve social welfare. Copyright 1996 by Ohio State University Press.(This abstract was borrowed from another version of this item.)

An MINLP Approach for Safe Process Plant Layout

Abstract: The tragic accidents at Flixborough and Bhopal have led to the development of new legislation concerning the design and operation of chemical plants. In addition, the growing concern with safety and environmental issues places many new demands upon the designer. Process plant layout, as an important step in the design of chemical plants, is effected by these demands. This paper presents a new approach to process plant layout that integrates safety and economics. In this approach, the cost of a layout is a function of piping cost, land cost, financial risk, and protection devices cost. The financial risk term captures the risk of unsafe plants and can be expressed as the expected losses if major accidents happen (i.e., fires or explosions). The proposed approach is a mixed-integer nonlinear optimization problem (MINLP) that identifies attractive layouts by minimizing overall costs. This approach gives the coordinates of each unit, an estimate for the total piping length, the amount of land occupied, and th...

Value-at-Risk: Implementing a Risk Measurement Standard

Abstract: In the wake of recent failures of risk management, there has been a widespread call for improved quantification of the financial risks facing firms. At the forefront of this clamor has been Value at Risk. Previous research has identified differences in models, or Model Risk, as an important impediment to developing a Value at Risk standard. By contrast, this paper considers the divergence in a model's implementation in software and how it too, affects the establishment of a risk measurement standard. Different leading risk management systems' vendors were given identical portfolios of instruments of varying complexity, and were asked to assess the value at risk according to one common model, J.P. Morgan's RiskMetrics. We analyzed the VaR results on a case by case basis, and in terms of prior expectations from the structure of financial instruments in the portfolio, as well as prior vendor expectations about the relative complexity of different asset classes. It follows that this research indicates the extent to which one particular model of risk can be effectively specified in advance, independent of the model's detailed implementation and use in practice.

Corporate hedging in the insurance industry: the use of financial derivatives by U.S. insurers

Abstract: In this paper we investigate the extent to which insurance companies utilize financial derivatives contracts in the management of risks. The data set we employ allows us to observe the universe of individual insurer transactions for a class of contracts, namely, those normally through of as off-balance-sheet (OBS). We provide information on the number of insurers using various types of derivatives contracts and the volume of transactions in terms of notional amounts and the number of counterparties. Life insurers are most active in interest rate and foreign exchange derivatives, while property-casualty insurers tend to be active in trading equity option and foreign exchange contracts. Using a multivariate probit analysis, we explore the factors that potentially influence the existence of OBS activities. We also investigate questions relating to whether certain subsets of OBS transactions (e.g., exchange traded) are related to such things as interest rate risk measures, organizational form, and other characteristics that may discriminate between desired risk/return profiles across a cross-section of insurers. We find evidence consistent with the use of derivatives by insurers to hedge risks posed by guaranteed investment contracts (GICs), collateralized mortgage obligations (CMOs), and other sources of financial risk.

Determinants of Couples' Defined Contribution Retirement Funds

Abstract: The study examined factors associated with the amount of defined contribution retirement funds using the 1992 Survey of Consumer Finances. Couples with larger amounts of income and smaller amount of nonfinancial assets had larger amounts of defined contribution funds. Also, the funds increased as years of employment and employer contribution rate increased. Households with lower levels of education, less skilled occupations, and with respondents who were unwilling to take financial risks, or who were Black and Hispanic had smaller amounts of defined contribution funds, all other things equal. Most households 30 or more years from retirement had predicted fund levels of zero.

The Influence of Political, Economic and Financial Risk on Expected Fixed Income Returns

Abstract: Is there information in the commonly used indicators of country risk for expected global fixed income returns and volatility? We examine the information content in publicly available measures of political, financial and economic risk. We find that these ex-ante measures contain important information about the cross-section of expected fixed income and currency returns. Trading strategies based on the change in, and level of, these risk measures produce positive risk-adjusted returns. We find that the country risk measures are significantly correlated with international bond metrics, such as real yields. This is the final working paper version of our 1996 Journal of Fixed Income publication.

Risk and Market Segmentation in Financial Intermediaries' Returns

Abstract: This study examines both the quantity and price of risk exposure for different segments of financial intermediaries in order to determine whether market segmentation exists in the financial services industry in the United States. We distinguish between depository institutions, securities firms, insurance companies, mutual funds, and other financial firms using each company s SIC code. We find evidence of market segmentation in both market risk levels and market risk premiums. The results provide little evidence of interest rate risk exposure across all types of financial intermediaries, suggesting the prevalence of hedging programs using interest rate derivatives. However, the market prices interest rate risk exposure differentially by type of financial intermediary. We find that as a market segment, insurance companies were exposed to more interest rate risk particularly in the period late 1980 s to early 1990 s. The interest rate risk premium for banks was among the highest of all financial intermediaries. Overall, we find that securities firms, as a group, have the most market risk exposure, followed in order of descending market beta, by banks, other financial firms, insurance companies, and mutual funds, although the order is reversed when examining the market risk premium. Indeed, we find support for an inverse relationship between the quantity and price for market risk, but not for interest rate risk. When we investigate the impact of two regulatory policy changes, we find that (1) the shift in the conduct of monetary policy towards targeting of monetary aggregates induced banks to take on more market risk, probably due to a decline in their charter value; (2) bank market risk-taking increased further with the introduction of riskbased capital requirements which further reduce charter value for banks; and (3) insurance companies are subject to the highest interest rate risk premiums during the 1988-1994 subperiod, following by commercial banks, probably due to interest rate risk subsidy under the risk-based capital requirements. Overall, during the period 1974-1994, banks increased their market risk exposure despite the tightening of regulatory restrictions, insurance companies increased their interest rate risk exposure over the subperiods. We create synthetic universal banks comprised of portfolios of banks, securities firms, and insurance companies. We find that the synthetic universal banks have significantly positive excess returns, with lower market and interest rate risk exposures and higher expected returns than securities firms.

Financial risk management : domestic and international dimensions

Abstract: Preface. 1. Introduction: The Nature of Financial Risk. 2. The Fixed Income Markets: Nature and Dynamics. 3. Interest Risk Management: Hedging Assets and Liabilities. 4. The Foreign Exchange Markets: Nature and Dynamics. 5. Currency Risk Management: Hedging and Speculating with Options and Futures. 6. Portfolio Risk Management: Domestic Dimensions. 7. Portfolio Risk Management: International Dimensions. 8. The Search for Higher Returns: Anomalies. Index.

A Comprehensive Model for Managing Credit Risk on Home Mortgage Portfolios

Abstract: Managing credit risk in financial institutions requires the ability to forecast aggregate losses on existing loans, predict the length of time that loans will be on the books before prepayment or default, analyze the expected performance of particular segments in the existing portfolio, and project payment patterns of new loans. Described in this paper are tools created for these functions in a large California financial institution. A forecasting model with Markovian structure and nonstationary transition probabilities is used to model the life of a mortgage. Logistic and regression models are used to estimate severity of losses. These models are integrated into a system that allows analysts and managers to depict the expected performance of individual loans and portfolio segments under different economic scenarios. With this information, analysts and managers can establish appropriate loss reserves, suggest pricing differentials to compensate for risk, and make strategic lending decisions.

Risk Analysis and Capital Budgeting Techniques of U.S. Multinational Enterprises

Abstract: The purpose of this study is to examine the capital budgeting strategies that are used by foreign subsidiaries of U.S.‐based multinational enterprises. While the results indicated a preference for sophisticated capital budgeting techniques as the primary method of analysis, the actual use of sophisticated capital budgeting techniques by foreign managers may not be as widespread as expected by financial theorists. Although it was found that certain environmental and company‐specific factors influenced the level of sophistication of capital budgeting practices used by U.S. foreign subsidiaries, the associations were small and had only minor explanatory significance. The results showed that foreign subsidiaries exposed to high levels of political and financial risk tended to use sophisticated capital budgeting strategies. Subsidiaries characterized by high levels of financial leverage and high cost of capital requirements also employed advanced capital budgeting strategies. Multinational enterprises (MNEs) have many options available to them in terms of how they manage their foreign subsidiaries. Traditionally, most major policy decisions were made at the parent firm's headquarter office while foreign subsidiaries had few opportunities to influence major corporate decisions. Today, more companies are using a flexible approach which involves setting strategic goals at the home office and allowing local managers to implement their own specific policies. An important question in this study involved determining how effective local foreign managers were in implementing their capital budgeting processes. As U.S.‐based MNEs continue to expand their operations abroad, there is an increased need to examine which financial decision models are actually used by subsidiary managers to deal with the increased complexity of investing in foreign countries. Unlike traditional capital budgeting analysis, international analysis is a considerably more complex process. These complexities occur for a number of reasons including complicated cash flows estimates, changes in foreign exchange rates, different accounting systems, potential for blocked funds, and political risk considerations. These factors are rarely experienced by traditionally domestic U.S. firms. To maintain a competitive edge, MNEs must continue to use the most efficient approaches available to them. This study provides a detailed analysis of the capital budgeting practices that are actually being used by foreign subsidiaries of U.S.‐based MNEs. The paper is organized in the following manner. Section I provides a brief overview of the theoretical and practical issues of international capital budgeting analysis. Section II focuses on the areas of data collection, questionnaire design, and environment‐specific and company‐specific factors. Section III discusses usage of capital budgeting techniques, adjustment and assessment of project risk, and factors influencing capital budgeting policies. The final section presents some findings from this study.

The Impact of Operating and Financial Risk on Equity Risk

Abstract: This paper empirically investigates a complete theoretical model relating the operating characteristics of a firm to the total, systematic, and unsystematic risk of its equity. The degree of operating leverage, the ratio of net profits to firm value, and the variability of unit output are all found to be positively correlated with each of the three risk measures. The degree of financial leverage, while positively related to total and unsystematic risk, does not appear to be related to systematic risk. After controlling for the business risk of the firm, no evidence can be found of an interaction between the degree of operating leverage and the degree of financial leverage.

Value at risk: a new methodology for measuring portfolio risk

Abstract: Many different types of institutions hold portfolios of assets, and prudent financial management dictates that these firms be alert to any risks these assets may carry. How can these institutions judge the likelihood and magnitude of potential losses on their portfolios? A new methodology called value at risk (VAR) can be used to estimate these losses. In this article, Greg Hopper describes the various methods used to calculate VAR, paying special attention to its weaknesses.

The Influence of Political, Economic, and Financial Risk on Expected Fixed-Income Returns

Abstract: Is there information in the commonly used indicators of country risk for expected global fixed income returns and volatility? We examine the information content in publicly available measures of political, financial and economic risk. We find that these ex-ante measures contain important information about the cross-section of expected fixed income and currency returns. Trading strategies based on the change in, and level of, these risk measures produce positive risk-adjusted returns. We find that the country risk measures are significantly correlated with international bond metrics, such as real yields.

International Financial Instability and the Financial Derivatives Market

Abstract: The financial derivatives market evolved rapidly in the 1980s in response to the deregulation of financial markets and financial innovation. Encompassing futures, options, currency swaps, and interest rate swaps, this market has grown to a value of more than $8 trillion in outstanding contracts. While these financial innovations have assisted business enterprises in hedging risk, they have also created conditions for heightened financial fragility on an international scale. The rapid growth of the derivatives market has been accompanied by a lag in instituting regulatory controls that would limit the destabilizing impact of these new financial innovations. Since many derivatives involve cross-border trading, the derivatives market has led to increased international financial fragility and the attendant need for greater supranational governance of derivatives. To explore these themes, I will use a monetary theory of production provided by institutionalist economic theory.

Financial liberalisation and interest rate risk management in Sub-Saharan Africa

Abstract: The appropriateness of financial liberalisation in Africa - at least over the short-term - is in doubt. It has been suggested that the credit risks faced by financial institutions will be detrimental to the supply of credit. The contribution of this paper is to point out that financial liberalisation creates a significant interest rate risk. It is argued that this interest rate risk will bias African banks’ activities towards brokerage rather than maturity-transformation functions. Furthermore, it is stressed that the management of interest rate risk is in itself likely to lead to a reduction in the supply of credit. In this regard the usefulness of capital adequacy as defined by the Basle Committee is investigated.