Showing papers on "Financial risk published in 1999"

Financial development and economic growth : views and agenda

Abstract: The author argues that the preponderance of theoretical reasoning and empirical evidence suggests a positive first order relationship between financial development and economic growth. There is evidence that the financial development level is a good predictor of future rates of economic growth, capital accumulation, and technological change. Moreover, cross-country, case-style, industry level and firm-level analysis document extensive periods when financial development crucially affects the speed and pattern of economic development. The author explains what the financial system does and how it affects, and is affected by, economic growth. Theory suggests that financial instruments, markets and institutions arise to mitigate the effects of information and transaction costs. A growing literature shows that differences in how well financial systems reduce information and transaction costs influence savings rates, investment decisions, technological innovation, and long-run growth rates. A less developed theoretical literature shows how changes in economic activity can influence financial systems. The author advocates a functional approach to understanding the role of financial systems in economic growth. This approach focuses on the ties between growth and the quality of the functions provided by the financial systems. The author discourages a narrow focus on one financial instrument, or a particular institution. Instead, the author addresses the more comprehensive question: What is the relationship between financial structure and the functioning of the financial system?

Modeling Term Structures of Defaultable Bonds

Abstract: This article presents convenient reduced-form models of the valuation of contingent claims subject to default risk, focusing on applications to the term structure of interest rates for corporate or sovereign bonds. Examples include the valuation of a credit-spread option. This article presents a new approach to modeling term structures of bonds and other contingent claims that are subject to default risk. As in previous “reduced-form” models, we treat default as an unpredictable event governed by a hazard-rate process. 1 Our approach is distinguished by the parameterization of losses at default in terms of the fractional reduction in market value that occurs at default. Specifically, we fix some contingent claim that, in the event of no default, pays X at time T . We take as given an arbitrage-free setting in which all securities are priced in terms of some short-rate process r and equivalent martingale measure Q [see Harrison and Kreps (1979) and Harrison and Pliska (1981)]. Under this “risk-neutral” probability measure, we letht denote the hazard rate for default at time t and let Lt denote the expected fractional loss in market value if default were to occur at time t , conditional

Against The Gods: The Remarkable Story of Risk

Abstract: Against the Gods: The Remarkable Story of Risk by Peter L. Bernstein. 1996. New York: John Wiley & Sons. Reviewer: Brian J. Glenn, St. Antony's College, University of Oxford; Insurance Law Center, University of Connecticut School of Law In Against the Gods: The Remarkable Story of Risk, Peter Bernstein presents the reader with an easy to read and often entertaining introduction to the history and theory behind financial risk analysis. The first half of the book is devoted to the development of statistics and utility theory. As Bernstein walks the reader through the history of probability, he brings to life not only the theories being developed, but also the colorful lives of some of the major figures involved, such as Cardano, Pascal, Fermat and several members of the Bernoulli family. Those who use statistics on a daily basis will find the book offers a rich and interesting history behind statistical methods that are otherwise cold and impersonal. In the second half of the book, Bernstein presents the reader with the theory that underlies financial risk analysis. Written in the same historical style as the first half, the second half of the book focuses on issues such as incomplete information, case selection, utility theory, and the appropriateness of quantitative analysis to estimating future events. These standard issues of probability theory are presented in a highly approachable manner. The non-statistician will find these chapters helpful. Those who already understand the material will find Bernstein's handling of it remarkably refreshing. A major issue with the book is the depiction of risk. Bernstein explains that, "The word "risk" derives from the early Italian riscare, which means "to dare." In this sense, risk is a choice rather than a fate. The actions we dare to take, which depend on how free we are to make choices, are what the story of risk is all about." (p. 8) Risk is consistently presented as something to be embraced, rather than something to be avoided. Risk is also depicted as a highly personal decision made in pursuit of financial gain, as opposed to a highly social-or indeed, societal-necessary evil to be shared. In his discussion of utility theory, for example, Bernstein notes that different people have different levels of risk tolerance, "And that's a good thing." he explains, since, "If everyone valued every risk in precisely the same way, many risky opportunities would be passed up ...Without the venturesome, the world would turn a lot more slowly. Think of what life would be like if everyone were phobic about lightening, flying in airplanes, or investing in start-up companies. We are indeed fortunate that human beings differ in their appetite for risk." (p. 105) The wise risk-taking financial entrepreneurs are the heroes in this book. Indeed, after a discussion of how Bernoulli assimilated methods of financial risk assessment, Bernstein declares that, "Risk is no longer something to be faced; risk has become a set of opportunities open to choice." (p. …

Financial Decision-Making: Are Women Really More Risk-Averse?

Abstract: 40 males, 33 females gain-gambling (gain domain) loss-gambling (loss domain) a Contextual frames. b Abstract gambling frames. studies, the application of experimental methods provided stronger control of the economic environment in which decisions were made. We elicited data which call into question the prevalence of stereotypic risk attitudes in financial decision-making. First, we find that the comparative risk propensity of male and female subjects is strongly dependent on the financial decision setting. Second, and more important, we observe no gender differences in risk propensity when subjects face contextual decisions. Since in practice financial decisions are always contextual, our results suggest that the above gender stereotype may not reflect true male and female attitudes toward financial risks. I. Gender-Specific Risk Behavior: An Experimental Design Our experiment was designed to examine gender-specific risk propensity in decisions relevant for investors and managers. Table 1 gives an overview of the experimental design. In the main treatment, we implemented risky choices in the form of investment and insurance decisions. Choice behavior in this treatment (henceforth called the context treatment) directly measures the risk behavior of male and female subjects in contextual financial decisions. We also ran a control treatment in which the same risky choices were presented as abstract gambling decisions. This control treatment (henceforth called the abstract treatment) allows us to validate the risk behavior induced by our experimental procedure in the light of the above-mentioned gambling evidence. In the context treatment, subjects were confronted with risky choices in two different decision contexts. Subjects first had to complete a series of investment decisions. They were then presented with a series of identical choices, this time, however, framed as insur1 Wealth effects from income differences outside the laboratory may still affect risk behavior in our experiment. They are controlled for in our model. 2 Experimental instructions are available in German from the authors or in English from our web page: »www.wif.ethz.ch/publikationen.htm... . ance decisions. Each investment and insurance decision incorporated a choice between a risky lottery and a certain payoff. With the series of choices implemented in the two frames we elicited our subjects’ certainty equivalents for the same four risky lotteries (L1, L2, L3, L4) in both contexts. We implemented two frames in the context treatment in order to measure the risk propensity of subjects toward both perceived gains and perceived losses. In both frames, all possible payoffs for each decision were positive. In the investment frame these payoffs were also presented as gains, while in the insurance frame the same payoffs were presented as losses relative to an initial endowment. Therefore, elicited certainty equivalents in the investment frame measure subjects’ risk propensities in the gain domain, while certainty equivalents in the insurance frame measure risk propensity in the loss domain. If, in contextual financial decisions, female subjects are generally more risk-averse than men, our results should display, ceteris paribus, lower female certainty equivalents in both the investment and insurance frames. 3 The four lotteries (L1, L2, L3, and L4) each had two possible outcomes. Payoffs in Swiss francs (1 SFr A $0.60) and their probabilities were (30 SFr, /6; 10 SFr, /6) , (30 SFr, /2; 10 SFr, /2) , (30 SFr, /6; 10 SFr, /6) , and (50 SFr, /2; 20 SFr, /2) , respectively. 4 Experimental evidence suggests that individual risk propensity will vary systematically between the gain and loss domain ( Daniel Kahneman and Amos Tversky, 1979). 383 VOL. 89 NO. 2 GENDER AND ECONOMIC TRANSACTIONS / 3y16 my68 Mp 383 Friday Dec 10 08:20 AM LP–AER my68 FIGURE 1. DIFFERENCES IN MEAN CERTAINTY EQUIVALENTS (CE) BETWEEN MALE AND FEMALE SUBJECTS, BY FRAME Note: Certainty equivalents ( and male – female differences) are measured in Swiss francs. In the abstract treatment we confronted a different group of subjects with exactly the same risky decisions as those in the main treatment. However, as mentioned before, all choices in this control treatment were framed as abstract gambling decisions. Again, two frames were implemented. In the gaingambling and loss-gambling frames we measured the risk attitudes of subjects toward gambles in the gain and loss domain, respectively. Subjects in both treatments were told in advance that one of their choices would determine their experimental earnings. Further, all subjects completed a post-experimental questionnaire which yielded information on each subject’s disposable income. This information is necessary to exclude wealth effects due to income differences outside the laboratory as an explanation of gender-specific choice behavior.

Extreme Value Theory as a Risk Management Tool

Abstract: The financial industry, including banking and insurance, is undergoing major changes. The (re)insurance industry is increasingly exposed to catastrophic losses for which the requested cover is only just available. An increasing complexity of financial instruments calls for sophisticated risk management tools. The securitization of risk and alternative risk transfer highlight the convergence of finance and insurance at the product level. Extreme value theory plays an important methodological role within risk management for insurance, reinsurance, and finance.

A Brief History of Downside Risk Measures

Abstract: Downside risk measures in portfolio analysis purport to be a major improvement over traditional portfolio theory. This article traces the development of the concept from the initial portfolio theory articles in 1952 to articles in the Journal of Investing in 1994. An understanding of the issues facing the researchers provides better knowledge of the concept.

Financial Institutions Management: A Modern Perspective

Abstract: Part 1 Introduction: the financial services industry - depository institutions the financial services industry - insurance companies the financial service industry - securities firms and investment banks the financial services industry - mutual funds the financial services industry - finance companies why are financial intermediaries special risks of financial mediation. Part 2 Measuring risk: interest rate risk I interest rate risk II market risk credit risk - individual loan risk credit risk - loan portfolio and concentration risk foreign exchange risk sovereign risk liquidity risk. Part 3 Managing risk: liability and liquidity management deposit insurance and other liability guarantees capital adequacy product diversification geographic diversification - domestic geographic diversification - international futures and forwards options, caps, floors, and collars swaps, loan sales and other credit management techniques securitization.

How risky is your company

Abstract: In boom times, it is easy for managers to forget about risk. And not just financial risk, but organizational and operational risk as well. Now there's the risk exposure calculator, a new tool that will help managers determine exactly where and how much internal risk is mounting in their companies. The risk calculator is divided into three parts: The first set of "keys" alerts managers to the pressures that come from growth. Now that the company has taken off, are employees feeling increased pressure to perform? Is the company's infrastructure becoming overloaded? And are more new employees coming on board as the company rushes to fill positions? If the answer is yes to any one of those questions, then risk may be rising to dangerous levels. The second set of keys on the calculator highlights pressures that arise from corporate culture. Are too many rewards being given for entrepreneurial risk taking? Are executives becoming so resistant to bad news that no one feels comfortable alerting them to problems? And is the company's level of internal competition so high that employees see promotion as a zero-sum game? The final set of pressures, the author says, revolves around information management. When calculating these pressures, managers should ask themselves, what was the company's complexity, volume, and velocity of information a year ago? Have they risen? By how much? How much of the time am I doing the work that a computer system should be doing? High pressure on many or all of these points should set off alarm bells for managers. To control risk, managers have four levers of control at their disposal that will show them where they need to make organizational adjustments.

Data Envelopment Analysis and its Use in Banking

Abstract: Data envelopment analysis (DEA) is a linear-programming-based method for assessing the performance of homogeneous organizational units and is increasingly being used in banking. The unit of assessment is normally the bank branch. Studies are mostly centered on deriving a summary measure of the efficiency of each unit, on estimating targets of performance for the unit, and on identifying role-model units of good operating practice. Additional uses for DEA in banking include the measurement of efficiency in light of resource and output prices, the estimation of operating budgets that are conducive to efficiency, the assessment of financial risk at bank-branch level, and the measurement of the impact of managerial change initiatives on productivity.

Integrated Risk Management and the Role of the Risk Manager

Abstract: Although the transferring of a firm's pure risk historically has been conducted through the insurance and reinsurance markets, risk managers of large corporations are reportedly becoming more sophisticated with regard to their risk financing strategies. This increased sophistication has come in the form of greater use of techniques such as captives, finite risk insurance, financial reinsurance, and risk retention groups. The purpose of this study is to assess the characteristics and extent of integrated risk management. Using survey data, we evaluate several aspects of risk management integration, including (1) the extent to which risk managers are involved in managing both pure and financial risks facing their firms, (2) the nonoperational types of risks handled by risk managers and the techniques being used to handle a broader set of risks, and (3) the effect that factors such as the size of the firm, the firm's industry, and the background and training of the risk manager has on participation in integrated risk management activities.

Risk response techniques employed currently for major projects

Abstract: Risk management is fundamental to the success of a major project. However, the variations in using risk management practices are considerable and are dependent on numerous factors such as the industry sector, the size of the project, and the stage in the project life cycle. One of the major constituents of successful risk control is the use of risk response. This paper concentrates on the choice and use of the most successful risk response techniques within the oil and gas industry and compares them with the use of those chosen by the construction industry. Results were ascertained through a survey of over one hundred companies within these two sectors by use of an extensive questionnaire. The main conclusions are that risk reduction as a response to assessed risks is most commonly used by both sectors; and that the construction industry concentrates almost exclusively on reduction of financial risk. It is proposed that the construction industry can benefit greatly from the more experienced oil and gas in...

Financial Risk Management

Abstract: This article presents an integrated theoreticalframework to guidefinancial risk management decisions. Theframework is based on two key principles: the use of a "Sharpe rule" to assess prospective changes in a firm's or portfolio's risk-expected return profile and the maintenance of a constant probability of default, which determines the firm's or portfolio's leverage. The rules are not restricted to normal return distributions; they can also accommodate a variety of nonnormal distributions. The approach can be applied with either portfolio standard deviation or value at risk as the measure of risk.

Risk management model for international construction joint ventures

Abstract: The current Asian financial crisis has put the role of risk management in the construction business into focus. For firms engaging in the international construction business, one of the most effective means of mitigating financial risks is through a joint venture (JV) with a local partner. There are, however, risks associated with an international construction JV. Based on a study by the writers on the risk factors and their mitigating measures, the most effective risk mitigating measures were categorized into eight groups. These are partner selection, agreement, employment, control, subcontracting, engineering contract, good relationship, and renegotiation. In this paper, a risk management model incorporating these measures was proposed. Three cases of international construction JVs were analyzed from the perspectives of the execution of these measures. It is hoped that this model would help construction firms in improving their decision-making process for their overseas ventures.

Financial incentives and drug spending in managed care

Abstract: This study estimates the impact of patient financial incentives on the use and cost of prescription drugs in the context of differing physician payment mechanisms A large data set was developed that covers persons in managed care who pay varying levels of cost sharing and whose physicians are compensated under two different models: independent practice association (IPA)-model and network-model health maintenance organizations (HMOs) Our results indicate that higher patient copayments for prescription drugs are associated with lower drug spending in IPA models (in which physicians are not at risk for drug costs) but have little effect in network models (in which physicians bear financial risk for all prescribing behavior)

A framework for regulating microfinance institutions

Abstract: The continuum of institutions providing microfinance cannot develop fully without a regulatory environment conducive to their growth. Without such an environment, fragmentation and segmentation will continue to inhibit the institutional transformation of microfinance institutions. The authors recommend a tiered approach to external regulations, one that takes into account the different types of microfinance institutions, the products they offer, and the markets they service. A tiered approach can be useful in designing regulatory standards that recognize the basic differences in structure of capital, funding, and risks faced by different kinds of microfinance institutions. The model they develop for a regulatory framework identifies thresholds of financial intermediation activities, thresholds that trigger the requirement that an institution satisfy external or mandatory regulatory guidelines. It focuses on risk-taking activities that must be managed and regulated. They illustrate the usefulness of the model by practically applying prudential considerations to various categories and values of financial risk for each of three broad categories of microfinance institution: 1) Those that depend on other peoples' money (such as donor or public sector funding). 2) Those that depend on members' money. 3) Those that leverage the general public's money to fund microfinance loans. For each category, the model highlights: 1) The observed value ranges for selected indicators of financial risk. 2) Recommended ranges of value suitable for consideration under internal governance. 3) Suggested threshold values that indicate the need for external regulation. A transparent, inclusive framework for regulation will preserve the market specialties of different types of microfinance institutions - and will promote their ultimate integration into the formal financial system. One example of the kind of regulation the authors recommend: Require standard registration documents and procedures - no different from those required of regular corporations - including the designation of a central government agency with which they should register as corporate entities.

The capital structure of islamic banks under the contractual obligation of profit sharing

Abstract: Islamic banks are established with the mandate of conducting all their transactions in conformity with Islamic precepts which prohibit, among other things, the receipt and payment of interest. Unlike conventional (non-Islamic) commercial banks, Islamic banks mobilise funds primarily via investment accounts using profit sharing contracts. In this paper, we argue that the concept of financial risk, on which modern capital structure theories are based, is not relevant to Islamic banks. Given the contractual obligation binding the Islamic bank's shareholders and investment account holders to share profits from investments, we propose a theoretical model in which, under certain assumptions, an increase in investment accounts financing enables the Islamic bank to increase both its market value and its shareholders' rates of return at no extra financial risk to the bank. We theoretically demonstrate that such a process leads to an increase in the Islamic bank's market value but does not alter its weighted average cost of capital, i.e. the weighted average cost of capital of the Islamic bank remains constant. The evidence obtained from estimating and testing the model on annual accounts drawn from a sample of 12 Islamic banks lends support to our theoretical predictions, as do the results from counterfactual simulations and sensitivity experiments. Hence, in the context of Islamic banks both our theoretical and empirical results provide a new dimension to the theory of capital structure, which is based on a mixture of only debt and equity financing. In general, viewed against the main competing tenets of the traditional school and the MM standpoint, our results provide an encompassing paradigm on the theory of capital structure.

Credit risk and financial instability

Abstract: Recent advances in modelling credit risk bring much greater discipline to the pricing of credit risk and should promote diversification by penalizing concentrations of credit risk with greater allocations of economic capital. Although these models perform well with regard to high-frequency hazards, they are ill equipped to deal with the low-frequency, high-severity events that are likely to be the most serious threat to financial stability. Cognitive biases in estimating the probability of such losses may lead to disaster myopia. In periods of benign financial conditions, disaster myopia is likely to lead to decisions regarding allocations of economic capital, the pricing of credit risk, and the range of borrowers who are deemed creditworthy, that make the financial system increasingly vulnerable to crisis. Alternative policy measures to counter disaster myopia are considered.

The Risk and Rewards of Minimizing Shortfall Probability

Abstract: Dynamic investment strategies that minimize the probability of a shortfall relative to a given target return or other investment goal are useful in a variety of economic and risk management settings, but the author argues that some properties of these strategies are misunderstood For example, some advocate minimizing shortfall probability as a risk management tool by claiming that it reduces investment risk This is not always the case, and, indeed, the author shows that dynamic strategies, and for those who do wish to take the associated risks, the author argues that there is a very simple way to implement that dynamic strategy, namely, by purchasing a digit option with a specific set of parameters This result allows a decision-maker to make some definitive quantitative comparisons that are in the understanding of risk

Perception of Financial Risk: A Survey Study of Advisors and Planners

Abstract: Financial advisors are continually faced with the challenge of evaluating the quality of financial investments. Previous research has indicated that even among researchers of financial markets, diverse views exist about the meaning of risk and its relationship to returns. A survey study of 265 financial advisors and planners was undertaken to develop a deeper understanding of how financial judgment is related to other characteristics of asset classes, particularly perceptions of their risks, returns and return/risk relationships. Risk-related dimensions included volatility, investment time horizon, performance predictability, knowledge level and overall perceived risk. Return-related dimensions included overall perceived return, return/risk ratio and one & ten year rate of return. The results indicated a strong correlation between perceived risk and return, consistent with finance theory. However, a more complex, curvilinear picture emerged with respect to the relationship between perceived risk and perceived return/risk. The findings suggest that among financial advisors, risk can take on a variety of meanings when the concept is applied to evaluating different asset classes.

Analyzing banking risk : a framework for assessing corporate governance and financial risk management

Abstract: Provides a comprehensive overview of topics dealing with the assessment, analysis, and management of financial risks in banking. The report emphasizes risk-management principles and stresses that key players in the corporate governance process are accountable for managing the different dimensions of financial risk.

Regulatory structure and risk and infrastructure firms : an international comparison

Abstract: Evidence about how choice of regulatory regimes affects the level of shareholder risk for the regulated company has traditionally focused on studies in the United Kingdom and the United States. Broad comparisons of price-cap based regimes (as practiced in the UK) with rate-of-return regulation (as practiced in the US) show price-cap based regimes to be associated with higher levels of shareholder risk (as measured by the beta value) than rate-of-return regulation is. But so few countries were compared that it was suspected that other factors could be at work. The authors broaden the investigation by studying more countries (including regulated utilities in Canada, Europe,, and Latin America), doing a sectoral comparison to control for some risks related to factors other than the regulatory regime, and use narrower classifications for the regulatory regime. They also look at such recent evidence as the move from relatively pure price caps in the UK electricity sector to a mixed-revenue/price-cap based system. The authors find results aligned with earlier research, namely that investors bear the greatest nondiversifiable risk with price caps and the least nondiversifiable risk with rate-of-return regulation.

Explaining Variation in Risk Across Insurance Companies

Abstract: The purpose of this study is to determine what firm-specific factors affect the risk of insurance companies. Traditional methods used to identify potential failures have been severely criticized. Thus, alternative approaches to risk assessment should be of interst to investors and managers of these companies. Models for measuring the impact of factors on risk are developed and empirically tested. The models employed expain a high proportion of variation in risk levels across companies. The sensitivity of insurance company risk to financial characteristics vary with the variable used as a proxy for risk and the type of insurance company assessed. Given the strong relationships between firm-specific characteristics and company risk, it appears that the risk of insurance companies can be effectively controlled with proper management.

Project Financing and the International Financial Markets

Abstract: Acronyms. About the Authors. Introduction. 1. Overview of Financial Innovations in the International Financial Markets. 2. Syndicated Eurocredit Loans. 3. Marketable Debt Securities in the International Financial Markets. 4. Depositary Receipts. 5. Interest Rate, Currency and Commodity Derivatives. 6. Off-balance Sheet Activities of Commercial Banks. 7. What is Project Financing? 8. Description of a Project Finance Transaction. 9. Advantages and Characteristics of Project Financing. 10. Appraisal Techniques in Project Financing. 11. Risk Identification and Risk Assessment in Project Financing. 12. Risk Management Techniques in Project Financing. 13. Limited-recourse Structures. Glossary of Terms. Bibliography. Index.

Risk Capital and VaR

Abstract: In a few short years, Value at Risk has become one of the most widely used metrics for evaluating exposure to financial risk. Originally presented as a way to measure exposure to market risk over very short periods — typically overnight, or perhaps up to ten days — the VaR concept has been extended to broader uses, including estimating the need for risk capital to fund a risky business unit or investment project. In this article, Kupiec points out a couple of pitfalls in applying the VaR approach to the longer-horizon problem of allocating risk capital. One issue is how to treat the expected return on the assets: Do you measure VaR relative to the initial value, or to the expected end-of-period value? (Kupiec argues for the former.) Another issue is that when debt is part of the financing mix, the probability of insolvency at maturity depends on the firm9s ability to pay both the principal and the interest on its bonds, but interest payments may not be included in a standard VaR calculation. Moreover, the size of the interest payment will be endogenous, because the rate depends on default risk, which in turn is a function of the firm9s risk capital allocation. Kupiec discusses these issues and illustrates their quantitative importance under different parameter values.

Default Risk and the Effective Duration of Bonds

Abstract: Estimates of how much credit risk shortens the effective duration of corporate bonds based on observable data and easily estimated bond pricing parameters. Basis risk is the risk attributable to uncertain movements in the spread between yields associated with a particular financial instrument or class of instruments, and a reference interest rate over time. There are seven types of basis risk: Yields on - Long-term versus short-term financial instruments. - Domestic currency versus foreign currencies. - Liquid versus illiquid investments. - Bonds with higher or lower sensitivity to changes in interest rate volatility. - Taxable versus tax-free instruments. - Spot versus futures contracts. - Default -f ree versus non - default - free securities. Basis risk makes it difficult for the fixed-income portfolio manager to measure the portfolio's exposure to interest rate risk, heightens the anxiety of traders and arbitrageurs who are hedging their investments, and compounds the financial institution's problem of matching assets and liabilities. Much attention has been paid to the first type of basis risk. In recent years, attention has turned toward understanding the relation between credit risk and duration. Babbel, Merrill, and Panning focus on that, emphasizing the importance of taking credit risk into account when computing measures of duration. The consensus of all work in this area is that credit risk shortens the effective duration of corporate bonds. The authors estimate how much durations shorten because of credit risk, basing their estimates on observable data and easily estimated bond pricing parameters. An earlier version of this paper - a product of the Financial Sector Development Department - was presented at the Second Biennial Conference on the Financial Dynamics of the Insurance Industry, New York University.

Evaluating Credit Risk Models

Abstract: Over the past decade, commercial banks have devoted many resources to developing internal models to better quantify their financial risks and assign economic capital. These efforts have been recognized and encouraged by bank regulators. Recently, banks have extended these efforts into the field of credit risk modeling. However, an important question for both banks and their regulators is evaluating the accuracy of a model's forecasts of credit losses, especially given the small number of available forecasts due to their typically long planning horizons. Using a panel data approach, we propose evaluation methods for credit risk models based on cross-sectional simulation. Specifically, models are evaluated not only on their forecasts over time, but also on their forecasts at a given point in time for simulated credit portfolios. Once the forecasts corresponding to these portfolios are generated, they can be evaluated using various statistical methods.