Showing papers on "Financial risk published in 2002"

Stochastic Finance: An Introduction in Discrete Time

Abstract: This book is an introduction to financial mathematics. It is intended for graduate students in mathematics and for researchers working in academia and industry. The focus on stochastic models in discrete time has two immediate benefits. First, the probabilistic machinery is simpler, and one can discuss right away some of the key problems in the theory of pricing and hedging of financial derivatives. Second, the paradigm of a complete financial market, where all derivatives admit a perfect hedge, becomes the exception rather than the rule. Thus, the need to confront the intrinsic risks arising from market incomleteness appears at a very early stage. The first part of the book contains a study of a simple one-period model, which also serves as a building block for later developments. Topics include the characterization of arbitrage-free markets, preferences on asset profiles, an introduction to equilibrium analysis, and monetary measures of financial risk. In the second part, the idea of dynamic hedging of contingent claims is developed in a multiperiod framework. Topics include martingale measures, pricing formulas for derivatives, American options, superhedging, and hedging strategies with minimal shortfall risk. This third revised and extended edition now contains more than one hundred exercises. It also includes new material on risk measures and the related issue of model uncertainty, in particular a new chapter on dynamic risk measures and new sections on robust utility maximization and on efficient hedging with convex risk measures.

Default Risk in Equity Returns

Abstract: This is the first study that uses Merton's (1974) option pricing model to compute default measures for individual firms and assess the effect of default risk on equity returns. The size effect is a default effect, and this is also largely true for the book-to-market (BM) effect. Both exist only in segments of the market with high default risk. Default risk is systematic risk. The Fama-French (FF) factors SMB and HML contain some default-related information, but this is not the main reason that the FF model can explain the cross-section of equity returns.

Measuring Market Risk

Abstract: Preface to the Second EditionAcknowledgements1 The Rise of Value at Risk1.1 The emergence of financial risk management1.2 Market risk management1.3 Risk management before VaR1.4 Value at riskAppendix 1: Types of Market Risk2 Measures of Financial Risk2.1 The Mean-Variance framework for measuring financial risk2.2 Value at risk2.3 Coherent risk measures2.4 ConclusionsAppendix 1: Probability FunctionsAppendix 2: Regulatory Uses of VaR3 Estimating Market Risk Measures: An Introduction and Overview3.1 Data3.2 Estimating historical simulation VaR3.3 Estimating parametric VaR3.4 Estimating coherent risk measures3.5 Estimating the standard errors of risk measure estimators3.6 OverviewAppendix 1: Preliminary Data AnalysisAppendix 2: Numerical Integration Methods4 Non-parametric Approaches4.1 Compiling historical simulation data4.2 Estimation of historical simulation VaR and ES4.3 Estimating confidence intervals for historical simulation VaR and ES4.4 Weighted historical simulation4.5 Advantages and disadvantages of non-parametric methods4.6 ConclusionsAppendix 1: Estimating Risk Measures with Order StatisticsAppendix 2: The BootstrapAppendix 3: Non-parametric Density EstimationAppendix 4: Principal Components Analysis and Factor Analysis5 Forecasting Volatilities, Covariances and Correlations5.1 Forecasting volatilities5.2 Forecasting covariances and correlations5.3 Forecasting covariance matricesAppendix 1: Modelling Dependence: Correlations and Copulas6 Parametric Approaches (I)6.1 Conditional vs unconditional distributions6.2 Normal VaR and ES6.3 The t-distribution6.4 The lognormal distribution6.5 Miscellaneous parametric approaches6.6 The multivariate normal variance-covariance approach6.7 Non-normal variance-covariance approaches6.8 Handling multivariate return distributions with copulas6.9 ConclusionsAppendix 1: Forecasting longer-term Risk Measures7 Parametric Approaches (II): Extreme Value7.1 Generalised extreme-value theory7.2 The peaks-over-threshold approach: the generalised pareto distribution7.3 Refinements to EV approaches7.4 Conclusions8 Monte Carlo Simulation Methods8.1 Uses of monte carlo simulation8.2 Monte carlo simulation with a single risk factor8.3 Monte carlo simulation with multiple risk factors8.4 Variance-reduction methods8.5 Advantages and disadvantages of monte carlo simulation8.6 Conclusions9 Applications of Stochastic Risk Measurement Methods9.1 Selecting stochastic processes9.2 Dealing with multivariate stochastic processes9.3 Dynamic risks9.4 Fixed-income risks9.5 Credit-related risks9.6 Insurance risks9.7 Measuring pensions risks9.8 Conclusions10 Estimating Options Risk Measures10.1 Analytical and algorithmic solutions m for options VaR10.2 Simulation approaches10.3 Delta-gamma and related approaches10.4 Conclusions11 Incremental and Component Risks11.1 Incremental VaR11.2 Component VaR11.3 Decomposition of coherent risk measures12 Mapping Positions to Risk Factors12.1 Selecting core instruments12.2 Mapping positions and VaR estimation13 Stress Testing13.1 Benefits and difficulties of stress testing13.2 Scenario analysis13.3 Mechanical stress testing13.4 Conclusions14 Estimating Liquidity Risks14.1 Liquidity and liquidity risks14.2 Estimating liquidity-adjusted VaR14.3 Estimating liquidity at risk (LaR)14.4 Estimating liquidity in crises15 Backtesting Market Risk Models15.1 Preliminary data issues15.2 Backtests based on frequency tests15.3 Backtests based on tests of distribution equality15.4 Comparing alternative models15.5 Backtesting with alternative positions and data15.6 Assessing the precision of backtest results15.7 Summary and conclusionsAppendix 1: Testing Whether Two Distributions are Different16 Model Risk16.1 Models and model risk16.2 Sources of model risk16.3 Quantifying model risk16.4 Managing model risk16.5 ConclusionsBibliographyAuthor IndexSubject Index

Managing Information Technology Investment Risk: A Real Options Perspective

Abstract: Past information systems research on real options has focused mainly on evaluating information technology (IT)investments that embed a single, a priori known option (such as, deferral option, prototype option). In other words, only once a specific isolated option is identified as being embedded in a target IT investment, does this research call upon using real options analysis to evaluate the option. In effect, however, because real options are not inherent in any IT investment, they usually must be planned and intentionally embedded in a target IT investment in order to control various investment-specific risks, just like financial risk management uses carefully chosen options to actively manage investment risks. Moreover, when an IT investment involves multiple risks, there could be numerous ways to reconfigure the investment using different series of cascading (compound) options. In this light, we present an approach for managing IT investment risk that helps to rationally choose which options to deliberately embed in an investment so as to optimally control the balance between risk and reward. We also illustrate how the approach is applied to an IT investment entailing the establishment of an Internet sales channel.

How Informative Are Value‐at‐Risk Disclosures?

Abstract: Value at Risk (VAR), a measure of the dollar amount of potential loss from adverse market moves, has become a standard benchmark for measuring financial risk. Spurred by regulators and competitive pressures, more institutions are reporting VAR numbers in annual and quarterly financial reports. To provide preliminary evidence on the informativeness of these new disclosures, I investigate the relation between the trading VAR disclosed by a small sample of U.S. commercial banks and the subsequent variability of their trading revenues. The empirical results suggest that VAR disclosures are informative in that they predict the variability of trading revenues. Thus, analysts and investors can use VAR disclosures to compare the risk profiles of banks' trading portfolios.

Against the Gods

Abstract: This chapter discusses various risks of financial markets. Understanding the risks in financial markets involves examining the case studies of when, how, and why a risk manifests itself.. Currently, supervisors and the banking industry have recognized the importance of operational risk in shaping the risk profiles of financial institutions. Developments such as the use of more highly automated technology, the growth of e-commerce, and large-scale mergers and acquisitions that test the viability of newly integrated systems, all suggest that operational risk exposures may be substantial and growing. This recognition has led to an increased emphasis on the importance of sound operational risk management at financial institutions and to greater prominence of operational risk in banks' internal capital assessment and allocation processes. There has been a significant shift in the regulatory and best practice approaches in the industry. Organizations of all types have operations teams that handle a wide variety of functions and processes and also develop procedures to control the efficiency and any risk associated with the processes. Other areas of the business manage nonoperational risks that a business could face so that for instance market risk issues are managed by management teams, compliance and to some extent audit.

The effect of corporate social responsibility on the branding of financial services

Abstract: In today's global world, corporate social responsibility (CSR) is increasing public demand for greater transparency from multinational companies. CSR is a new and growing financial risk factor. If it is mismanaged, a firm's corporate reputation can be badly damaged and a direct negative impact on its business and bottom-line may result. Instead of simply campaigning directly against industrial groups and lobbying governments and international organisations to issue new legislation, non-governmental organisations (NGOs) are increasingly putting pressure on the financial services groups and insurance companies. This new global tactic may affect a bank's relationship with its clients and shareholders. There are market benefits and competitive advantages for those companies whose business policies integrate CSR. The growth in socially responsible investments and in CSR awareness among City people persuades some bankers that the most successful firms of the future will be those who proactively balance short-term financial goals with long-term sustainable franchise building. To respond to this challenge, corporations will have to convince citizens they can trust both their brands and the people behind them. In this context, one must recognise that finance brands have been clumsily managed. Nowadays, several big consumer brands are used as societal role models, but they are also the targets of anti-globalisation and anti-logo activists. In order to avoid such an outcome — not to mention corporate mortification — the key social marketing strategy must be to communicate proactively the business activity's raison d'etre to opinion leaders and the general public. In general, industry does not yet care enough and many companies are reacting only when put under pressure by public opinion. It is time, however, to market the social raison d'etre of a business and indeed to contest its current exclusion from ‘civil society’. Consumer and service sectors lead the field. In view of the downturn of the global economy, more than ever before, CSR branding is of paramount importance to the financial sector if bankers do not want to become the easy scapegoats. It is necessary to make it clear that financial services companies are global citizens too.

Risk Management and Value Creation in Financial Institutions

Abstract: Figures.Tables.Symbols.Abbreviations.CHAPTER 1: Introduction.CHAPTER 2: Foundations for Determining the Link between Risk Management and Value Creation in Banks.Value Maximization in Banks.Value Maximization as the Firm's Objective.Valuation Framework for Banks.Problems with the Valuation Framework for Banks.Empirical Conundrum.Other Stakeholders' Interests in Banks.Risk Management in Banks.Definition of Risk.Definition of Risk Management.Role and Importance of Risk and Its Management in Banks.Link between Risk Management and Value Creation in Banks.Goals of Risk Management in Banks.Choice of the Goal Variable.Choice of the Stakeholder Perspective.Choice of the Risk Dimension.Choice of the Risk-Management Strategy.Ways to Conduct Risk Management in Banks.Eliminate/Avoid.Transfer.Absorb/Manage.Empirical Evidence.Summary.Appendix.Part A: Bank Performance.Part B: Systematic versus Specific Risk.CHAPTER 3: Rationales for Risk Management in Banks.Risk Management and Value Creation in the Neoclassical Finance Theory.The Neoclassical Finance Theory.Corollaries from the Neoclassical Finance Theory with Regard to Risk Management.The Risk Management Irrelevance Proposition.Summary and Implications.Discrepancies Between Neoclassical Theory and Practice.Risk Management and Value Creation in the Neoinstitutional Finance Theory.Classification of the Relaxation of the Assumptions of the Neoclassical World.The Central Role of the Likelihood of Default.Agency Costs as Rationale for Risk Management.Agency Costs of Equity as a Rationale for Risk Management.Agency Costs of Debt as a Rationale for Risk Management.Coordination of Investment and Financing.Transaction Costs as a Rationale for Risk Management.The Costs of Financial Distress.The Costs of Implementing Risk Management.The Costs of Issuance.The Costs of a Stable Risk Profile.Taxes and Other Market Imperfections as Rationales for Risk Management.Taxes.Other Market Imperfections.Additional Rationales for Risk Management in Banks.Summary and Conclusions.Appendix.CHAPTER 4: Implications of the Previous Theoretical Discussion for This Book.CHAPTER 5: Capital Structure in Banks.The Role of Capital in Banks.Capital as a Means for Achieving the Optimal Capital Structure.Capital as Substitute for Risk Management to Ensure Bank Safety.The Various Stakeholders' Interests in Bank Safety.Available Capital.Required Capital from an Economic Perspective.Determining Capital Adequacy in the Economic Perspective.Summary and Consequences.Derivation of Economic Capital.Types of Risk.Economic Capital as an Adequate Risk Measure for Banks.Ways to Determine Economic Capital for Various Risk Types in Banks (Bottom-Up).Credit Risk.Market Risk.Operational Risk.Aggregation of Economic Capital across Risk Types.Concerns with the Suggested Bottom-Up Approach.Suggestion of an Approach to Determine Economic Capital from the Top Down.Theoretical Foundations.Suggested Top-Down Approach.Assessment of the Suggested Approach.Evaluation of Using Economic Capital.Summary.CHAPTER 6: Capital Budgeting in Banks.Evolution of Capital-Budgeting Tools in Banks.RAROC as a Capital-Budgeting Tool in Banks.Definition of RAROC.Advantages of RAROC.Assumptions of RAROC.Deficiencies of RAROC.Deficiencies of the Generic RAROC Model.Modifying RAROC to Address Its Pitfalls.Fundamental Problems of RAROC.Evaluation of RAROC as a Single-Factor Model for Capital Budgeting in Banks.New Approaches to Capital Budgeting in Banks.Overview of the New Approaches.Evaluation of RAROC in the Light of the New Approaches.Implications of the New Approaches to Risk Management and Value Creation in Banks.Implications for Risk-Management Decisions.Implications for Capital-Budgeting Decisions.Implications for Capital-Structure Decisions.New Approaches as Foundations for a Normative Theory of Risk Management in Banks.Areas for Further Research.Summary.CHAPTER 7: Conclusion.References.Index.

Social Health Insurance in Developing Countries: A Continuing Challenge

Abstract: This paper addresses the issue of the feasibility of 'social' health insurance (SHI) in developing countries. SHI aims at protecting all population groups against financial risks due to illness. There are substantial difficulties in implementation, however, due to lack of debate and consensus about the extent of financial solidarity, problems with health service delivery, and insufficient managerial capacity. The transition to universal coverage is likely to take many years, but it can be speeded up. Adopting a 'family' approach to financial protection, sustained financial support from governments and donors, and deconcentrating the development of SHI may slash several years from the time needed to achieve full universal protection against healthcare costs.

An introduction to market risk measurement

Abstract: Preface.Acknowledgements.The Risk Measurement Revolution. Measures of Financial Risk. Basic Issues in Measuring Market Risk. Non parametric VaR and ETL. Parametric VaR and ETL. Simulation Approaches to VaR and ETL Estimation. Incremental and Component Risks. Estimating Liquidity Risks. Backtesting Market Risk Models. Stress Testing. Model Risk.Toolkit.Bibliography.Author Index.Subject Index.Software Index.

Incorporating Systemic Influences into Risk Measurements: A Survey of the Literature

Abstract: Procyclicality has emerged as a potential drawback to adoption of risk-sensitive bank capital requirements. Systematic risk factors may result in increases (decreases) in bank capital requirements when the economy is depressed (overheated), thereby decreasing (increasing) bank lending capacity and exacerbating business cycle fluctuations. Procyclicality may result from systematic risk emanating from common macroeconomic influences or from interdependencies across firms as financial markets and institutions consolidate internationally. We describe cyclical effects on operational risk, credit risk and market risk measures.

Social health insurance in developing countries: a continuing challenge

Abstract: This paper addresses the issue of the feasibility of “social” health insurance (SHI) in developing countries. SHI aims at protecting all population groups against financial risks due to illness. There are substantial difficulties in implementation, however, due to lack of debate and consensus about the extent of financial solidarity, problems with health service delivery, and insufficient managerial capacity. The transition to universal coverage is likely to take many years, but it can be speeded up. Adopting a “family” approach to financial protection, sustained financial support from governments and donors, and deconcentrating the development of SHI may slash several years from the time needed to achieve full universal protection against healthcare costs.

Options, Option Repricing and Severance Packages in Managerial Compensation: Their Effects on Corporate Risk

Abstract: While stock options are commonly used in managerial compensation to provide desirable incentives, their adverse effects have not been widely appreciated. We show that a call-type contract creates incentives to distort the choice of investment risk. Relative to the risk level that maximizes firm value, a call option contract can induce too much or too little corporate risk-taking, depending on managerial risk aversion and the underlying investment technology. We show that including additional compensation features of option repricing and/or severance packages has desirable countervailing effects on managerial choice of corporate risk policies. We argue that lookback call options are analogous to the observed practice of option repricing, and put options are analogous to severance packages. Such complex option-like features in managerial contracts can induce risk policies that increase shareholder wealth.

Modeling correlated market and credit risk in fixed income portfolios

Abstract: Current risk assessment methodologies separate the analysis of market and credit risk and thus misestimate security and portfolio risk levels. We propose a new approach that relates financial market volatility to firm specific credit risk and integrates interest rate, interest rate spread, and foreign exchange rate risk into one overall fixed income portfolio risk assessment. Accounting for the correlation between these significant risk factors as well as portfolio diversification results in improved risk measurement and management. The methodology is shown to produce reasonable credit transition probabilities, prices for bonds with credit risk, and portfolio value-at-risk measures.

Advertising in the mutual fund business: The role of judgmental heuristics in private investors' evaluation of risk and return

Abstract: Effective advertising strategies are of growing importance in the mutual fund industry due to keen competition and changes in market structure. But the dominant variables in financial decision making, investor's perceived investment risk and expected return, have not yet been analysed in an advertising context, although these productrelated evaluations can be influenced by advertising and therefore serve as additional indicators of advertising effectiveness. In this study, the authors use a large-scale experimental study (n=499) to detect how risk-return assessments of private investors are influenced by specific elements of print ads. In this context, judgmental heuristics used systematically by private investors play a crucial role.

Intelligent agents and financial risk monitoring systems

Abstract: A society of intelligent agents can work together to monitor financial transactions and yield important information regarding potential financial calamities.

Systems and methods for selectively delaying financial transactions

Abstract: A risk system that performs a risk assessment of a financial transaction to obtain an initial risk score. Based on the initial risk score, the risk system performs at least one post-score assessment by selectively utilizing various scoring engines and databases. The at least one post-score risk assessment may include delaying the shipment of merchandise in financial transactions that are of marginal risk to thereby provide a check acceptance service with more time to further evaluate the financial transaction risks. Thus, marginally risky financial transactions that are likely to benefit the check acceptance service and a merchant that subscribes to the check acceptance service are authorized for increased profitability and customer satisfaction. Furthermore, the post-score risk assessment may approve or authorize financial transactions that generally fail standard risk assessments that use a cut-off risk score to divide the financial transactions into either approved or declined groups. As a result, the post-score assessment process efficiently re-evaluates some of the borderline exception cases for the purpose of securing beneficial financial transactions.

Structure and Asymptotic Theory for Multivariate Asymmetric Volatility: Empirical Evidence for Country Risk Ratings *

Abstract: Following the rapid growth in the international debt of less developed countries in the 1970s and the increasing incidence of debt rescheduling in the early 1980s, country risk has become a topic of major concern for the international financial community. A critical assessment of country risk is essential because it reflects the ability and willingness of a country to service its financial obligations. Various risk rating agencies employ different methods to determine country risk ratings, combining a range of qualitative and quantitative information regarding alternative measures of economic, financial and political risk into associated composite risk ratings. This paper provides an international comparison of country risk ratings compiled by the International Country Risk Guide (ICRG), which is the only international rating agency to provide detailed and consistent monthly data over an extended period for a large number of countries. As risk ratings can be treated as indexes, their rate of change, or returns, merits attention in the same manner as financial returns. For this reason, a constant correlation multivariate asymmetric ARMA-GARCH model is presented and its underlying structure is established, including the unique, strictly stationary and ergodic solution of the model, its causal expansion, and convenient sufficient conditions for the existence of moments. Alternative empirically verifiable sufficient conditions for the consistency and asymptotic normality of the quasi-maximum likelihood estimator are established under non-normality of the conditional (or standardized) shocks. The empirical results provide a comparative assessment of the conditional means and volatilities associated with international country risk returns across countries and over time, enable a validation of the regularity conditions underlying the models, highlight the importance of economic, financial and political risk ratings as components of a composite risk rating, evaluate the multivariate effects of alternative risk returns and different countries, and evaluate the usefulness of the ICRG risk ratings in modelling risk returns.

Financing Infrastructure Projects

Abstract: Project finance as a tool for financing infrastructure projects Public finance for infrastructure projects Financial instruments Financial engineering Restructuring projects Financial markets The concession or build-own-operate-transfer (BOOT) procurement strategy The private finance initiative Challenges and opportunities for infrastructure development in developing countries Financial institutions Privatisation as a method of financing infrastructure projects Typical risks in the procurement of infrastructure projects Mechanism for risk management and its application to risks in private finance initiative projects Insurance and bonding Case study of a toll bridge project Case study on managing project financial risks utilising financial engineering techniques

Managing risk using macro-financial risk analysis

Abstract: The disclosed technology enables a software application program, executed by a processor of a digital data processing device, to analyze and model economic/financial risk associated with sovereigns, financial sectors, non-financial sectors, and/or investment portfolios. The disclosed technology can calculate and assess, for example, contingent claim values, asset values, volatilities, default barriers, and monetary parameters from financial and macroeconomic data associated with government and monetary authorities and can use such calculations to calibrate risk models and generate economic balance sheets for an economy useful in valuation, risk and vulnerability analysis, risk mitigation, design of investment strategies, and policy analysis and design.

Greater Downside Risk Aversion

Abstract: Although investors are concerned foremost with mean and variance, they are also sensitive to downside risk. In this paper, we introduce an index of downside risk aversion to distinguish risk aversion from higher-order aspects of risk preference, including prudence. We show that the index of downside risk aversion S increases with monotonic downside risk averse transformations of utility, thereby directly linking S to the definition of downside risk aversion introduced by Menezes et al. (American Economic Review, 70, 921–932, 1980). Although the index S applies equally to risk averse and risk loving decision makers, for a given positive degree of risk aversion, S is greater when the index of prudence is greater and vice versa.

Hedging Housing Risk in London

Abstract: This paper investigates the benefits of allowing households to compensate the portfolio distortion due to their housing consumption through investments in housing price derivatives. Focusing on the London market, we show that a major loss from over-investment in housing is that households are forced to hold a very risky portfolio. However, the strong performance of the London housing market means that little is lost in terms of expected returns. Even households with limited wealth are better off owning their home rather than renting and investing in financial assets, as long as they are willing to face the financial risk involved. In this context, access to housing price derivatives would benefit most poor homeowners looking to limit their risk exposure. It would also benefit wealthier investors looking for the high returns provided by housing investments without the costs of direct ownership of properties. Comparisons with French, Swedish and US data provide a broader perspective on our findings.

Financial Market Integration, Corporate Financing and Economic Growth

Abstract: This study provides a thorough assessment of the likely effects of financial market integration on the ability of European countries to grow faster and on how the possible benefits will be distributed among the Community countries and industries. It achieves several conclusions strongly supportive of the idea that promoting financial market integration is an important step in promoting economic growth in Europe.