Showing papers on "Financial risk published in 2006"

Has Finance Made the World Riskier

Abstract: Developments in the financial sector have led to an expansion in its ability to spread risks. The increase in the risk bearing capacity of economies, as well as in actual risk taking, has led to a range of financial transactions that hitherto were not possible, and has created much greater access to finance for firms and households. On net, this has made the world much better off. Concurrently, however, we have also seen the emergence of a whole range of intermediaries, whose size and appetite for risk may expand over the cycle. Not only can these intermediaries accentuate real fluctuations, they can also leave themselves exposed to certain small probability risks that their own collective behaviour makes more likely. As a result, under some conditions, economies may be more exposed to financial-sector-induced turmoil than in the past. The paper discusses the implications for monetary policy and prudential supervision. In particular, it suggests market-friendly policies that would reduce the incentive of intermediary managers to take excessive risk.

Risk management and financial institutions

Abstract: Table of Contents: Preface *Introduction *Financial Products and How They are Used for Hedging *How Traders Manage Their Exposures *Interest Rate Risk *Volatility *Correlation and Copulas *Bank Regulation and Basel II *The VaR Measure *Market Risk VaR: Historical Simulation Approach *Market Risk VaR: Model Building Approach *Credit Risk: Estimating Default Probabilities *Credit Risk Losses and Credit VaR *Credit Derivatives *Operational Risk *Model Risk and Liquidity Risk *Economic Capital and RAROC *Weather, Energy, and Insurance Derivatives *Big Losses and What We Can Learn from Them Appendix A: Value Forward and Futures Contracts Appendix B: Valuing Swaps Appendix C: Valuing European Options Appendix D: Valuing American Options Appendix E: Manipulation of Credit Transition Matrices Answers to End-of Chapter Problems Glossary of Terms Tables for N(x) Index

Firm Value and Hedging: Evidence from U.S. Oil and Gas Producers

Abstract: This paper studies the hedging activities of 119 U.S. oil and gas producers from 1998 to 2001 and evaluates their effect on firm value. Theories of hedging based on market imperfections imply that hedging should increase the firm’s market value (MV). To test this hypothesis, we collect detailed information on the extent of hedging and on the valuation of oil and gas reserves. We verify that hedging reduces the firm’s stock price sensitivity to oil and gas prices. Contrary to previous studies, however, we find that hedging does not seem to affect MVs for this industry. IN A CLASSIC MODIGLIANI AND MILLER (M&M) WORLD with perfect capital markets, risk management should be irrelevant. When there are no information asymmetries, taxes, or transaction costs, hedging financial risk should not add value to the firm because shareholders can undo any risk management activities implemented by the firm at the same cost. In practice, imperfections in capital markets create a rationale for lowering the volatility of earnings through hedging. Conventional explanations relate to the cost of financial distress, tax incentives, and the underinvestment problem. Risk management may also add value if hedging positions in derivatives contracts carry a premium that is not commensurate with risk, or if active trading activities create a profit. Most empirical studies on this topic focus on the relation between corporate hedging and firm characteristics, and try to determine whether the behavior of firms that hedge is consistent with extant theories. The empirical evidence does not support any single theory, however. In addition, most of these empirical studies provide only indirect evidence that hedging increases firm value. Recently, however, Allayannis and Weston (2001) directly test the relation between firm value and the use of foreign currency derivatives. Using a sample of 720 large firms between 1990 and 1995, they find that the value of firms that hedge, on average, is higher by about 5%. This hedging premium is statistically and economically significant. With a median market value (MV) of about

Risk reporting: A study of risk disclosures in the annual reports of UK companies

Abstract: The concepts of risk and risk management have received considerable attention lately, but this has yet to be reflected in empirical research examining firms’ risk reporting practices. This study seeks to address this gap in the literature and explores risk disclosures within a sample of 79 UK company annual reports using content analysis. A significant association is found between the number of risk disclosures and company size. Similarly a significant association is found between the number of risk disclosures and level of environmental risk as measured by Innovest EcoValue`21™ Ratings. However, no association is found between the number of risk disclosures and five other measures of risk: gearing ratio, asset cover, quiscore, book to market value of equity and beta factor. The paper also discusses the nature of the risk disclosures made by the sample companies specifically examining their time orientation, whether they are monetarily quantified and if good or bad risk news is disclosed. It was uncommon to find monetary assessments of risk information, but companies did exhibit a willingness to disclose forward-looking risk information. Overall the dominance of statements of general risk management policy and a lack of coherence in the risk narratives implies that a risk information gap exists and consequently stakeholders are unable to adequately assess the risk profile of a company.

An Application of Extreme Value Theory for Measuring Financial Risk

Abstract: Assessing the probability of rare and extreme events is an important issue in the risk management of financial portfolios. Extreme value theory provides the solid fundamentals needed for the statistical modelling of such events and the computation of extreme risk measures. The focus of the paper is on the use of extreme value theory to compute tail risk measures and the related confidence intervals, applying it to several major stock market indices.

An Application of Extreme Value Theory for Measuring Financial Risk 1

Abstract: Assessing the probability of rare and extreme events is an important issue in the risk management of flnancial portfolios. Extreme value theory provides the solid fundamentals needed for the statistical modelling of such events and the computation of extreme risk measures. The focus of the paper is on the use of extreme value theory to compute tail risk measures and the related confldence intervals, applying it to several major stock market indices.

A Tale of Tails: An Empirical Analysis of Loss Distribution Models for Estimating Operational Risk Capital

Abstract: Operational risk is being recognized as an important risk component for financial institutions as evinced by the large sums of capital that are allocated to mitigate this risk. Therefore, risk measurement is of paramount concern for the purposes of capital allocation, hedging, and new product development for risk mitigation. We perform a comprehensive evaluation of commonly used methods and introduce new techniques to measure this risk with respect to various criteria. We find that our newly introduced techniques perform consistently better than the other models we tested.

Audit Firm Portfolio Management Decisions

Abstract: We examine client acceptance and client continuance decisions of a large audit firm to provide empirical evidence on the extent and nature of risk avoidance that the firm uses to purposefully manage its client portfolio. Our results support several key new inferences regarding audit firm portfolio management decisions. First, the results show that this firm is shedding the riskier clients in its portfolio, consistent with the risk avoidance theory of audit firm portfolio management. Second, the results show that the firm's newly accepted clients are less risky than its continuing clients. Although results of both the client continuance and client acceptance decisions imply a less risky portfolio emerging over time, there are greater differences in risk between continuing and discontinued clients than between continuing and newly accepted clients. Third, we find that audit risk factors are more important in audit firm portfolio management decisions than are financial risk factors. Finally, we find no evidence that audit pricing affects the client acceptance and continuance decisions of this firm, controlling for risk and other client characteristics.

After VaR: The Theory, Estimation, and Insurance Applications of Quantile‐Based Risk Measures

Abstract: We discuss a number of quantile-based risk measures (QBRMs) that have recently been developed in the financial risk and actuarial/insurance literatures. The measures considered include the Value-at-Risk (VaR), coherent risk measures, spectral risk measures, and distortion risk measures. We discuss and compare the properties of these different measures, and point out that the VaR is seriously flawed. We then discuss how QBRMs can be estimated, and discuss some of the many ways they might be applied to insurance risk problems. These applications are typically very complex, and this complexity means that the most appropriate estimation method will often be some form of stochastic simulation.

On the financial interpretation of risk contribution: risk budgets do add up

Abstract: There are lingering questions in the financial industry regarding the concepts of risk contribution and risk budgeting. The questions stem from both the simple belief that risks are non-additive and a lack of financial intuition behind mathematical definitions of these concepts. This paper demonstrates that these questions are misguided, by both providing and analyzing risk contribution's financial interpretation. The interpretation is based on expected contribution to potential losses of a portfolio. We show risk contribution, defined through either standard deviation or value at risk (VaR), is closely linked to the expected contribution to the losses. In a sense, risk contribution or risk budgeting can be regarded as loss contribution or loss budgeting. We also provide empirical evidences of this interpretation using asset allocation portfolios of stocks and bonds. Our results should dispel any doubts toward the validity of the risk contribution concept. In the case of VaR contribution, our use of Cornish-Fisher expansion method provides practitioners an efficient way to calculate risk contributions or risk budgets of portfolios with non-normal underlying returns.

Do investment risk tolerance attitudes predict portfolio risk

Abstract: We investigated a new instrument designed to assess investment risk tolerance, the Risk Tolerance Questionnaire (RTQ). RTQ scores were positively correlated with scores on two other investment risk measures, but were not correlated with a measure of sensation-seeking (Zuckerman, 1994), suggesting that investment risk tolerance is not explainable by a general cross-domain appetite for risk. Importantly, RTQ scores were positively correlated with the riskiness of respondents’ actual investment portfolios, meaning that investors with high risk-tolerance score tend to have higher-risk portfolios. Finally, respondents with relatively more investment experience had more risk-tolerant responses and higher-risk portfolios than less experienced investors.

Auditor Risk Assessment: Insights from the Academic Literature

Abstract: To contribute to the PCAOB project on risk assessment in financial statement audits, we draw on the academic literature to offer insights and conclusions on the risk‐assessment process. We use the PCAOB's (2005) recent briefing paper on risk assessment as the organizing framework for our literature review, and we examine academic auditing literature addressing topics including business risk, inherent risk, control risk, fraud risk, linking risk assessments to subsequent testing, and the audit risk model. Overall, we believe that the results of academic research are consistent with the PCAOB staff's apparent reconsideration of the auditor's risk‐assessment process. We conclude with identification of future research topics and recognition of barriers to performing research that is relevant to standard setters.

Financial Risk Taking by Age and Birth Cohort

Abstract: This study decomposes the effects of chronological age, birth cohort, and calendar year on the age profile of household financial risk taking. Using two measures of risk taking, one based on observed portfolio allocations of wealth and another based on survey respondents' stated willingness to take risk, the results support the conventional wisdom that risk taking decreases with age. The results also reveal a cohort effect that shifts the age-risk profile down from older to younger cohorts. This finding is consistent with households taking less risk in response to decreasing financial security over time. The results have implications for the impact of an aging population on stock prices and for the impact on household well-being of the trend toward individual responsibility for asset management in vehicles such as defined-contribution pensions and the proposed Social Security personal accounts.

Does Information Risk Really Matter? An Analysis of the Determinants and Economic Consequences of Financial Reporting Quality

Abstract: I investigate the determinants and economic consequences associated with financial reporting quality. I find evidence of a positive association between investors' demands for firm-specific information and financial reporting quality. In addition, the evidence suggests that higher proprietary costs (proxied by capital intensity, product market competition, and growth opportunities) are associated with a lower quality of financial information. Controlling for the firm-specific characteristics determining financial reporting quality, I find evidence of a negative association between firms' total risk and financial reporting quality. Decomposing total risk into a systematic component and an idiosyncratic one, the results imply that firms providing financial information of higher quality do not necessarily enjoy a lower cost of equity capital. However, a significant negative relation is documented between reporting quality and idiosyncratic risk. This suggests that the quality of accounting information cannot be characterized as an additional systematic priced risk factor, but rather as an idiosyncratic one, once the firm-specific characteristics determining information quality are controlled for. These results demonstrate the importance of explicitly controlling for the determinants of financial reporting quality when investigating the associated economic consequences and question recent empirical evidence on the association between reporting quality and the cost of equity capital.

The Influence of Corporate Responsibility on the Cost of Capital

Abstract: Corporate responsibility (CR) issues have gained importance within the financial community due to the exponential growth of specialized institutes, expansion of academic and research departments, increased launching of mutual funds allocated according to sustainability criteria, proliferation of online resources and other publications, and specialized corporate responsibility reports. A closer look at the literature concerning the relationship between CR issues and financial measures indicated three major fields for improvement in this area: (1) the development of a common understanding of CR issues; (2) the measurement of CR performance; and (3) the question of how CR issues affect the risk profile of a company. We hypothesized that there is a relationship between CR and financial performance (H1) and that good CR performance reduces the risk to a company (H2). A clear relationship between CR and financial performance was not found, but CR and financial performance were indirectly linked throughout company risk. This research delivers evidence that CR performance is strongly linked to financial risk measures. There is also support for the assumption that CR issues are likely to be regulation-driven. Regulation seems to be a driver for CR engagement in the utility industry. It seems that a complete lack of CR engagement exposes a company to unnecessary high risk.

Credit risk management: a survey of practices

Abstract: Purpose – Proposes to investigate the current practices of credit risk management by the largest US‐based financial institutions. Owing to the increasing variety in the types of counterparties and the ever‐expanding variety in the forms of obligations, credit risk management has jumped to the forefront of risk management activities carried out by firms in the financial services industry. This study is designed to shed light on the current practices of these firms.Design/methodology/approach – A short questionnaire, containing seven questions, was mailed to each of the top 100 banking firms headquartered in the USA.Findings – It was found that identifying counterparty default risk is the single most‐important purpose served by the credit risk models utilized. Close to half of the responding institutions utilize models that are also capable of dealing with counterparty migration risk. Surprisingly, only a minority of banks currently utilize either a proprietary or a vendor‐marketed model for the management ...

Beyond Survival: Protecting Households from Health Shocks in Latin America

Abstract: This book breaks new ground in the ongoing debate about health finance and financial protection from the costs of health care. The evidence and discussion support the need to consider financial protection, in addition to health status, as a policy objective when setting priorities for health systems. This book reviews the Latin American experience with health reform in the last 20 years and the fundamentals of health system financing, using new evidence to show the magnitude and mechanisms that determine the impoverishing effects of health events (diseases, accidents, and those of the life cycle). It provides options for policy makers on how to protect, and help household to protect themselves, against this impoverishment. The authors use empirical evidence from six case studies commissioned for this report, on Argentina, Chile, Colombia, Ecuador, Honduras, and Mexico. This book provides policy makers with a solid conceptual basis for decisions on the contents of mandatory health insurance benefit packages, choices of financing mechanisms, and the roles of public policy in this field. It provides an in-depth analysis of, and organizational alternatives for, risk pooling and health insurance for financial protection. It analyzes the urgent need to extend risk pooling to the informal sector, the challenges for current social insurance arrangements, and options for policy makers to effectively extend risk pooling to the informal sector.

The Effect of Financial Development on the Investment Cash Flow Relationship: Cross-Country Evidence from Europe

Abstract: We investigate financing constraints in a large cross-country data set covering most of the European economy. Firm level investment sensitivity to cash flow is used to identify financing constraints. We find that the sensitivities are significantly positive on average, controlling for country and industry fixed effects, as well as firm level controls. Most importantly, the cash flow sensitivity of investment is lower in countries with better-developed financial markets. This suggests that financial development may mitigate financial constraints. This effect is weaker in conglomerate subsidiaries, which are likely to have access to internal capital markets and depend less on the outside financial environment, and possibly for firms in industries with highly liquid assets as well. This result sheds light on the link between financial and economic development.

Downside Risk in Practice

Abstract: Although investors associate risk with negative outcomes and downside fluctuations, modern portfolio theory does not. For investors, volatility per se is not necessarily bad; volatility below a benchmark is. A stock that magnifies the market's fluctuations is not necessarily bad; one that magnifies the market's downside swings is. Even Harry Mar-kowitz, the father of modern portfolio theory, viewed downside risk as a better way to assess risk than the "mean-variance" framework that he ultimately proposed and that has since become the standard. 2006 Morgan Stanley.

A New Framework for Analyzing and Managing Macrofinancial Risks of an Economy

Abstract: The high cost of international economic and financial crises highlights the need for a comprehensive framework to assess the robustness of national economic and financial systems This paper proposes a new comprehensive approach to measure, analyze, and manage macroeconomic risk based on the theory and practice of modern contingent claims analysis (CCA) We illustrate how to use the CCA approach to model and measure sectoral and national risk exposures, and analyze policies to offset their potentially harmful effects This new framework provides economic balance sheets for inter-linked sectors and a risk accounting framework for an economy CCA provides a natural framework for analysis of mismatches between an entity's assets and liabilities, such as currency and maturity mismatches on balance sheets Policies or actions that reduce these mismatches will help reduce risk and vulnerability It also provides a new framework for sovereign capital structure analysis It is useful for assessing vulnerability, policy analysis, risk management, investment analysis, and design of risk control strategies Both public and private sector participants can benefit from pursuing ways to facilitate more efficient macro risk accounting, improve price and volatility discovery, and expand international risk intermediation activities

Dynamic Choice, Independence and Emotions

Abstract: From the viewpoint of the independence axiom of expected utility theory, an interesting empirical dynamic choice problem involves the presence of a global risk, that is, a chance of losing everything whichever safe or risky option is chosen. In this experimental study, participants have to allocate real money between a safe and a risky project. Treatment variable is the particular decision stage at which a global risk is resolved: (i) before the investment decision; (ii) after the investment decision but before the resolution of the investment risk; (iii) after the resolution of the investment risk. The baseline treatment is without global risk. Our goal is to investigate the isolation effect and the principle of timing independence under the different timing options of the global risk. In addition, we examine the role played by anticipated and experienced emotions in the choice problem. Main findings are a violation of the isolation effect, and support for the principle of timing independence. Although behavior across the different global risk cases shows similarities, we observe clear differences in people's affective responses. This may be responsible for the conflicting results observed in earlier experiments. Dependent on the timing of the global risk different combinations of anticipated and experienced emotions influence decision making.

What Makes a Stock Risky? Evidence from Sell-Side Analysts' Risk Ratings

Abstract: We examine the determinants and the informativeness of financial analysts' risk ratings using a large sample of research reports issued by Salomon Smith Barney, now Citigroup. We find that the cross-sectional variation in risk ratings is largely explained by variables commonly viewed as risk proxies such as idiosyncratic risk, size, book-to-market and leverage. In addition, earnings-based measures of risk such as earnings quality and accounting losses also contribute to explaining the cross-sectional variation in the risk ratings. Finally, we document that the risk ratings can be used to predict future return volatility after controlling for other predictors of future volatility. We conclude that analysts play an important role as providers of information about investment risk.

A New Risk Indicator and Stress Testing Tool: A Multifactor nth-to-Default CDS Basket 1

Abstract: This paper generalizes a market-based indicator for financial sector surveillance using a multifactor latent structure in the determination of the default probabilities of an nth-to-default credit default swap (CDS) basket of large complex financial institutions (LCFIs). To estimate the multifactor latent structure, we link the market risk (the covariance of the LCFIs' equity) to credit risk (the default probability of the CDS basket) in a coherent manner. In addition, to analyze the response of the probabilities of default to changing macroeconomic conditions, we run a stress test by generating shocks to the latent multifactor structure. The results unveil a rich set of default probability dynamics and help in identifying the most relevant sources of risk. We anticipate that this approach could be of value to financial supervisors and risk managers alike.

Evaluation of macroeconomic models for financial stability analysis

Abstract: As financial stability has gained focus in economic policymaking, the demand for analyses of financial stability and the consequences of economic policy has increased Alternative macroeconomic models are available for policy analyses, and this paper evaluates the usefulness of some models from the perspective of financial stability Financial stability analyses are complicated by the lack of a clear and consensus definition of ‘financial stability’, and the paper concludes that operational definitions of this term must be expected to vary across alternative models Furthermore, since assessment of financial stability in general is based on a wide range of risk factors, one can not expect one single model to satisfactorily capture all the risk factors Rather, a suite of models is needed This is in particular true for the evaluation of risk factors originating and developing inside and outside the financial system respectively