Showing papers on "Financial risk published in 2011"

Theory of Financial Risk and Derivative Pricing: From Statistical Physics to Risk Management

Abstract: Foreword Preface 1. Probability theory: basic notions 2. Maximum and addition of random variables 3. Continuous time limit, Ito calculus and path integrals 4. Analysis of empirical data 5. Financial products and financial markets 6. Statistics of real prices: basic results 7. Non-linear correlations and volatility fluctuations 8. Skewness and price-volatility correlations 9. Cross-correlations 10. Risk measures 11. Extreme correlations and variety 12. Optimal portfolios 13. Futures and options: fundamental concepts 14. Options: hedging and residual risk 15. Options: the role of drift and correlations 16. Options: the Black and Scholes model 17. Options: some more specific problems 18. Options: minimum variance Monte-Carlo 19. The yield curve 20. Simple mechanisms for anomalous price statistics Index of most important symbols Index.

Financial Knowledge and Best Practice Behavior

Abstract: The current research examines the relationship between personal financial knowledge (both objective and subjective), financial satisfaction, and selected demographic variables in terms of best practice financial behavior. Data are taken from the Financial Industry Regulatory Authority’s (FINRA) National Financial Capability Study, a nationally representative sample of 1,488 participants and are analyzed using multiple regression analysis. Findings suggest that both objective and subjective financial knowledge influence financial behavior, with subjective knowledge having a larger relative impact. Other variables that have a significant impact on financial behavior include financial satisfaction, income, education, age, race, and ethnicity.

Systemic Risk Contributions

Abstract: We adopt a systemic risk indicator measured by the price of insurance against systemic financial distress and assess individual banks’ marginal contributions to the systemic risk. The methodology is applied using publicly available data to the 19 bank holding companies covered by the U.S. Supervisory Capital Assessment Program (SCAP), with the systemic risk indicator peaking around $1.1 trillion in March 2009. Our systemic risk contribution measure shows interesting similarity to and divergence from the SCAP loss estimates under stress test scenarios. In general, we find that a bank’s contribution to the systemic risk is roughly linear in its default probability but highly nonlinear with respect to institution size and asset correlation.

A framework of organisational innovation and outcomes in SMEs

Abstract: Purpose – The purpose of this paper is to examine innovation in small and medium‐sized enterprises (SMEs), and develop a comprehensive theoretical framework of how innovation occurs, the end result, and impact on business financial performance, focusing on three types of innovations.Design/methodology/approach – The study uses a grounded methodology. Interviews with entrepreneurs from across industries inform the development of the research propositions.Findings – Besides market environment, business and quality aspects, for SMEs innovation is driven by a desire to be successful, and improve working conditions. Positive outcomes of innovation include an enhancement of SMEs' reputation and image, an increase in operational efficiency and cost benefits, resulting in a better business financial performance, recruitment of a more skilled workforce, and greater in‐house expertise leading to further innovation. The negative outcomes of innovation relate to management, operational issues, and financial risks; in...

From counting risk to making risk count: Boundary-work in risk management

Abstract: For two decades, risk management has been gaining ground in banking. In light of the recent financial crisis, several commentators concluded that the continuing expansion of risk measurement is dysfunctional ( Power, 2009 , Taleb, 2007 ). This paper asks whether the expansion of measurement-based risk management in banking is as inevitable and as dangerous as Power and others speculate. Based on two detailed case studies and 53 additional interviews with risk-management staff at five other major banks over 2001–2010, this paper shows that relentless risk measurement is contingent on what I call the “calculative culture” ( Mikes, 2009a ). While the risk functions of some organizations have a culture of quantitative enthusiasm and are dedicated to risk measurement, others, with a culture of quantitative scepticism, take a different path, focusing instead on risk envisionment, aiming to provide top management with alternative future scenarios and with expert opinions on emerging risk issues. In order to explain the dynamics of these alternative plots, I show that risk experts engage in various kinds of boundary-work ( Gieryn, 1983 , 1999), sometimes to expand and sometimes to limit areas of activity, legitimacy, authority, and responsibility.

Attributes of Corporate Risk Disclosure: An International Investigation in the Manufacturing Sector

Abstract: This paper is the first multi-country investigation of comprehensive corporate risk disclosure. Based on a detailed content analysis of 160 annual reports, we analyze the attributes and the quantity of risk disclosure and its association with the level of firm risk in the U.S., Canadian, U.K., and German settings. We find a consistent pattern where risk disclosure is most prevalent in management reports, concentrates on financial risk categories, and comprises little quantitative and forward-looking disclosure across sample countries. In terms of risk disclosure quantity, U.S. firms generally dominate, followed by German firms. Cross-country variation in risk disclosure attributes can only partly be linked to domestic disclosure regulation, suggesting that risk disclosure incentives play an important role. While risk disclosure quantity appears to be positively associated with proxies of firm risk in the North American settings, we find a negative association with leverage for Germany. This coin...

Does community and environmental responsibility affect firm risk? Evidence from UK panel data 1994–2006

Abstract: The question of how an individual firm’s environmental performance impacts its firm risk has not been examined in any empirical UK research. Does a company that strives to attain good environmental performance decreases its market risk or is environmental performance just a disadvantageous cost that increases such risk levels for these firms? Answers to this question have important implications for the management of companies and the investment decisions of individuals and institutions. The purpose of this paper is to examine the relationship between corporate environmental performance and firm risk in the British context. Using the largest dataset so far assembled, with Community and Environmental Responsibility (CER) rankings for all rated UK companies between 1994 and 2006, we show that a company’s environmental performance is inversely related to its systematic financial risk. However, an increase of 1.0 in the CER score is associated with only a 0.02 reduction in firm’s risk and cost of capital.

Default Risk of Advanced Economies: An Empirical Analysis of Credit Default Swaps during the Financial Crisis

Abstract: What determines the price of insurance against default of advanced economies? Our laboratory to answer this question is the credit default swap (CDS) market on government debt of 18 advanced economies. The price of credit protection on these countries shows a strong degree of co-movement, has severely increased since the beginning of the financial crisis, and remains at elevated levels. We document that the state of a country's domestic financial system, and since the beginning of the crisis also the state of the world financial system have strong explanatory power for the behavior of CDS spreads, and that the magnitude of this impact depends on the relative importance of a country's financial system pre-crisis. Furthermore, it matters whether a country is a member of the Economic and Monetary Union of the European Union (EMU), in that their sensitivities to the health of the financial system are higher compared to non-EMU members. While one would expect the unconditional risk of default to be low in case of advanced economies, our results suggest the presence of an important economic channel in adverse economic times: a private-to-public risk transfer through which market participants incorporate their expectations about financial industry bailouts and the potential burden of government intervention.

An empirical study of classification algorithm evaluation for financial risk prediction

Abstract: A wide range of classification methods have been used for the early detection of financial risks in recent years. How to select an adequate classifier (or set of classifiers) for a given dataset is an important task in financial risk prediction. Previous studies indicate that classifiers' performances in financial risk prediction may vary using different performance measures and under different circumstances. The main goal of this paper is to develop a two-step approach to evaluate classification algorithms for financial risk prediction. It constructs a performance score to measure the performance of classification algorithms and introduces three multiple criteria decision making (MCDM) methods (i.e., TOPSIS, PROMETHEE, and VIKOR) to provide a final ranking of classifiers. An empirical study is designed to assess various classification algorithms over seven real-life credit risk and fraud risk datasets from six countries. The results show that linear logistic, Bayesian Network, and ensemble methods are ranked as the top-three classifiers by TOPSIS, PROMETHEE, and VIKOR. In addition, this work discusses the construction of a knowledge-rich financial risk management process to increase the usefulness of classification results in financial risk detection.

A comprehensive analysis of the effects of risk measures on bank efficiency: Evidence from emerging Asian countries

Abstract: This study investigates the role of risk in determining the cost efficiency of international banks in eight emerging Asian countries. Researchers of this paper consider three distinct risk aspects under a total of eight risk measures: credit risk, operational risk, and market risk. We apply a heteroscedastic stochastic frontier model to estimate bank cost efficiency in our analysis. Additionally, this study analyzes the marginal effects of all risk measures on the inefficiency effect in order to explore a more detailed relationship between risks and efficiency. The empirical results indicate that the risk measures represent significant effects on both the level and variability of bank efficiency. We also find that these effects vary across countries and over time.

Monitoring Financial Stability: A Financial Conditions Index Approach

Abstract: Monitoring financial stability requires an understanding of both how traditional and evolving financial markets relate to each other and how they relate to economic conditions. This article describes two new indexes of financial conditions that aim to quantify these relationships.

Understanding the risks in China's PPP projects: ranking of their probability and consequence

Abstract: Purpose – Based on the Chinese government's increased public‐private partnership (PPP) experience in the last decade, they have made a lot of efforts to improve the investment environment. This paper hence aims to conduct a more up‐to‐date evaluation of the potential risks in China's PPP projects.Design/methodology/approach – As part of a comprehensive research looking at implementing PPP, a two‐round Delphi survey was conducted with experienced practitioners to identify the key risks that could be encountered in China's PPP projects. The probability of occurrence and severity of the consequence for the selected risks were derived from the surveys and used to calculate their relative risk significance index score.Findings – The results showed that the top ten risks identified according to their risk significance index score are: government's intervention; poor political decision making; financial risk; government's reliability; market demand change; corruption; subjective evaluation; interest rate change;...

The global financial crisis and Islamic finance

Abstract: The conventional view holds that the current global financial crisis was caused by extraordinarily high liquidity, reckless lending practices, and the rapid pace of financial engineering, which created complex and opaque financial instruments used for risk transfer. There was a breakdown of the lender-borrower relationship and informational problems caused by a lack of transparency in asset market prices, particularly in the market for structured credit instruments. There was outdated, lax, or absent regulatory-supervisory oversight; faulty risk management and accounting models; and the emergence of an incentive structure that not only encouraged excessive risk taking but also created a complicit coalition of financial institutions, real estate developers and appraisers, insurance companies, and credit rating agencies whose actions led to a deliberate underpricing of risk. Such a crisis would not have occurred under an Islamic financial system—due to the fact that most, if not all, of the factors that have caused or contributed to the development and spread of the crisis are not allowed under the rules and guidance of Shariah. The current global financial crisis is largely seen as a real test of the resilience of the Islamic financial services industry and its ability to present itself as a more reliable alternative to the conventional financial system. © 2011 Wiley Periodicals, Inc.

An intraday market risk management approach based on textual analysis

Abstract: The management of financial risk is one of the most challenging tasks of financial institutions. In the last two decades, diverse quantitative models and approaches have been developed and refined to address the impact of volatile markets on business. Whereas existing approaches have intensively utilized structured data such as historical price series, little attention has been paid to unstructured (textual) data, which could be a large source of information in this context. Previous empirical research has shown that certain news stories, such as corporate disclosures, can cause abnormal price behavior subsequent to their publication. On the basis of a data set comprising such news stories as well as intraday stock prices, this paper explores the risk implications of information being newly available to market participants. After showing that such events can significantly drive stock price volatilities, this research aims at identifying among the textual data provided those disclosures that have resulted in most supranormal risk exposures. To this end, four different learners - Naive Bayes, k-Nearest Neighbour, Neural Network, and Support Vector Machine - have been applied in order to detect patterns in the textual data that could explain increased risk exposure. Two evaluations are presented in order to assess the learning capabilities of the approach in the context of risk management. First, ''classic'' data mining evaluation metrics are applied and, second, a newly developed simulation-based evaluation method is presented. Evaluation results provide strong evidence that unstructured (textual) data represents a valuable source of information also for financial risk management - a domain in which, in the past, little attention has been paid to unstructured data. With regard to classification performance, it is also shown that there exist significant differences between the applied learning techniques.

Theory of financial risk

Abstract: This paper examines relationships between theory of financial risk and size. Based on the work of Makridakis / Taleb [2009] and Taleb / Tapiero [2009], presents the problems of excessive risk and imbalances caused by the size of firms. Markets mixed on firm growth traps externalities can influence risk, high-cost for the commons. A policy of regulation and control in markets, while necessary, are still insufficient in economies with little institutional support. Externalities of risk and firm size categories are fundamental to understanding the present financial crisis since the economies of scale.

Combined DEMATEL technique with a novel MCDM model for exploring portfolio selection based on CAPM

Abstract: This research proposes a novel MCDM model, including DEMATEL, ANP, and VIKOR for exploring portfolio selection based on CAPM. We probe into the influential factors and relative weights of risk-free rate, expected market return, and beta of the security. The purpose of this research is to establish an investment decision model and provides investors with a reference of portfolio selection most suitable for investing effects to achieve the greatest returns. Taking full consideration of the interrelation effects among criteria/variables of the decision model, this paper examined leading semiconductor companies spanning the hottest sectors of integrated circuit (IC) design, wafer foundry, and IC packaging by experts. Empirical findings revealed that risk-free rate was affected by budget deficit, discount rate, and exchange rate; expected market return was affected by country risk, industrial structure, and macroeconomic factors; and beta of the security was affected by firm-specific risk and financial risk. Also, the factors of the CAPM possessed a self-effect relationship according to the DEMATEL technique. In the eight evaluation criteria, macroeconomic criterion was the most important factor affecting investment decisions, followed by exchange rate and firm-specific risk. In portfolio selection, leading companies in the wafer foundry industry outperformed those in IC design and IC packaging, becoming the optimal portfolio of investors during the time that this study was conducted.

Do Independence and Financial Expertise of the Board Matter for Risk Taking and Performance

Abstract: During the recent financial crisis, financial expertise among independent directors of commercial banks is negatively related to changes in both firm value and cumulative stock returns. Furthermore, financial expertise is positively associated with risk-taking levels in the run-up to the crisis using both balance-sheet and market-based measures of risk. These results are not driven by powerful CEOs who select independent experts to rubber stamp strategies that satisfy their risk appetite. They are, however, consistent with independent directors with financial expertise recognizing the residual nature of shareholders’ claim and supporting a heightened risk profile for their bank.

Efficient Risk Estimation via Nested Sequential Simulation

Abstract: We analyze the computational problem of estimating financial risk in a nested simulation. In this approach, an outer simulation is used to generate financial scenarios, and an inner simulation is used to estimate future portfolio values in each scenario. We focus on one risk measure, the probability of a large loss, and we propose a new algorithm to estimate this risk. Our algorithm sequentially allocates computational effort in the inner simulation based on marginal changes in the risk estimator in each scenario. Theoretical results are given to show that the risk estimator has a faster convergence order compared to the conventional uniform inner sampling approach. Numerical results consistent with the theory are presented. This paper was accepted by Gerard Cachon, stochastic models and simulation.

Balance sheet capacity and endogenous risk

Abstract: Banks operating under Value-at-Risk constraints give rise to a welldefined aggregate balance sheet capacity for the banking sector as a whole that depends on total bank capital. Equilibrium risk and market risk premiums can be solved in closed form as functions of aggregate bank capital. We explore the empirical properties of the model in light of recent experience in the financial crisis and highlight the importance of balance sheet capacity as the driver of the financial cycle and market risk premiums.

The Case for Intervening in Bankers' Pay

Abstract: This paper studies banker remuneration in a competitive market for banker talent. I model, and then calibrate, the default risk of the banks generated by investments and remuneration pressures. Competing banks prefer to pay their banking staff in bonuses and not in fixed wages as risk sharing on the remuneration bill is valuable. Competition for bankers generates a negative externality driving up market levels of banker remuneration and so rival banks' default risk. Optimal financial regulation involves an appropriately structured limit on the proportion of the balance sheet used for bonuses. However stringent bonus caps are value destroying, default risk enhancing and cannot be optimal for regulators who control only a small number of banks. The paper allows an assessment of the intellectual arguments behind widespread calls to regulate the pay of bankers. The paper uses US data to calibrate the analysis and demonstrate the significant contribution of remuneration to default risk.

Credit Default Swap Spreads and Systemic Financial Risk

Abstract: This paper presents a novel method to measure the joint default risk of large financial institutions (systemic default risk) using information in bond and credit default swap (CDS) prices. Bond prices reflect individual default probabilities of the issuers. CDS contracts, which insure against such defaults, pay o only as long as the seller of protection itself is solvent. Therefore, CDS prices contain information about the probability of joint default of both the bond issuer and the protection seller. If we consider the entire set of CDS contracts written by each financial institution against the default of each other institution we can learn about all pairwise default probabilities across the financial network. This information, however, is not sucient to completely characterize the joint distribution function of defaults of these banks. In this paper, I show how this information can be optimally aggregated to construct bounds on the probability of systemic default events. This method enables me to measure systemic default risk without making any assumptions about the joint distribution function. Two main results emerge from the empirical application of this method to the recent financial crisis. First, I show that an increase in systemic risk in large global banks did not occur until after Bear Stearns’ collapse in March 2008. Second, some of the large observed spikes in CDS spreads and bond yield spreads during this period (for example, following Lehman Brothers’ default) correspond to spikes in idiosyncratic default risk rather than systemic risk.

Decomposing the Age Effect on Risk Tolerance

Abstract: The importance of investment portfolio allocation has become more apparent since the onset of the late 2000s Great Recession. Individual willingness to take financial risks affects portfolio decisions and investment returns among other factors. Previous research found that people of different ages have dissimilar levels of risk tolerance but the effects of generation, period, and aging were confounded. Using the 1998 to 2007 Survey of Consumer Finances cross-sectional datasets, this study uses an analytical method to separate such effects on financial risk tolerance. Aging and period effects on financial risk tolerance were statistically significant. Implications for researchers and financial planning practitioners and educators are provided.

The global financial crisis and the evolution of markets, institutions and regulation

Abstract: This paper analyses the recent global financial crisis in the context of the dual processes of market development and regulation. It discusses how, in the absence of a globally integrated financial framework, past and present regulations and interventions in reaction to national and global financial crises did not resolve the cross border regulatory arbitrage. The paper discusses how crises often lead to the emergence of new national and international institutions. It also analyses the proposed “new global framework” that needs to be in place if the policy recommendations contained in the G20 communique are going to be effectively implemented. The paper argues that unless international agreements are ratified by all nations and become part of national rules and laws, the presence of regulatory arbitrage and the lack of adequate cross border information and data may prevent the global economy from addressing the underlying causes of the recent global financial crisis. The paper also discusses the evolution of central banks and their new role in contributing to global financial stability. The paper argues that the recent global financial crisis has provided a unique opportunity to go beyond economic data and attempt to capture cross border financial data and other information that could assist international and national institutions to measure and manage financial risk more effectively. Finally, the paper discusses “too big to fail” and argues that only an internationally integrated financial system will make large banks global, both when operational and in the event of insolvency.

Voluntary risk reporting to enhance institutional and organizational legitimacy: Evidence from Portuguese banks

Abstract: Purpose – This paper aims to explore the factors that affected the voluntary risk‐related disclosures (RRD) in the individual annual reports for 2006 of Portuguese banks. It also explores the extent to which those reports conformed to Basel II requirements in terms of the voluntary disclosure of operational risk and capital structure and adequacy matters.Design/methodology/approach – The authors conduct a content analysis of the annual reports of a sample of 111 banks. Voluntary operational risk and capital structure and adequacy disclosures were assessed using a list of disclosure categories that were developed from the Third Pillar disclosure requirements of the Basel II Accord.Findings – Stakeholder monitoring and corporation reputation are crucial factors that explain the risk reporting practices observed. Voluntary risk reporting appears to enhance legitimacy for two major reasons: first, by fulfilling institutional pressures to assure the effectiveness of market discipline; and second, by managing s...