Market Risk of Mortgage-Backed Securities with Consistent Measures

Due to the complex prepayment behavior, mortgage contracts and their derivatives are generally priced using Monte Carlo simulations. The typical approach used by the industry, which involves simulating interest rates under the risk-neutral measure and applying a physically measured prepayment function, is subject to the problem of internal inconsistency. This is the first paper that directly investigates the potential impact of this issue. Following the general equilibrium setting by Cox, Ingersoll and Ross, we incorporate the market risk price parameter to derive the physical interest rate process from an observed yield curve. This allows us to model mortgage values under the consistent physical measures of interest rates and prepayment functions. By analyzing a default-free Ginnie Mae MBS, we find that the mixed measures lead to slower prepayment rate estimates and overpriced mortgage securities by approximately 5%. Further, there can be substantial biases in the duration and convexity measures depending on market condition and the particular security of interest. The internal inconsistency also leads to biased predictions of both expected and stressed returns for different investment horizons. Depending on the particular security, the bias in expected and stressed returns can be either positive or negative. These biases in risk estimates can introduce misallocation of risk-based capital and/or failure in hedging the market risk of a mortgage-related portfolio.

Idiosyncratic Risk and REIT Returns

The volatility of a stock returns can be decomposed into market and firm-specific volatility, with the former commonly known as systematic risk and the later as idiosyncratic risk. This study examines the relevance of idiosyncratic risk in explaining the monthly cross-sectional returns of REIT stocks. Contrary to the CAPM theory, a significant positive relationship is found between idiosyncratic volatility and the cross-sectional returns. This suggests that firm-specific risk matters in REIT pricing. The regression results further show that once idiosyncratic risk is controlled for in the asset-pricing model, the size and book-to-market equity ratio factors ceased to be significant. The explanatory power of the momentum effect remains robust in the presence of idiosyncratic risk.

The impact of exchange rate risk on international asset pricing under various market structures

This article derives international equity pricing relations by taking into account inflationary exchange risk under various forms of market segmentation/integration. In a mean-variance framework, a two-country, two-period, two-goods model is analyzed under three different market structures: segmented, mildly segmented and integrated. It is found that as long as investors are consuming imported goods, in the presence of market frictions, inflationary exchange risk is an important determinant of real equity prices. This is the case because inflationary exchange rate affects the real purchasing power of investors.

Enterprise risk management in financial groups: analysis of risk concentration and default risk

In financial groups, enterprise risk management is becoming increasingly important in controlling and managing the different independent legal entities in the group. The aim of this paper is to assess and relate risk concentration and joint default probabilities of the group’s legal entities in order to achieve a more comprehensive picture of a financial group’s risk situation. We further examine the impact of the type of dependence structure on results by comparing linear and nonlinear dependencies using different copula concepts under certain distributional assumptions. Our results show that even if financial groups with different dependence structures do have the same risk concentration factor, joint default probabilities of different sets of subsidiaries can vary tremendously.

Credit Risk and the Term Structure of Lease Rates: A Reduced Form Approach

Previous research either assumes default free leases or leases subject to default risk using a structural approach. However, structural credit risk models suffer from a common criticism that the firm’s asset value process is unobservable. We develop a reduced form credit risk model for leases that avoids making assumptions regarding unobservable asset valuation processes. Furthermore, we assume a correlated market and credit risk that provides us with a simple analytic formula for valuing defaultable lease contracts. Numerical analysis reveals that tenant credit risk can have a substantial impact on the term structure of leases. Finally, we use the model to demonstrate the implied lease term structure for a set of retail and financial firms in the Fall of 2000.

Selecting credit rating models: a cross-validation-based comparison of discriminatory power

In commercial banking, various statistical models for corporate credit rating have been theoretically promoted and applied to bank-specific credit portfolios. In this paper, we empirically compare and test the performance of a wide range of parametric and nonparametric credit rating model approaches in a statistically coherent way, based on a ‘real-world’ data set. We repetitively (k times) split a large sample of industrial firms’ default data into disjoint training and validation subsamples. For all model types, we estimate k out-of-sample discriminatory power measures, allowing us to compare the models coherently. We observe that more complex and nonparametric approaches, such as random forest, neural networks, and generalized additive models, perform best in-sample. However, comparing k out-of-sample cross-validation results, these models overfit and lose some of their predictive power. Rather than improving discriminatory power, we perceive their major contribution to be their usefulness as diagnostic tools for the selection of rating factors and the development of simpler, parametric models.

Trading House Price Risk with Existing Futures Contracts

This paper examines the use of futures contracts to hedge residential real estate price risk. We examine whether existing futures contacts can effectively be used to offset volatility in national house prices. Little evidence of any simple systematic relation between national prices and futures prices is found. Since house prices are not easily replicated with a portfolio of existing futures contracts, a further implication is that the Chicago Mercantile’s introduction of a financial asset whose value reflects house prices will help complete the market. Nevertheless, the success of the CME’s new derivative contracts may be limited in light of state and regional house price correlations.

Identity Theft and Consumer Payment Choice: Does Security Really Matter?

In their paper “Spectral Risk Measures: Properties and Limitations”, Dowd et al. (J Financ Serv Res 341:61–75, 2008) introduce exponential and power spectral risk measures as subclasses of spectral risk measures (SRMs) to the literature, and claim that they are subject to three serious limitations: First, for these subclasses, the spectral risk may be counterintuitively decreasing when the user’s risk aversion is increasing. Second, these subclasses, and power SRMs in particular, become completely insensitive to market volatility when the respective parameters of risk aversion tend to their lower and upper boundaries. Third, exponential SRMs exhibit constant absolute risk aversion, while constant relative risk aversion better meets the empirical evidence. Consequently, “users of spectral risk measures must be careful to select utility functions that fit the features of the particular problems they are dealing with, and should be especially careful when using power SRMs.” (p. 61). In this comment, we show that the findings of Dowd et al. (J Financ Serv Res 341:61–75, 2008) suffer from misinterpretations and wrong conclusions.     

Value relevance of value-at-risk disclosure

The SEC issued FRR No. 48 in 1997 to enhance public disclosure of firms’ exposures to market risk. We examine whether the quantitative value-at-risk (VAR) estimates disclosed by 81 non-financial firms during the period 1997–2002 are value-relevant using the earnings-returns relation. The empirical results indicate that high VAR is associated with weaker earnings-returns relation. Further analysis shows that VAR is positively and significantly associated with future stock return volatility. Our evidence suggests that investors perceive the earnings of firms with substantial market risk exposure to be less persistent, and adjust the future abnormal earnings for the higher risk exposure. Thus, this results in a lower expected rate of return.

Bank Competition and Financial Stability

Under the traditional “competition-fragility” view, more bank competition erodes market power, decreases profit margins, and results in reduced franchise value that encourages bank risk taking. Under the alternative “competition-stability” view, more market power in the loan market may result in higher bank risk as the higher interest rates charged to loan customers make it harder to repay loans, and exacerbate moral hazard and adverse selection problems. The two strands of the literature need not necessarily yield opposing predictions regarding the effects of competition and market power on stability in banking. Even if market power in the loan market results in riskier loan portfolios, the overall risks of banks need not increase if banks protect their franchise values by increasing their equity capital or engaging in other risk-mitigating techniques. We test these theories by regressing measures of loan risk, bank risk, and bank equity capital on several measures of market power, as well as indicators of the business environment, using data for 8,235 banks in 23 developed nations. Our results suggest that—consistent with the traditional “competition-fragility” view—banks with a higher degree of market power also have less overall risk exposure. The data also provides some support for one element of the “competition-stability” view—that market power increases loan portfolio risk. We show that this risk may be offset in part by higher equity capital ratios.

Bank Competition,Risk, and Subordinated Debt

This paper studies a dynamic model of banking in which banks compete for insured deposits, issue subordinated debt, and invest in either a prudent or a gambling asset. The model allows banks to choose their level of risk after the interest rate on subordinated debt is contracted. We show that requiring banks to issue a small amount of subordinated debt can reduce their gambling incentives. Moreover, when equity capital is more expensive than subordinated debt, adding a subordinated debt requirement to a policy regime that only uses equity capital requirements is Pareto improving.

Credit default swap prices as risk indicators of listed German banks

This paper explores empirically the usefulness of credit default swap (CDS) prices as market indicators. The sample of reference entities consists of large, internationally active German banks and the observation period covers 3 years. By analysing the explanatory power of three risk sources: idiosyncratic credit risk, systematic credit risk and liquidity risk, we gain important insights into modeling the dynamics of CDS spreads. The impact of systematic risk, for example, has three components; one is related to the overall state of the economy, another related to the risk of the internationally active banking sector, and the third is an unobservable systematic factor. Default probabilities, inferred from a tractable reduced form model for CDS spreads, are compared with expected default frequencies from the Moody’s KMV model. The results lend empirical support to the hypothesis that structural models can be less informative than reduced-form models of CDS spreads in the case of banks with major investment banking activities as the leverage loses explanatory power. Although the CDS market appears to have matured over the observation period, during certain periods premiums for liquidity risk can increase substantially thus limiting the value of CDS spreads as market indicators. We conclude that equity prices and CDS premia should be considered together to fully exploit the information content of both market indicators and to mitigate their respective drawbacks.

Insurer's insolvency risk and tax deductions for the individual's net losses

Using the representative agent approach as in Kaplow (Am Econ Rev 82:1013–1017, 1992b), this paper shows that providing tax deductions for the individual’s net losses is socially optimal when the insurer faces the risk of insolvency. We further show that the government should adopt a higher tax deduction rate for net losses when the insurer is insolvent than when the insurer is solvent. Thus, tax deductions for net losses could be used to provide an insurance for individuals against the insurer’s risk of insolvency. These findings could also be used to explain why a government provides supplementary public insurance or government relief. Finally, we discuss that, if the individuals are heterogeneous in terms of loss severity, loss probability, or income level, providing a tax deduction for the individual’s net losses may not always achieve a Pareto improvement, and cross subsidization should be taken into consideration.

Dynamical analysis of corporate bonds based on the yield spread term-quality surface

Our aim of this research is to propose a model which estimates implied relative credit reliability from the yield spread of defaultable bonds and evaluates their spread risk. We introduce “yield spread term-quality surface” (YSTQS) which is defined on the space of duration and credit reliability of the issuers, and express their yield spread. First, we review the general pricing theorem of defaultable bonds with unpredictable recovery in the no-arbitrage context based on the external hazard rates. Second, we show that the dynamics of state variables determine the shape of the YSTQS, and they drive the YSTQS if the loss-adjusted hazard rates are described by a function of them. Finally, we show an empirical analysis of our model with daily yield spread, duration, and the credit ratings of corporate bonds.

Fortune Favours the Bold? Exploring Tournament Behavior among Australian Superannuation Funds

In this paper we investigate the tournament induced risk-shifting behavior of Australian “multi-sector growth funds”. We apply a regression-based methodology and examine tournaments based on the calendar year and the financial year. In our core analysis we find evidence in favor of Taylor’s (J Econ Behav Organ 1455:1–11, 2003) risk shifting tournament hypothesis for financial year-end tournaments. Apart from the standard tournament hypothesis we also report a range of findings regarding stability; fund age; and fund size. Support for the Taylor hypothesis generally continues across these variations as well.

Regulatory Capital Arbitrage and the Potential Competitive Impact of Basel II in the Market for Residential Mortgages

U.S. banking regulators have proposed a bifurcated system of capital regulation where the largest, internationally active banking organizations would be subject to significantly more risk sensitive regulatory capital requirements than are currently in place, while most others would remain subject to the current rules. The proposed new capital regime has the potential to affect the competitive landscape among banking institutions, particularly in the area of residential mortgage lending. We analyze the potential competitive effects of the proposed, bifurcated regulatory capital system on competition in the residential mortgage market from the perspective of the theory of regulatory capital arbitrage. We then apply the theory and available evidence to perform some benchmark calculations that suggest a significant, potential shift of market share and income to the largest banking institutions in the mortgage market.

Property Derivatives and Index-Linked Mortgages

Economists have forcefully argued for the introduction and use of property derivatives as a hedge against house price risk (e.g. Shiller and Weiss, J. Real Estate Finance Econ., 19(1):21–47, 1999). The rationale for these financial instruments seems clear, as many households are heavily invested in housing and standard financial instruments offer a poor hedge. In practice, however, most of the property derivatives available have been targeted to meet the needs of institutional investors, not those of owner-occupiers. Building on the recent launch of the first Swiss property derivative, we here propose index-linked mortgages tailored to retail consumers. The payments of these mortgages depend on the corresponding housing market performance. We further price the instruments, discuss the stabilization of the homeowner’s net wealth, and quantify the expected decrease in the mortgage default risk achieved by this immunization effect.

Information, Credit Risk, Lender Specialization and Loan Pricing: Evidence from the DIP Financing Market

We provide an empirical support for theories of lender specialization using the recently developed market for Debtor-in-Possession (DIP) financing. The legal environment in which DIP financing operates represents a natural laboratory for testing determinants of lending specialization (e.g. lender choice). We find that the choice of lender is not driven by credit risk, but by information considerations and that this lending specialization has loan pricing effects. In short, banks (non-bank lenders) lend to more (less) transparent firms and at lower (higher) loan spreads. Our results are consistent with the interpretation that banks provide important and useful services.

Who hedges more when leverage is endogenous? A testable theory of corporate risk management under general distributional conditions

This paper develops a theory of a firm’s hedging decision with endogenous leverage. In contrast to previous models in the literature, our framework is based on less restrictive distributional assumptions and allows a closed-form analytical solution to the joint optimization problem. Using anecdotal evidence of greater benefits of risk management for firms selling “credence goods” or products that involve long-term relationships, we prove that those optimally leveraged firms, which face more convex indirect bankruptcy cost functions, will choose higher hedge ratios. Moreover, we suggest a new approach to test this relationship empirically.