Economic and regulatory capital allocation for revolving retail exposures

We present two internal capital allocation models and compare the capital ratios they generate with those prescribed by the latest revision of Basel’s New Capital Accord proposal for advanced retail portfolios, which allows for explicit future margin income recognition. Given a test portfolio of credit card exposures that we assemble, we find that Basel’s ratios are closer to those generated by our models for low credit risk segments. We attribute the discrepancies to the different ways Basel and our models account for future margin income, to Basel’s assumptions about asset correlations and to one model taking macroeconomic conditions into account.     

Credit Derivatives and the Default Risk of Large Complex Financial Institutions

This paper proposes and implements a multivariate model of the coevolution of the first and second moments of two broad credit default swap indices and the equity prices of sixteen large complex financial institutions. We use this empirical model to build a bank default risk model, in the vein of the classic Merton-type, which utilises a multi-equation framework to model forward-looking measures of market and credit risk using the credit default swap (CDS) index market as a measure of the conditions of the global credit environment. In the first step, we estimate the dynamic correlations and volatilities describing the evolution of the CDS indices and the banks’ equity prices and then impute the implied assets and their volatilities conditional on the evolution and volatility of equity. In the second step, we show that there is a substantial ‘asset shortfall’ and that substantial capital injections and/or asset insurance are required to restore the stability of our sample institutions to an acceptable level following large shocks to the aggregate level of credit risk in financial markets.     

Asset correlations and bank capital adequacy

This paper addresses the estimation of confidence sets for asset correlations used in credit risk portfolio models. Research on the estimation of asset correlations using endogenous probabilities of default estimations has focused on the impact of concentration risk factors, such as firm size and industry. The empirical evidence from Italian small- and medium-size companies show that the assumptions underlying the Basel Committee regulatory capital risk weight function are not substantiated. The regulatory impact is that the capital adequacy is significantly compromised, driving an adverse selection, which favors the worst companies, and transferring the procyclical effects from firms to banks.     

Timing and diversification: A state-dependent asset allocation approach

Abstract

The influence of changing economic environment leads the distribution of stock market returns to be time-varying. A conditionally optimal investment hence requires a dynamic adjustment of asset allocation. In this context, this paper examines the improvement in portfolio performance by simulating portfolio strategies that are conditioned on the Markov regime switching behaviour of stock market returns. Including a memory effect eliminates the empirical shortcoming of discrete state models, namely that they produce a standard and an extreme state in stock returns. So far, this has prevented the regimes from being used as a valuable conditioning variable. Based on a discrete state indicator variable, is presented evidence of considerable performance improvement relative to the static model due to optimal shifting between aggressive and well diversified portfolio structures.     

A structural model for credit risk with switching processes and synchronous jumps

This paper studies a switching regime version of Merton's structural model for the pricing of default risk. The default event depends on the total value of the firm's asset modeled by a switching Lévy process. The novelty of this approach is to consider that firm's asset jumps synchronously with a change in the regime. After a discussion of dynamics under the risk neutral measure, two models are presented. In the first one, the default happens at bond maturity, when the firm's value falls below a predetermined barrier. In the second version, the firm can enter bankruptcy at multiple predetermined discrete times. The use of a Markov chain to model switches in hidden external factors makes it possible to capture the effects of changes in trends and volatilities exhibited by default probabilities. With synchronous jumps, the firm's asset and state processes are no longer uncorrelated. Finally, some econometric evidence that switching Lévy processes, with synchronous jumps, fit well historical time series is provided.     

Time‐Varying Asset Volatility and the Credit Spread Puzzle

Most extant structural credit risk models underestimate credit spreads—a shortcoming known as the credit spread puzzle. We consider a model with priced stochastic asset risk that is able to fit medium‐ to long‐term spreads. The model, augmented by jumps to help explain short‐term spreads, is estimated on firm‐level data and identifies significant asset variance risk premia. An important feature of the model is the significant time variation in risk premia induced by the uncertainty about asset risk. Various extensions are considered, among them optimal leverage and endogenous default.     

Empirical credit cycles and capital buffer formation

We model 1927–1997 US business failure rates using an unobserved components time series model. Clear evidence is found of cyclical behavior in default rates. We also detect significant longer term movements in default rates and default correlations. In a multi-year backtest experiment we show that accommodation of default rate dynamics has important consequences for credit risk capitalization requirements. Static or myopic variants of credit portfolio models miss significant periods of credit risk accumulation. Empirically congruent dynamic models by contrast provide more timely warning signals of credit risk build-up. In this way they may mitigate some of the pro-cyclicality concerns.     

Credit contagion in the presence of non-normal shocks

We generalize existing structural credit risk models that account for contagion effects across economic sectors, to capture the impact of neglected skewness and excess kurtosis in the asset return process, on the shape of the credit loss distribution. We specify Skew-Normal and Skew-Student t densities for the underlying asset return process and estimate the derived credit loss density using sector default rates based on proprietary data from the Central Bank of Mexico for six firm sectors. We show that, out of the six sectors analyzed, there is a significant contagion effect in ‘Commerce’, ‘Services’ and ‘Transport’. Moreover, we show that the non-Gaussian modelling of the common factor provides a better characterization than its Gaussian counterpart for the ‘Services’ sector. This result has a significant impact on the shape and the corresponding Value-at-Risk levels of the ‘Services’ credit loss distribution. In this context, traditional Basel and vendor-based credit risk models are inadequate as these do not consider the individual or the joint impact of contagion and non-Gaussian asset returns.     

Investment‐Based Corporate Bond Pricing

A standard assumption of structural models of default is that firms' assets evolve exogenously. In this paper, we examine the importance of accounting for investment options in models of credit risk. In the presence of financing and investment frictions, firm‐level variables that proxy for asset composition are significant determinants of credit spreads beyond leverage and asset volatility, because they capture the systematic risk of firms' assets. Cross‐sectional studies of credit spreads that fail to control for the interdependence of leverage and investment decisions are unlikely to be very informative. Such frictions also give rise to a realistic term structure of credit spreads in a production economy.     

Basel II: Correlation Related Issues

Basel II aims to aggressively improve on Basel I, and is projected to capitalize on the technological advancements that have permeated the financial industry since Basel I. This paper examines the correlation issues that arise, and provides recommendations on implementation as we move forward. We provide the following results: (1) We demonstrate that fixing asset value correlations by regulators without a specification of business unit granularity and aggregation impacts franchise risk. (2) Loss distributions for credit risk are more sensitive to correlation assumptions that those for market risk; arbitrary, inaccurate correlation specifications can cause large errors in capital requirements. (3) Current regulations do not recognize that credit losses depend on four distinct correlations, not just one. (4) Recovery rates may be determined uniformly across banks. (5) Tail risk comes from LGD correlations and non-Gaussian risks. (6) The 1-year VaR horizon causes distortions especially when regimes and pro-cyclicality are involved. (7) We recommend a quantitative measure for implementing market discipline, the third pillar of the Basel II accord. Therefore, this paper highlights many issues that may be addressed using the tools banks already employ for internal risk management.     

Pricing Annuity Guarantees Under a Regime-Switching Model

Abstract

We consider the pricing problem of equity-linked annuities and variable annuities under a regimeswitching model when the dynamic of the market value of a reference asset is driven by a generalized geometric Brownian motion model with regime switching. In particular, we assume that regime switching over time according to a continuous-time Markov chain with a finite number state space representing economy states. We use the Esscher transform to determine an equivalent martingale measure for fair valuation in the incomplete market setting. The paper is complemented with some numerical examples to highlight the implications of our model on pricing these guarantees.     

Should SME exposures be treated as retail or corporate exposures? A comparative analysis of default probabilities and asset correlations in French and German SMEs

We use a one-factor credit risk model to provide new estimates of stationary default probabilities and asset correlations in two large samples of French and German Small and Medium-sized Enterprises. Results show that, on average, SMEs are riskier than large businesses; and the asset correlations in the SME population are very weak (1–3% on average) and decrease with size. On average, the relationship between PDs and asset correlations is not negative, as assumed by Basel II, but positive, especially at the industry level, in the two countries. It is also possible to distinguish different segments inside the SMEs’ population: at least between very small and small SMEs and large SMEs.     

Dynamic portfolio optimization with liquidity cost and market impact: a simulation-and-regression approach

We present a simulation-and-regression method for solving dynamic portfolio optimization problems in the presence of general transaction costs, liquidity costs and market impact. This method extends the classical least squares Monte Carlo algorithm to incorporate switching costs, corresponding to transaction costs and transient liquidity costs, as well as multiple endogenous state variables, namely the portfolio value and the asset prices subject to permanent market impact. To handle endogenous state variables, we adapt a control randomization approach to portfolio optimization problems and further improve the numerical accuracy of this technique for the case of discrete controls. We validate our modified numerical method by solving a realistic cash-and-stock portfolio with a power-law liquidity model. We identify the certainty equivalent losses associated with ignoring liquidity effects, and illustrate how our dynamic optimization method protects the investor's capital under illiquid market conditions. Lastly, we analyze, under different liquidity conditions, the sensitivities of certainty equivalent returns and optimal allocations with respect to trading volume, stock price volatility, initial investment amount, risk aversion level and investment horizon.     

The market's perception of the riskiness of large U.S. Bank commercial letters of credit

This article improves upon the market discipline studies of commercial letters of credit (CLC) by employing two new capital market tests, in addition to traditional beta and equity risk tests. Option pricing models have been used to calculate implied asset risk. Two implied asset risk measures have been used to examine the riskiness of commercial letters of credit. The results indicate that stockholders view CLCs as reducing bank risk, and debt holders are indifferent about CLCs. A policy conclusion of these findings is that additional capital requirements of CLCs for large commercial banks may be inappropriate.     

Exploring Portfolio Diversification Opportunities Through Venture Capital Financing: Evidence from MGARCH-DCC,Markov Switching,and Wavelet Approaches

Islamic financial institutions are being pressurized by critics to offer profit and loss sharing (PLS) financing, such as venture capital (VC) financing, for the purpose of entrepreneurial development aligned to the principle of equity risk sharing. Our study aims to link PLS investments with portfolio optimization opportunities for the Islamic asset managers. Using portfolio analysis with dynamic conditional correlation, Markov switching, and maximal overlap discrete wavelet transformation, our findings tend to indicate that there is indeed a portfolio optimization opportunity in investment universe for the fund managers who invested in PLS investments in the context of VC asset class over the long run.     

Can Linear Predictability Models Time Bull and Bear Real Estate Markets? Out-of-Sample Evidence from REIT Portfolios

A recent literature has shown that REIT returns contain strong evidence of bull and bear dynamic regimes that may be best captured using nonlinear econometric models of the Markov switching type. In fact, REIT returns would display regime shifts that are more abrupt and persistent than in the case of other asset classes. In this paper we ask whether and how simple linear predictability models of the vector autoregressive (VAR) type may be extended to capture the bull and bear patterns typical of many asset classes, including REITs. We find that nonlinearities are so deep that it is impossibile for a large family of VAR models to either produce similar portfolio weights or to yield realized, ex-post out-of-sample long-horizon portfolio performances that may compete with those typical of bull and bear models. A typical investor with intermediate risk aversion and a 5-year horizon ought to be ready to pay an annual fee of up to 5.7 % to have access to forecasts of REIT returns that take their bull and bear dynamics into account instead of simpler, linear forecast.     

Foreign reserve and money dynamics with asset portfolio adjustment: international evidence

In this paper we argue that more complete modeling of foreign exchange intervention and sterilization dynamics is necessary when there are adjustment costs to changing private portfolios and/or the central bank attempts to balance longer-run monetary control against short-term exchange rate objectives. We show that measured correlations between domestic credit and foreign asset changes, often interpreted as ‘sterilization coefficients’, may be misleading because they vary with the pattern of disturbances as well as private agent and central bank behavior. We assess the empirical significance of this issue by estimating vector error correction models of the domestic and foreign asset components of the monetary base for Japan and Germany. In both countries, we find that that the impact of foreign exchange intervention on domestic credit falls markedly after several months, implying that the degree of sterilization decreases over time. However, the monetary base remained largely insulated as foreign asset positions were subsequently ‘unwound.’     

On the characteristics of dynamic correlations between asset pairs

Recent research provides considerable evidence that correlations between assets change significantly over time and diversification benefits of correlations may vary substantially based on the time-varying measure of correlation used for different asset types. Our study evaluates and compares alternative time-series correlation modeling techniques according to both statistical and economic metrics, focusing specifically on individual asset pairs. We identify the moving correlation structure that best tracks the dynamic conditional correlation estimates using a large set of different financial time series encompassing 467 asset pairs in nine different asset classes. Results from our direct, statistical loss function based, and indirect, portfolio mean-variance based, forecast evaluations provide optimal window-length ranges for 36 asset-class pairs which should help in portfolio construction as well as risk management. Furthermore for robustness tests, we implement the model confidence set approach which, without a benchmark specification, produces a set of models constructed to contain the best models with a given level of confidence among competing forecast evaluations.     

Dynamic correlations and volatility effects in the Balkan equity markets

This paper investigates the presence of time-varying comovements, volatility implications and dynamic correlations in major Balkan and leading mature equity markets, in order to provide quantified responses to international asset allocation decisions. Since asset returns and correlation dynamics are critical inputs in asset pricing, portfolio management and risk hedging, emphasis is placed on the respective (constant and dynamic) equity market correlations produced by alternative multivariate GARCH forms, the Constant Conditional Correlation and the Asymmetric Dynamic Conditional Correlation models. The Balkan stock markets are seen to exhibit time-varying correlations as a peer group, although correlations with the mature markets remain relatively modest. In conjunction with sensitivity analysis on the asymmetric variance–covariance matrix, active portfolio diversification to the Balkan equity markets indicates to potentially improve investors’ risk-return trade-off.     

Modeling the business risk of financially weakened firms: A new approach for corporate bond pricing

Most structural models of default risk assume that the firm's asset return is normally distributed, with a constant volatility. By contrast, this article details the properties that the process of assets should have in the case of financially weakened firms. It points out that jump-diffusion processes with time-varying volatility provide a refined and accurate perspective on the business risk dimension of default risk. Representative Arrow-Debreu state price densities (SPD) and term structures of credit spreads are then explored. The credit curves show that the business uncertainties play a major in the pricing of corporate liabilities.