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2008, 54
The paper provides novel insights on the effect of a firm’s risk management objective on the optimal design of risk transfer instruments. I analyze the interrelation between the structure of the optimal insurance contract and the firm’s objective to minimize the required equity it has to hold to accommodate losses in the presence of multiple risks and moral hazard. In contrast to the case of risk aversion and moral hazard, the optimal insurance contract involves a joint deductible on aggregate losses in the present setting.
2005, 02
What do academics have to offer market risk management practitioners in financial institutions? Current industry practice largely follows one of two extremely restrictive approaches: historical simulation or RiskMetrics. In contrast, we favor flexible methods based on recent developments in financial econometrics, which are likely to produce more accurate assessments of market risk. Clearly, the demands of real-world risk management in financial institutions - in particular, real-time risk tracking in very high-dimensional situations - impose strict limits on model complexity. Hence we stress parsimonious models that are easily estimated, and we discuss a variety of practical approaches for high-dimensional covariance matrix modeling, along with what we see as some of the pitfalls and problems in current practice. In so doing we hope to encourage further dialog between the academic and practitioner communities, hopefully stimulating the development of improved market risk management technologies that draw on the best of both worlds.
2005, 07
This paper analyzes dynamic equilibrium risk sharing contracts between profit-maximizing intermediaries and a large pool of ex-ante identical agents that face idiosyncratic income uncertainty that makes them heterogeneous ex-post. In any given period, after having observed her income, the agent can walk away from the contract, while the intermediary cannot, i.e. there is one-sided commitment. We consider the extreme scenario that the agents face no costs to walking away, and can sign up with any competing intermediary without any reputational losses. We demonstrate that not only autarky, but also partial and full insurance can obtain, depending on the relative patience of agents and financial intermediaries. Insurance can be provided because in an equilibrium contract an up-front payment e.ectively locks in the agent with an intermediary. We then show that our contract economy is equivalent to a consumption-savings economy with one-period Arrow securities and a short-sale constraint, similar to Bulow and Rogo. (1989). From this equivalence and our characterization of dynamic contracts it immediately follows that without cost of switching financial intermediaries debt contracts are not sustainable, even though a risk allocation superior to autarky can be achieved. JEL Klassifikation: G22, E21, D11, D91.
2005, 06
Default risk sharing between banks and markets : the contribution of collateralized debt obligations
(2005)
This paper contributes to the economics of financial institutions risk management by exploring how loan securitization a.ects their default risk, their systematic risk, and their stock prices. In a typical CDO transaction a bank retains through a first loss piece a very high proportion of the expected default losses, and transfers only the extreme losses to other market participants. The size of the first loss piece is largely driven by the average default probability of the securitized assets. If the bank sells loans in a true sale transaction, it may use the proceeds to to expand its loan business, thereby incurring more systematic risk. We find an increase of the banks' betas, but no significant stock price e.ect around the announcement of a CDO issue. Our results suggest a role for supervisory requirements in stabilizing the financial system, related to transparency of tranche allocation, and to regulatory treatment of senior tranches. JEL Klassifikation: D82, G21, D74 .
1998, 17
Derivatives usage in risk management by U.S. and German non-financial firms : a comparative survey
(1998)
This paper is a comparative study of the responses to the 1995 Wharton School survey of derivative usage among US non-financial firms and a 1997 companion survey on German non-financial firms. It is not a mere comparison of the results of both studies but a comparative study, drawing a comparable subsample of firms from the US study to match the sample of German firms on both size and industry composition. We find that German firms are more likely to use derivatives than US firms, with 78% of German firms using derivatives compared to 57% of US firms. Aside from this higher overall usage, the general pattern of usage across industry and size groupings is comparable across the two countries. In both countries, foreign currency derivative usage is most common, followed closely by interest rate derivatives, with commodity derivatives a distant third. Usage rates across all three classes of derivatives are higher for German firms than US firms. In contrast to the similarities, firms in the two countries differ notably on issues such as the primary goal of hedging, their choice of instruments, and the influence of their market view when taking derivative positions. These differences appear to be driven by the greater importance of financial accounting statements in Germany than the US and stricter German corporate policies of control over derivative activities within the firm. German firms also indicate significantly less concern about derivative related issues than US firms, which appears to arise from a more basic and simple strategy for using derivatives. Finally, among the derivative non-users, German firms tend to cite reasons suggesting derivatives were not needed whereas US firms tend to cite reasons suggesting a possible role for derivatives, but a hesitation to use them for some reason.