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Tomorrow's Research Today

Sponsored by the Global Association of Risk Professionals (GARP) Working Paper Series
Vol. 9, No. 51: Jun 08, 2009

Interdisciplinary Center (IDC) - Caesarea Center, National Bureau of Economic Research (NBER)


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RISK MANAGEMENT ABSTRACTING JOURNAL AVAILABLE AT NO CHARGE The Global Association of Risk Professionals (GARP) and the GARP Digital Library are proud to sponsor this journal, making it available at no charge to subscribers. GARP is the leading professional association for financial risk managers, dedicated to the advancement of risk management through education, training and the promotion of best practices globally. The GARP Digital Library provides convenient access to highly recommended educational material and information on financial risk management for both practitioners and researchers. For more information, please visit http://www.garp.com and http://www.garpdigitallibrary.com

Table of Contents
The Pricing of Subprime Mortgage Risk in Good Times and Bad: Evidence from the ABX.HE Indices Ingo Fender, Bank for International Settlements (BIS) Martin Scheicher, European Central Bank (ECB) Risk Horizon and Rebalancing Horizon in Portfolio Risk Measurement Paul Glasserman, Columbia Business School The Cost of Capital in Markets with Opaque Intermediaries and the RiskStructure of Interest Rates Fernando Mierzejewski, Catholic University of Leuven (KUL) The Fragile Capital Structure of Hedge Funds and the Limits to Arbitrage Xuewen Liu, Imperial College Business School Antonio S. Mello, University of Wisconsin - Madison - School of Business Don?t They Care? Or, Are They Just Unaware? Risk Perception and the Demand for Long-Term Care Insurance Tian Zhou-Richter, Humboldt University of Berlin - School of Business and Economics Mark J. Browne, University of Wisconsin - Madison - School of Business Helmut Grndl, Humboldt University of Berlin - School of Business and Economics,
Humboldt University of Berlin - Center for Applied Statistics and Economics (CASE)

Correlations, Risk and Crisis: From Physiology to Finance Alexander N. Gorban, University of Leicester, UK Elena V. Smirnova, affiliation not provided to SSRN Tatiana A. Tyukina, affiliation not provided to SSRN Developing a New, Probabilistic Model of Asset Pricing: A Response to the Short-Comings of CAPM and Other Deterministic Financial Models Jonathan Ross Charlton, affiliation not provided to SSRN Regulatory Reform in the Wake of the Financial Crisis of 2007-2008 Andrew W. Lo, MIT Sloan School of Management, National Bureau of Economic Research ^top

RISK MANAGEMENT ABSTRACTS Sponsored by the Global Association of Risk Professi onals (GARP)
"The Pricing of Subprime Mortgage Risk in Good Times and Bad: Evidence from the ABX.HE Indices"

ECB Working Paper No. 1056 INGO FENDER, Bank for International Settlements (BIS) Email: Ingo.Fender@bis.org MARTIN SCHEICHER, European Central Bank (ECB) Email: martin.scheicher@ecb.int This paper investigates the market pricing of subprime mortgage risk on the basis of data for the ABX.HE family of indices, which have become a key barometer of mortgage market conditions during the recent financial crisis. After an introduction into ABX index mechanics and a discussion of historical pricing patterns, we use regression analysis to establish the relationship between observed index returns and macroeconomic news as well as market based proxies of default risk, interest rates, liquidity and risk appetite. The results imply that declining risk appetite and heightened concerns about market illiquidity - likely due in part to significant short positioning activity - have provided a sizeable contribution to the observed collapse in ABX prices since the summer of 2007. In particular, while fundamental factors, such as indicators of housing market activity, have continued to exert an important influence on the subordinated ABX indices, those backed by AA and AAA exposures have tended to react more to the general deterioration of the financial market environment. This provides further support for the inappropriateness of pricing models that do not sufficiently account for factors such as risk appetite and liquidity risk, particularly in periods of heightened market pressure. In addition, as related risk premia can be captured by unconstrained investors, ABX pricing patterns appear to lend support to government measures aimed at taking troubled assets off banks? balance sheets - such as the US Troubled Asset Relief Program (TARP) in its original form. "Risk Horizon and Rebalancing Horizon in Portfolio Risk Measurement" PAUL GLASSERMAN, Columbia Business School Email: pg20@columbia.edu This paper analyzes portfolio risk and volatility in the presence of constraints on portfolio rebalancing frequency. This investigation is motivated by the incremental risk charge (IRC) introduced by the Basel Committee on Banking Supervision. In

contrast to the standard market risk measure based on a ten-day value-at-risk calculated at 99% confidence, the IRC considers more extreme losses and is measured over a one-year horizon. More importantly, whereas ten-day VaR is ordinarily calculated with a portfolio's holdings held fixed, the IRC assumes a portfolio is managed dynamically to a target level of risk, with constraints on rebalancing frequency. The IRC uses discrete rebalancing intervals (e.g., monthly or quarterly) as a rough measure of potential illiquidity in underlying assets. We analyze the effect of these rebalancing intervals on the portfolio's profit and loss distribution over a risk-measurement horizon. We derive limiting results, as the rebalancing frequency increases, for the difference between discretely and continuously rebalanced portfolios; we use these to approximate the loss distribution for the discretely rebalanced portfolio relative to the continuously rebalanced portfolio. Our analysis leads to explicit measures of the impact of discrete rebalancing under a simple model of asset dynamics. "The Cost of Capital in Markets with Opaque Intermediaries and the RiskStructure of Interest Rates"

MPRA Paper No. 9827 FERNANDO MIERZEJEWSKI, Catholic University of Leuven (KUL) Email: femierze@lycos.com The demand for cash balances of financial intermediaries that establish contractual liabilities with credit-sensitive customers is characterized. As stated by Merton, the success of the business activities of such firms crucially depends on their credit quality, and hence, they are obliged to rely on deposit insurance and capital cushions in order to assure that their promised payments are free of default. Unlike the Merton's approach, the optimal guaranteeing contract is formulated in actuarial terms in this paper, because in this way the model can be extended to consider the situation of firms that can only hedge up to a limited extent. Within this framework, the equilibrium in the market determines the rate at which a unit of capital is exchange by a unit of risk, or, in other words, it determines the market price of risk. Episodes of liquidity crises are meaningful in this theoretical setting. "The Fragile Capital Structure of Hedge Funds and the Limits to Arbitrage" XUEWEN LIU, Imperial College Business School Email: xuewen.liu@ic.ac.uk ANTONIO S. MELLO, University of Wisconsin - Madison - School of Business Email: amello@bus.wisc.edu During a financial crisis, when markets most need liquidity and arbitrage tradings, hedge funds often reduce their exposures and positions. The paper explains this phenomenon in light of coordination risk. We argue that the fragile nature of capital structure of hedge funds, combined with low market liquidity, introduces coordination risk to hedge fund's investors. Coordination risk effectively limits hedge funds' arbitrage capabilities. We present a model of hedge funds' optimal asset allocation with coordination risk. We show that hedge fund managers behave conservatively and even give up participating in the market when they factor coordination risk into their investment decisions. The model gives a new explanation to the limits to arbitrage. We also discuss other implications of the model. "Don?t They Care? Or, Are They Just Unaware? Risk Perception and the Demand for Long-Term Care Insurance" TIAN ZHOU-RICHTER, Humboldt University of Berlin - School of Business and Economics Email: zhourich@wiwi.hu-berlin.de

MARK J. BROWNE, University of Wisconsin - Madison - School of Business Email: MJBROWNE@FACSTAFF.WISC.EDU HELMUT GRNDL, Humboldt University of Berlin - School of Business and Economics,
Humboldt University of Berlin - Center for Applied Statistics and Economics (CASE) Email: gruendl@wiwi.hu-berlin.de

The potential need for long-term care (LTC) is one of the greatest financial risks faced not only by the elderly, but also by their adult children, who often provide care or financial assistance. We investigate adult children?s role in the demand for LTC insurance. Similar to flood insurance, we find that demand for LTC insurance is low due to low risk perception. The more aware adult children are of the risk, the more often LTC insurance is purchased, either by the adult children themselves on behalf of their parents or by the parents under the influence of their adult children. "Correlations, Risk and Crisis: From Physiology to Finance" ALEXANDER N. GORBAN, University of Leicester, UK Email: ag153@le.ac.uk ELENA V. SMIRNOVA, affiliation not provided to SSRN TATIANA A. TYUKINA, affiliation not provided to SSRN We study the dynamics of correlation and variance in systems under the load of environmental factors. A universal effect in ensembles of similar systems under load of similar factors is described: in crisis, typically, even before obvious symptoms of crisis appear, correlation increases, and, at the same time, variance (and volatility) increases too. After the crisis achieves its bottom, it can develop into two directions: recovering (both correlations and variance decrease) or fatal catastrophe (correlations decrease, but variance not). This effect is supported by many experiments and observation of groups of humans, mice, trees, grassy plants, and on financial time series. A general approach to explanation of the effect through dynamics of adaptation is developed. Different organization of interaction between factors (Liebig's versus synergistic systems) lead to different adaptation dynamics. This gives an explanation to qualitatively different dynamics of correlation under different types of load. "Developing a New, Probabilistic Model of Asset Pricing: A Response to the Short-Comings of CAPM and Other Deterministic Financial Models" JONATHAN ROSS CHARLTON, affiliation not provided to SSRN The "market" is too complex to model deterministically. Deterministic financial models such as CAPM have invalid assumptions such as normally distributed asset price fluctuations, independent price fluctuations, and continuous price fluctuations, well documented by Benoit Mandelbrot. Despite these short-comings, the financial field continues to use them to inaccurately price assets. This paper proposes an alternative, probabilistic pricing model based in utility theory, and using logistic regression to infer the significance of explanatory variables in accounting for the fluctuation of the likelihood of an asset's returns beating the risk-free rate. This paper provides an example application to a publicly-traded asset as well as discussion of its application to valuing a not-forprofit organization's assets. The paper concludes that the field of finance should move from one of faulty assumptions and ill-devised models that claim to be accurate and predictive for the purpose of generating excess returns, to a field of risk-management based on an accurate assessment of performance odds for the purpose of ensuring the present value, or "utility", of current capital.

"Regulatory Reform in the Wake of the Financial Crisis of 2007-2008" ANDREW W. LO, MIT Sloan School of Management, National Bureau of Economic Research
(NBER) Email: alo@mit.edu

Financial crises are unavoidable when hardwired human behavior - fear and greed, or ?animal spirits? - is combined with free enterprise, and cannot be legislated or regulated away. Like hurricanes and other forces of nature, market bubbles and crashes cannot be entirely eliminated, but their most destructive consequences can be greatly mitigated with proper preparation. In fact, the most damaging effects of financial crisis come not from loss of wealth, but rather from those who are unprepared for such losses and panic in response. This perspective has several implications for the types of regulatory reform needed in the wake of the Financial Crisis of 2007-2008, all centered around the need for greater transparency, improved measures of systemic risk, more adaptive regulations including counter-cyclical leverage constraints, and more emphasis on financial literacy starting in high school, including certifications for expertise in financial engineering for the senior management and directors of all financial institutions. ^top

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