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financial derivatives?

…aka…Risk allocation: the double

face of financial derivatives

Fulvio Corsi, Hykel Hosni and Stefano Marmi

http://homepage.sns.it/marmi/

http://alfaobeta.blogspot.com

Enterprise Risk Management and Corporate Governance

for Insurance Firms

17 May 2011 - EDHEC Business School – Lille

Paper available here:

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1844288

Derivatives: a boon to humanity or

weapons of financial mass destruction?

• Irving Fisher (1906): “risk is one of the direst economic evils, and

all of the devices which aid in overcoming it - whether increased

guarantees, safeguards, foresight, insurance or legitimate

speculation - represent a great boon to humanity”

the last 30 years has come from the emergence of derivative

markets”

the parties that deal in them and the economic system.(…) In my

view, derivatives are financial weapons of mass destruction,

carrying dangers that, while now latent, are potentially lethal”.

5/17/2011 2

derivatives

Both things can be true!

• Derivatives do allow for a more efficient risk management, they

have an important informative role (price discovery) and they may

also provide more liquidity to markets

reasonable doubt

magnified contagion and systemic risk: the Federal Reserve

Chairman Ben Bernanke has characterized AIG operations in

derivative markets as the behaviour of a "quasi-hedge fund" that

“made irresponsible bets and took huge losses".

5/17/2011 3

derivatives

From Markowitz to systemic risk

• Classical mean-variance separation theorem: optimal market portfolio

weights of risky assets are independent of individual preferences.

Agents decide leverage according to individual risk tolerance

• The agent leverage choice does not affect the joint probability

distribution of the returns in the economy.

• However different degrees of leverage, and hence different amounts

of aggregate investment, can and do affect total output of the

economy:

– risk externalities stemming from the size of institutions (TBTF)

– not constant return to scale of the projects

– not constant correlation

– different levels of credit risk which also induce different level of

systemic risk.

S. Marmi: Risk allocation and financial

5/17/2011 4

derivatives

Individiual choices and systemic risk

• A third dimension appears: the total amount of systemic risk

reached as a consequence of the individuals choices

5/17/2011 5

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A simple model

• M risky assets

• N agents, each with initial equity capital Ci

(risk capacity)

• ri = gross return per unit of capital invested

• μi = expected value of ri and σi its risk

• Ii = amount invested in the portfolio of risky

assets.

• Agent i will default when loss on his risky

portflolio will exceed Ci

• Probability of default PDi = P(Ii ri < - Ci)

• Distance to default: DDi = Ci / (Ii σi )

• The larger is the investment Ii the smaller

will be DDi

• Return On Equity: ROEi = Ii μi /Ci is an

increasing function of investment.

S. Marmi: Risk allocation and financial

5/17/2011 6

derivatives

Investment choices and estimation errors

(CARA) utility function with absolute risk aversion parameter

αi. If the risk free rate is zero, each individual i then maximizes

max Ii μi – αi Ii2 σi2/2

• Optimal level Ii* of investment: Ii* = μi / (αi σi2)

• But in practice true values of μi and σi are not known! Instead

use estimates μi and σi thus: Ii* = μi / (αi σi2) = Ii*ei

where ei = σi2 μi / (σi2 μi) is the estimation error.

• The realized distance to default becomes

DDi* = Ci /(Ii* σi ) = 1/(λi σi ei )

where λi = Ii / Ci is the leverage of the i-th agent position

5/17/2011 7

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Statistics vs. a-priori probability

• Ergodic theory studies the statistical behaviour

of the time evolution of systems restricting the

attention to their asymptotic distribution. One

waits until all transients have been wiped off

and looks for an invariant probability measure

describing the distribution of typical orbits.

• The probability of an event (if it exists) is almost

always impossible to be known a-priori

• The only possibility is to replace it with the

frequencies (if they exist) measured by

observing how often the event occurs

• The problem of backtesting

• The problem of ergodicity and of typical points: Douady and Taleb’s Statistical

from a single series of observations I would like Undecidability: under which

to be able to deduce the invariant probability assumptions is it possible and how to

• Bertrand Russell’s chicken make a decision based on the

observation of random variable? The

fourth quadrant…

S. Marmi: Risk allocation and financial

5/17/2011 8

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Systemic risk

defaults (ND) in the whole economy exceeds a certain threshold

n:

SRn = P(ND > n)

• SR is an increasing function of λi and σi

• Assume uncorrelated individual estimation errors ei but SR is an

increasing function of the variance of ei

• SR will also be an increasing function of the average correlation

ρ among the individual probabilities of default

5/17/2011 9

derivatives

Systemic risk literature

A collection of measures of systemic risk, each

designed to capture certain aspects (liquidity, leverage,

fragility, interconnection, losses, etc.).

1. CoVaR (Adrian and Brunnermeier, 2009): VaR

of economy conditional on distress of agent i

2. Systemic Expected Shortfall (SES) and

Marginal Expected Shortfall (MES) (Acharya,

Pedersen, Philippon and Richardson, 2010): SES

measures each agent’s contribution to systemic

risk, MES measures institution’s losses in the tail

of the system’s loss distribution

3. Distress Insurance Premium (Huang, Zhou,

and Zhu, 2010)

S. Marmi: Risk allocation and financial

5/17/2011 10

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Systemic risk literature

5. Conditional Marginal Expected Shortfall (Brownlees and Engle,

(2010)): here the marginal ES of an agent is computed conditional on a

fixed market decline

6. Econometric measures of systemic risk in the finance and insurance

sectors (Billio, Getmansky, Lo, and Pelizzon 2010) here the

interconnectedness among the monthly returns of hedge funds, banks,

brokers, and insurance companies is measured by PCA and Granger-

causality tests.

7. Liaisons Dangereuses: Increasing Connectivity, Risk Sharing, and

Systemic Risk (Battiston, Delli Gatti, Gallegati, Greenwald and Stiglitz

2009): non monotonicity of dependence of SR on networks’ connectivity

5/17/2011 11

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Socially efficient frontier and

cooperative financial derivatives

• The total gross return of the

whole economy will be

N

Y I i ri

i 1

• We define an allocation to be

socially efficient if it minimizes

the SR for any given level of

E[Y], or if it , maximizes the

expected value of E[Y] for any

given level of SR

to move from an interior and inefficient point to a superior aggregate

risk allocation having a higher E[Y] with same or lower SR (i.e.

moving in the second quadrant direction in the SR - E[Y] plane).

S. Marmi: Risk allocation and financial

5/17/2011 12

derivatives

Asset Backed Securities

ABS exposed financial institutions to more systemic risk through:

• increased Var(ei) (lack of transparency);

• a positive bias in ei, i.e. E[ei] > 1 (mispricing and moral

hazard);

• increased individual leverages λi

• increased correlation of default probabilities, which magnifies

SRn = P(ND > n)

cooperative or socially efficient: even if E [Y] might increase, SR

is also increased, and the net change in the position of the

economy in the return-systemic risk space does not dominate the

initial one.

5/17/2011 13

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Credit Default Swaps

• CDS are simply a form of insurance against default. They do

not require an exposure to the underlying credit risk (naked

CDS)

• Non-naked CDS transfer credit risk from protection buyer to

protection seller: SR change depends on the relative risk

capacity of the two parties.

• Naked CDS increase the total amount of counterparty risk.

The risk over the two sides does not necessarily compensate.

• Since the market of CDS is highly concentrated in few large

protection sellers, the counterparty risk generated by the

default of one of these dominant actors can generate default

contagion and domino effects.

S. Marmi: Risk allocation and financial

5/17/2011 14

derivatives

Credit Default Swaps

markets on financial stability crucially depends on clearing

mechanisms and capital and liquidity requirements for large

protection sellers. In particular, the culprits are not so much

speculative or “naked” credit default swaps but inadequate

risk management and supervision of protection sellers. When

protection sellers are inadequately capitalised, OTC (over-the-

counter) CDS markets may act as channels for contagion and

systemic risk.

5/17/2011 15

derivatives

Credit Default Swaps

The introduction of CDS have both positive and negative effects on SR

and E[Y]:

• price discovery on the creditworthiness of the issuer reduces Var(ei)

(and possibly bias) and hence SR;

• if credit risk is allocated to more capitalized and diversified subjects,

it either decreases SR or it increases E[Y];

• if CDS transfer credit risk to more leveraged and systemically

important institutions SR will increase;

• CDS can magnify the underlying credit risk by compounding it with

the counterparty risk of the protection sellers thus increasing the

possibility of contagion, which increases SRn = P(ND > n)

The social efficiency of CDS remains unclear, depending on which of

the above effects eventually dominates.

5/17/2011 16

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Conclusions

authorities should all cooperate to provide more direct and

better quality information concerning the leverage and

linkages among financial institutions, much of which is

currently proprietary and not available to any single regulator.

• An integrated approach, which aims at the control of the

buildup of systemic risk by using econometric and statistical

relationships as well as financial statements and regulatory

data and performance measures, is probably the correct way of

addressing the complexity of the global financial system.

• Firms need to take into account these global factors in their

financing and operational choices (feedbacks).

5/17/2011 17

derivatives

Thank you !

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