Editor: Barry Schachter
Published: 18 Oct 2006
Papers in this issue
by Robert Almgren, Neil Chriss
by Günther Helbok, Christian Wagner
by Alfred Hamerle, Thilo Liebig, Harald Scheule
by Marc Gürtler*, Dirk Heithecker
In 1989 Francis Fukayama published a now famous essay, "The End of History?", in which he claimed that liberal democracy had triumphed as the final, and highest, form of social organization. His thesis was as long on selective use of facts and idiosyncratic interpretations of history and philosophy, as it was short on logical rigor. Nevertheless, his message, with the events of that period as background, had great appeal, and continues to affect the thinking of many (no doubt). We perhaps find ourselves in a similar milieu today with respect to the possibility of the end of risk.
For several years, volatility and risk premiums in financial markets globally have been shrinking. Brief periods of heightened volatility have not shaken a growing belief that a new, and better, ie, safer, world economic regime has emerged. In fact, these periods have been cited as demonstrating the new resilience of financial markets in the face of shocks.
It is common to give central banks some of the credit for the current benign state of risk. The mechanisms cited are altering baseline inflation expectations, increasing the transparency of monetary policy, and inducing improvements in risk identification and management in the financial sector through prudent regulation.
It is important to guard against a tendency to Pollyannaism with regard to the final conquest of risk. One way to do so is to engage in more research on the economic effects of central banks and central bankers. For example, we could benefit from a closer look at the uniformity (lack of diversity) in approaches to regulation of risk, the impact of imperfect information on risk regulation and the regulatory process, models of the financial regulator's objective function, etc.
The papers in this issue again demonstrate the breadth of the open questions on risk and risk management. Almgren and Chriss propose a highly innovative approach to portfolio optimization. The sensitivity of optimized portfolio weights to estimates of mean returns is well known and improving estimation has been the subject of much research. Here expected returns are replaced with information on the ordering of expected returns, and an optimization method is described that offers exciting new results.
Helbok and Wagner look at the voluntary operational risk disclosures of banks. They relate those disclosures to potential motives through cross-sectional analysis of financial statement data. This research should be instructive for extracting information from such disclosures and for guiding the goals of mandated disclosure by regulators.
Hamerle, Liebig and Scheule present a hybrid credit risk model for estimating default probabilities. They explain the modeling of default correlation within their framework as a measure of the co-movement of asset returns of obligors. They find, in an empirical study of German banks, that their factor model with time-lagged factors can forecast default probabilities.
Gürtler and Heithecker examine LGD from the perspective of the relationship between default rates, recovery rates, and the value of financial collateral. Importantly, they describe how the relationship between collateral value and rates of default can be estimated. They identify a correspondence between the effects of collateral on estimates of credit risk and the Basel II IRB approach.
The issue concludes with a short paper by Joshi, who presents an algorithm for computing the drift in the Libor market model with additional idiosyncratic terms. The algorithm achieves a computational complexity of order equal to the number of common factors times the number of rates. It is demonstrated that this allows better matching of correlation matrices in reduced-factor models.
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