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Working Paper
Regulation and the cost of capital in Japan: a case study
Over the last several years, a combination of loan losses and regulatory barriers to equity issuance have left Japanese banks starved for capital. In September 1995, the Mitsubishi Bank was permitted to issue a complicated convertible security in a foreign market. The results of simulations of the price path of the underlying equity imply that Mitsubishi Bank's annualized risk-adjusted cost of capital through this instrument was between 80 and 310 basis points higher than if the bank had instead been able to issue common stock at its current price.
Working Paper
Long-term banking relationships in general equilibrium
I examine the relationship between a financial intermediary ("bank") and a borrowing firm in a three-period overlapping generations model. The model can accommodate two financing arrangements between the bank and the firm: one requires commitment to a long-term contract, the other does not. Which arrangement is chosen depends on whether such a commitment can be credibly made. After defining the two arrangements, I compare their features with real-world financial dealings. Once the form of the long-term relationship between the bank and the firm is set, investment and output of the economy ...
Working Paper
Pitfalls in tests for changes in correlations
Correlations are crucial for pricing and hedging derivatives whose payoff depends on more than one asset. Typically, correlations computed separately for ordinary and stressful market conditions differ considerably, a pattern widely termed "correlation breakdown." As a result, risk managers worry that their hedges will be useless when they are most needed, namely during "stressful" market situations. ; We show that such worries may not be justified since "correlation breakdowns" can easily be generated by data whose distribution is stationary and, in particular, whose correlation ...
Journal Article
An international survey of stress tests
In the summer of 2000, central banks from the Group of Ten countries surveyed large international banks about their use of stress tests_a risk management tool that measures a firm's exposure to extreme movements in asset prices. The survey findings highlight the risks that most concern financial institutions and clarify how these institutions use stress tests in their overall risk management programs.
Working Paper
More evidence on the link between bank health and investment in Japan
Among stock-market-listed Japanese firms in 1994-95, the financial health of the firm's main bank did not significantly affect its investment behavior, after controlling for stock market valuation and cash flow. However, among the subset of bank-dependent firms, investment was lower by over 50 percent at firms that have one of the lowest-rated banks as their main bank. Because low-rated banks are smaller and deal with fewer firms, and because bank-dependent firms themselves tend to be smaller than non-bank-dependent firms, the aggregate effect on business investment in 1994-95 that I identify ...
Working Paper
Improving grid-based methods for estimating value at risk of fixed-income portfolios
Jamshidian and Zhu (1997) propose a discrete grid method for simplifying the computation of Value at Risk (VaR) for fixed-income portfolios. Their method relies on two simplifications. First, the value of fixed income instruments is modeled as depending on a small number of risk factors chosen using principal components analysis. Second, they use a discrete approximation to the distribution of the portfolio's value. We show that their method has two serious shortcomings which imply it cannot accurately estimate VaR for some fixed-income portfolios. First, risk factors chosen using principal ...
Working Paper
Evaluating forecasts of correlation using option pricing
A forecast of the correlation between two asset prices is required to price or hedge an option whose payoff depends on both asset prices or to measure the risk of a portfolio whose return depends on both asset prices. However, a number of factors make it difficult to evaluate forecasts of correlation. We develop a forecast evaluation methodology based on option pricing, extending a technique that Engle et al. (1993) introduced to evaluate volatility forecasts. A forecast of the variance-covariance matrix of joint asset returns is used to generate a trading strategy for a package of simulated ...
Working Paper
Dynamic estimation of volatility risk premia and investor risk aversion from option-implied and realized volatilities
This paper proposes a method for constructing a volatility risk premium, or investor risk aversion, index. The method is intuitive and simple to implement, relying on the sample moments of the recently popularized model-free realized and option-implied volatility measures. A small-scale Monte Carlo experiment suggests that the procedure works well in practice. Implementing the procedure with actual S&P 500 option-implied volatilities and high-frequency five-minute-based realized volatilities results in significant temporal dependencies in the estimated stochastic volatility risk premium, ...
Working Paper
Understanding the risk of synthetic CDOs
Synthetic collateralized debt obligations, or synthetic CDOs, are popular vehicles for trading the credit risk of a portfolio of assets. Following a brief summary of the development of the synthetic CDO market, I draw on recent innovations in modeling to present a pricing model for CDO tranches that does not require Monte Carlo simulation. I use the model to analyze the risk characteristics of the tranches of synthetic CDOs. The analysis shows that although the more junior CDO tranches -- equity and mezzanine tranches -- typically contain a small fraction of the notional amount of the CDO's ...