Journal of Financial Engineering

Basel III requires banks to include a credit value adjustment (CVA) into capital charges. Both CVA and debt value adjustment (DVA) must be included for derivatives using mark-to-market accounting. An effective method to calculate bilateral-CVA (BR-CVA) by incorporating wrong-way risk (WWR) for a collateralized counterparty is proposed which handles WWR — defined as when counterparty credit exposure increases as default probability increases — by building a trivariate Gaussian copula between the aggregate market risk exposure factor and default quality of the financial institution and counterparty. This paper extends the ordered-scenario copula model proposed in the literature. It links BR-CVA pricing and WWR, which is close to the current regulatory requirement and useful for managing a financial institution's risk. A practical example is provided. Numerical results suggest that the proposed method is efficient and robust and can easily stress test the impact of WWR in BR-CVA pricing.

Commodity future prices are explained either by price expectations and a risk premium in the theory of normal backwardation or with the theory of storage in a cost of carry valuation. Both approaches are compared in separate equations with Johansen cointegration tests. The data sample contains five LME metals with maturities of 3–27 months and real inventory data. It is found that expected spot prices explain only short maturity future prices. But the cost of carry approach, with the inventory level-dependent convenience yield, explains prices for all maturities.

This paper studies an interest rate derivative when there is the model risk in an interest rate model. We consider a mean reverting interest rate process whose volatility model is not known. Most of prices of interest rate derivatives cannot be determined uniquely, based on this interest rate model. We study the price bounds of a derivative and propose how to calculate the price bounds by a trinomial model. Further, we analyze the model risk of derivatives and their portfolios numerically.

This paper studies the risk-adjusted optimal timing to liquidate an option at the prevailing market price. In addition to maximizing the expected discounted return from option sale, we incorporate a path-dependent risk penalty based on shortfall or quadratic variation of the option price up to the liquidation time. We establish the conditions under which it is optimal to immediately liquidate or hold the option position through expiration. Furthermore, we study the variational inequality associated with the optimal stopping problem, and prove the existence and uniqueness of a strong solution. A series of analytical and numerical results are provided to illustrate the nontrivial optimal liquidation strategies under geometric Brownian motion (GBM) and exponential Ornstein–Uhlenbeck models. We examine the combined effects of price dynamics and risk penalty on the sell and delay regions for various options. In addition, we obtain an explicit closed-form solution for the liquidation of a stock with quadratic penalty under the GBM model.

We propose a secondary spectrum market that allows wireless providers to purchase spectrum access licenses of short duration in the form of spot contracts and derivative contracts on spectrum. A spot contract provides immediate access to one or more wireless channels and cannot be further traded. On the other hand, derivative contracts on spectrum typically involve purchase of spectrum licenses in the future for predefined terms, and they can play an important role in risk management objectives of wireless providers. In this paper, we utilize a model for the spot price of spectrum licenses in which the price increases with increasing congestion in spectrum usage caused by the primary demand for spectrum. The spot price process, modeled as driven by a fractional Brownian motion (fBm) process to capture the self-similarity properties of wireless traffic, is utilized in fractional stochastic calculus to obtain the value of derivative contracts. We design a variety of derivative contracts considering the risk profile of both the buyers and sellers of spectrum. Through a detailed numerical study, we examine the value of these derivative contracts for changes in spot price volatility and the parameters that define the contracts.

Liability drives insurers' businesses. This paper examines the structural model approach of credit risk for the valuation of insurance liabilities and insurers' equity, and considers a stochastic process for liability. Grosen and Jørgensen's (2002) study presents the current approach taken by insurers; however, the model's structure is very simple, and its liability structure in particular has a deterministic time function. In contrast, we analyze a model that analytically evaluates an insurer's liability with the stochastic process. Furthermore, we analyze the model's default option originally presented by Myers and Read (2001).

This paper studies the pricing problem of group lending using the strength model and the Monte Carlo simulation method. Simulating the default process of farmers with a Poisson process, this paper describes the default distribution for farmers, and based on which the paper establishes the pricing model of the group lending and obtains the critical number of the defaulted farmers and the default probability for the group. Next, this paper introduces the t-Copula function to describe the default correlation between farmers, and obtains the partially analytical solution of the loan rate for the group lending, and it also provides the Monte Carlo simulation algorithm for the pricing of group lending based on t-Copula function. Finally, this paper carries out the Monte Carlo simulation algorithm on the pricing problem of group lending with three and five peasant households through an example, and discusses the relationship between the loan rate and each of the influencing factors in the pricing model of the group lending.

This study examines the regulatory hypothesis for bank dividend payouts using a panel dataset of 229 Italian banks over the period 2005–2012. Regulatory hypothesis suggests that undercapitalized banks face more regulatory pressure for increasing capital levels by paying lower amount of dividends. Empirical results support the regulatory hypothesis by finding that the Italian banks having lower equity to total assets ratios or lower regulatory capital ratios retain more profits and pay lower amount of dividends. Results also suggest that dividend payer banks try to maintain dividends at previous level by not skipping or reducing dividends. Results further support that Fama and French (2001)'s three characteristics of dividend payers are also applicable to banks. That is, big-in-size, more profitable and low growth Italian banks pay higher amount of dividends. Findings of this study have important implications for recent regulatory proposals that suggest a direct regulation of dividends. A direct regulation of dividends, on one hand, and regulatory pressure on dividend payout decisions through capital requirements, on the other hand, may have unintended consequences for dividends as signaling and agency cost reducing tools.

The aim of this paper is to examine the performance and efficiency changes of commercial banks in Japan and Taiwan. Banks in both countries operate in similar environments: nationally oriented with protected domestic banking market. Data envelopment analysis (DEA) is applied to a panel of 6 nationwide banks in Japan and 12 in Taiwan between 2006 and 2011 and utilizes a Malmquist index to measure the relative importance of productivity changes. In this mode, five input variables (i.e., number of branches, number of employee per branch, share in total assets, share in total loans, and share in total deposits) and five output variables (i.e., ROA, ROE, net interest income/total assets, net interest income/total operating income, and non-interest income/total assets) are utilized. The results indicated that 2008 financial crisis did profoundly impact performance for commercial banks in Taiwan in terms of TE, SE and TFP, but did not seem to have great impact on the TE and TFP for commercial banks in Japan. It is found that the relative importance of productivity changes decline after 2008 financial crisis for Taiwanese group. However, Japanese group shows slight affects in terms of technical change and total factor productivity (TFP) change. These findings suggest that there is still some catching-up for the inefficient banks in Japan and Taiwan to be more competitive with the intention of facing a more globalized competition after 2008 financial crisis.