Risk Management and Value

The following sections are included:

• CONTENTS

• INTRODUCTION

This chapter develops a simple option pricing model when markets can make sudden jumps in the presence of incomplete information. Incomplete information can be defined in the context of Merton's (1987) model of capital market equilibrium with incomplete information. In this context, analytic formulas can be derived for options using the Black–Scholes (1973) approach as in Bellalah (1999). The option value depends upon the probability and magnitude of jumps and a continuous volatility. The model is useful in explaining the smile effect and in extracting information costs. The model can be applied to hedging strategies for different strike prices and can be used for the valuation of different types of options. It can also be used in the identification of mispriced options. Some simulations are run with and without shadow costs of incomplete information. We run some simulations to extract information costs using market data. Our model can be used to estimate information costs in different markets.

This chapter deals with a delta-normal VaR application in the case of small developing economy. It assesses the exchange risk associated to the Tunisian public debt portfolio. We use daily spot exchange rates of the Tunisian dinar against the three main currencies composing the long run public debt portfolio, the dollar, the euro, and the yen. We are interested in the period from 1 January 1999 to 30 June 2006.

We firstly demonstrate that the VaR approach can be used for a small developing economy provided that time series are neither too long nor too short. For daily data, we show that the optimal length to validate the assumption normality is annual.

Secondly, we prove that the euro is the refuge value for managing the exchange risk in the Tunisian case. Only the systematic risk measured by the calculated betas associated to the dinar exchange rate versus the euro is negative. The component VaR analysis ascertains that the Japanese yen is the main source of exchange risk for the Tunisian debt portfolio. On the contrary, the euro constitutes a natural hedge against this risk. The euro component VaR values are slightly negative or null.

Finally, we demonstrate that the VaR diversification degree is stable throughout the studied period. The non-diversified VaR represents 65% of the total VaR.

Financial institutions face the important task of estimating the controlling of their exposure to market risk, which arises through different risk factors in their portfolio. Measurement of market risk has focused on a metric called Value at Risk (VaR). VaR quantifies the maximal amount that may be lost in a portfolio for a given period of time, at certain confidence level. For large portfolios the risk factor can be taken as an index. In this chapter, we come up with a method of estimating Historical VaR for a portfolio that reflects the S&P CNX Nifty index at any point of time. We assume that the value of index X (t) is independent of time and the distribution of X (t) is not necessarily Gaussian.

There is a large volume of financial literature related to factors that could have an influence on economic growth. Some of these factors can be under the influence of corruption. The main result of this study is the evidence that there is a direct relationship between corruption and economic growth.

Weather is the major uncontrollable factor that influences the development of agricultural and industrial products. Because there is a strong correlations between the fluctuation of production volume and the weather. Unanticipated changes of weather conditions cause important fluctuations on companies' revenues and profits. They also create evidently effects on general economic trends. Such effects have derived weather risk management concept and new financial instruments as named weather derivatives. The term weather derivatives applies to a fairly new class of weather risk management tolls that are structured like put options, call options, and swaps in the capital markets. By using a weather derivative, the company's profit levels are less dependent on foreign exchange rates as minimum incomes are projected in advance, and financial forecasts are more accruate and predictable. The strengthened risk management portfolio, combined with more transparent account, and revenue stability, also results in a lower cost of debt and makes corporate development and expansion planning easier. Weather derivatives mostly being used by developed countries are traded in the organized and OTC markets. Henceforth, they hedge lots of industries' financial statements against corrosion of weather risk, and present multi-functional advantages to users. In this article, we have analyzed the structure of weather derivatives, and discussed the applicability of these non-used financial instruments for Türkiye.

Securitization and credit derivatives are now commonly used by European Banks as tools in dynamic assets and liabilities management in order to optimize the allocation of regulatory capital by main activities and to increase their profitability through developing a maximum credit capacity with a more sensitive risk management.

In this chapter we wish to address the consequences of the implementation of the Basel II framework on securitizations in Europe, using data collected in QIS 5, and try to determine if it will change their utilization by European banks in their strategic allocation of capital.

We show that under the new framework, securitization does not lead to an economy in regulatory capital, and that considering the wide range of results under the Internal Rating Based approaches, we need to undertake a microeconomic analysis of the securitization portfolio of an international bank to measure the impact of the implementation of the new framework on traditional and synthetic securitizations.

The purpose of this chapter is to verify whether the stochastic time change leading to a Gaussian representation of the conditional asset returns density is best represented by the number of trades. We use the same procedure then on Ané and Geman (2000) to estimate the four first moments of the latent stochastic time change/information flow that permits to recover the normality of stock returns, using a sample of LSE highly traded stocks. We are able to show empirically that the moments greater than one of the stochastic time changes coincide virtually with the moments of the number of trades. Then, we recenter the number of trades so as to have the same mean than the stochastic time change. The distribution of returns conditioned on the recentered number of trades does not correspond to the normal case. We argue that, in our data, the choice of the cumulative number of trades to represent the economic clock is not adequate. Finally, we explain why we find such results which are in line with recent empirical findings, in particular Murphy and Izzeldin (2005) and Gillemot et al. (2005).

In this chapter, I investigate implied volatility surface patterns for call options on crude oil futures. Instead of studying the power of the large number of explanatory factors inherent in oil markets, I focus on the common characteristics of option prices. By using quadratic implied volatility functions (IVFs), I aim to establish a mapping from implied volatilities to the option's intrinsic characteristics, i.e. moneyness and time to expiration, and to test the capacity of these functions to provide a good forecast of option prices. I found that the profile of crude oil implied volatility is too complex to be fully explained by IVFs. The main aim to the chapter is to perform an econometric explanatory analysis on a high volatile market, the petroleum market.

Many authors emphasize the procyclicity of the capital ratio to explain financial instability. The extent of the debates leads us to question on the procyclicity of loan loss provisions (LLP). Few works were interested in the procyclical character of the policy of provisioning. However, the accounting practices as regards provisioning of the loans losses adopted by the banks can reinforce financial instability.

The objective of this contribution is to study the determinants of the pro-cyclical behavior of loan loss provisions in response to the interrogations caused by the new regulation of Basel II. We analyze the procyclical behavior of the universal banks in the constitution of loan loss provisions. An empirical model on panel data is then adopted by the European banks of 1992–2004. The results are in conformity with those obtained in the former literature to know that the banks adopt procyclical behavior as regards provisioning. We show that when we separately consider the banks according to their degree of diversification (of the activities) the results which we obtain are different. These results enable us to have interesting conclusions like the taking into account the risk weighted asset reduces the volatility of loan loss provisions during the cycle much more for diversified banks than for specialized banks. The findings of our research are consistent with the empirical work of Laeven and Majnoni (2003), and of Bikker and Metzemakers (2005) who show that the banks fund more the loans losses in economic downswings than in economic upswings for a whole of the OECD countries.

This chapter presents a study of the banking competition on the credit market, taking into account the banks' market power and their probability of success. Initially, we study the banking behavior in the case of the simultaneous entry on the market and we find that the diminution of the probability of success and the raise of the number of banks reduce the credit interest rate. This is the effect of the improvement of the quality of credit portfolio and of the increase in the banking competition. Another result is that the huge difference among probabilities of success can imply the exit of the market by the banks with poor quality of credit portfolio. Then, in the case of sequential entry on the market, we analyze the role of the probability of success, i.e. quality of bank portfolio, on the gain of the market shares. Basing on Tabuchi and Thisse's (1995) paper, we show that the leader is always localizing in the center of the market, that is, where the number of clients is most important, but it can abandon the center if the follower improves considerably the quality of its credit portfolio.

The aim of this paper is to predict banking distress resulting from capitalization problems in order to justify the viability of Prompt Corrective Actions in Europe. In particular, I examine the impact of the “safety net” and the role of rating agencies through negative credit watches, using a binomial logit model in order to predict European commercial banks capital stress and to test the contribution of institutions and regulatory factors. I also study the impact of concentration and moral hazard generated by deposit insurance on banking stability. My results are in line with previous findings in the literature and demonstrate not only a negative influence of institutional and regulatory factors on European banking systems' distress probability but also a significant role for the rating agencies. In addition, the quality of national regulatory frameworks including supervision restrains considerably moral hazard and excessive risk taken by European commercial banks.

The Romanian insurance market is very heterogeneous and, in this context, for the year 2005, three different insurance companies could be identified having together 50% from total gross written premiums. January the first was the starting point of future development, since Insurance Supervision Commission had already been informed on foreign insurers' intentions to provide financial services on this market. The main goal of this study was to analyze the determinants for the Romanian insurance companies' market share and its relationship with the degree of concentration and the most important finding was that the Romanian market is an oligopoly.

The existence of closed-end funds discounts/premiums, although an issue largely studied, it is still puzzling both academics as well as practitioners. As it is well known, they result from the difference between the value of the shares of the fund, determined by the market, and their net asset value (the market value of the securities held by the fund, less the liabilities). Taking into account that the closed-end fund shares are traded on the stock exchange, as well as the assets included on their portfolios, no discrepancies would be expected (at least theoretically) between the market value of the funds and their net asset values, since the market should be able to adjust and correct the prices, due to the fact that the information is widely diffused.

In attempt to explain this “puzzle” several theories have been suggested. On one hand, those based on rational factors, such as: potential tax liabilities due to unrealized capital gains, the dividend policy, the fund portfolio composition, agency costs and management performance and, on the other hand, those based on behavioral factors, such as the investor sentiment theory. This latter framework, at least theoretically is, in our view, the one that seems to better explain almost all the features of the “puzzle”, trying not only to explain the existence of discounts but also the existence of premiums and their behavior among the funds themselves and over time.

In this context, we developed our research trying to explain the existence and persistence of the discounts/premiums. We also investigate the correlation between the discounts/premiums of those funds among themselves and each other over time, the mean reversion of the discounts/premiums, as well as the predictability power of the fund shares and of the net asset value returns. It was also our objective to search for the relevance of the investor sentiment theory in order to explain the discounts/premiums, so that we used Brauer's (1993) methodology and the signal extraction technique of French and Roll (1986).We also carried out (as far as we know, for the first time) a panel data analysis in order to check how much of the discounts/premiums variability is due to the presence of “noise traders”.

This research was based on a sample of North-American closed-end funds, which invest mainly on stocks and/or bonds traded on the NYSE or on the AMEX, during the period from January 1987 to June 1999 (inclusive). The data was collected from the Wiesenberger database.

From the results that we got, we noticed that there seems to exist an indication of the presence of “noise traders” on the closed-end funds market which, in turn, seems to confirm the assumptions of the investor sentiment theory: the discounts/premiums were positively correlated, were mean reverted and had some predictability power in terms of fund share returns but not so much in relation to their net asset value returns. Nevertheless, we observed that the estimated proportion of the variance of standardized weekly discounts changes, explained by the investor sentiment on the total period studied, was only 8.6%. Also, the results from the panel data analysis seem to suggest the relatively low importance of the investor sentiment theory to explain those discounts/premiums.

This paper documents the evolution of idiosyncratic volatility across a sample composed by the main 250 European listed companies between 1987 and 2003, and investigates the corporate determinants. We estimate two measures of financial volatility based on the decomposition of CAPM and on the model of Campbell et al. (2001). We show that both the industry-level and the firm-level volatilities have increased significantly between 1987 and 2003, whereas the market-level component has stayed relatively stable over the sample period. Then, we try to explain this phenomenon by exploring the corporate determinants of this increase. Similarly to Dennis and Strickland (2005), the results of panel data regressions show that the growth of idiosyncratic volatility is significantly correlated with the volume of stocks traded, the movement of corporate refocusing and the reinforcement of institutional investors in the ownership structure of European listed firms.

The interactive impact of the leverage effects of debt, of taxes, of the risk of bankruptcy and the generation of free cash flow, on the enterprise value, is a constant concern for business leaders in order to make investments and financial decisions. We will focus on that topic throwing a new light on recent theoretic developments in the framework of: cost information, cost of bankruptcy, tax savings, coupons, and principal payments of the debt. In this framework, this chapter:

— provides the equity value as a Call of the enterprise value on the debt increased by the coupons effects and the risk of bankruptcy effects;

— demonstrates that the values of the different assets have stochastic drifts μ and volatilities σ

— gives the values of these rates;

— provides an adjusted CAPM and an instantaneous Beta which is stochastic and time-dependent, that better fits with the current reality;

— make the link between the various models studied of which the usual model is of the financial analysts Discounted Cash Flow (DCF).

Research in experimental financial markets suggests that, most people tend to overreact to unexpected, striking, and more recent news, and underreact to ordinary or non-desirable new events. Many researchers document, as a result that, if one of these behavioral designs exist, then stock prices will follow a mean-reversion phenomenon due to investor's overreaction, and a momentum behavior due to investor's underreaction. This study investigates if such behavior affects stock prices on the Tunisian Stock Market. In other words, we tend to discover the eventual existence of return mean-reversion and/or momentum behavior on the Tunisian Stock Market over the period between January 1997 and December 2005. For this purpose, we have applied a contrarian strategy, which consists in buying the previous (12, 18, 24, and 36 months) loser portfolio and selling the past winner portfolio. Our results point out that, over periods of 18, 24, and 36 months, stock returns exhibit statistically significant mean-reversion phenomenon, while, over 12 months periods, stock returns present significant momentum behavior. This means that stock prices are predictable on the basis of their historical recordings without using any accounting data, in contrast to the weak-form efficient market hypothesis.

In an environment characterized by uncertainty and moral hazard, the chapter studies the role and impact of monitoring on the performance of an investor–venture capitalist relationship. Monitoring (ensured by funds of funds in our model) allows minimization of uncertainty concerning the GP behavior and reduces the risk. The impact of monitoring on both the level of effort provided by the GP and the expected return of LP is determined by mean of modeling the expected return of LP and GP. Our main finding concerns the role of monitoring as a mechanism that allows maximization of the investor's return and limits the opportunistic behavior of the venture capitalist by providing him with incentives to raise his effort level.

This chapter studies efficient capital market hypothesis and checks whether adjustment stock prices dynamics is instantaneous, continuous, or linear. In particular, we propose to analyze stock prices evolution while taking into account the presence of transaction costs, the coexistence of heterogeneous investors and the interdependence between stock markets. Thus, we show, on the one hand, that efficiency hypothesis is rejected. On the other hand, we prove that stock indexes adjustment is rather discontinuous, asymmetrical, and nonlinear. While using threshold cointegration techniques, we propose a new nonlinear representation to reproduce CAC40 adjustment dynamics that not only replicates French market adjustment dynamics in presence of market frictions, but also it captures interdependence between French and American stock markets and reaction of French shareholders in relation to American speculators behavior change.

This chapter studies the short-term expectations of unemployment. A simple bounded rationality model (augmented adaptive–extrapolative process) of households' expectations of unemployment was proposed to analyze the microdata of French Household Surveys (ECAM). The households' perceptions of the French labor market was characterized by a pessimistic attitude which came on gradually.

This research aims at pointing out the impact of some governance mechanisms susceptible to influence the managerial risk taking within the Tunisian firms. Therefore, we ought to highlight the specificities of these firms. On the basis of a 46-quoted firm sample observed over a one nine-year period spreading from 1996 to 2004, we draw out some interesting findings. First of all, the firm belonging to a financial industry, the State shareholding, the institutional shareholding, the concentration of the property as well as the accumulation of the functions of manager and chairman of board slow down the managerial risk taking within theTunisian enterprises. However, the industry-based rules and the participation of supervisors into the capital incite the risk taking of Tunisian managers. Furthermore, our results reveal that the latter is positively influenced by both the size and the growth potential of Tunisian firms.

The irruption of the nonlinearity leads to an in-depth transformation of a number of financial fields such as stock exchange decision-making. Nonlinearity leads to a source of infinity of behaviors making, which allows to better understand the phenomena considered complex. Nevertheless, the nonlinear models consider the stocks only by their consequences. Thus, it is proved to be difficult to explain the emergent phenomena due to the interaction of these individual behaviors.

For the last two decades, thanks to the advent of the data-processing techniques, many works have followed one another in shedding light on the behaviors of the markets. The sophisticated tools borrowed from biology, such as the genetic algorithms, have been introduced in the field of finance and stock exchange decision-making.

In this chapter, we have compared the decision-making based on the nonlinear models and the genetic algorithms on the BVMT. It is true that the nonlinear models had a good capacity of estimation, but they lose their quality in term of stock exchange's decision. However, the genetic algorithms had a better capacity (94%) compared to the nonlinear models in the total of the decisions taken.

This chapter aims to identify the determinist relationship between companies, performance and their ICT use. Based on the literature review which seems to support the hypothesis of our research positing that the use of ICT by firms is meant to improve their performance, we developed a stochastic of formulation relationship in which different aspects of the ICT use were retained having explanatory constructs of performance improvement. This relationship was empirically tested based on the data collected from the sample of Tunisian companies.

The obtained results suggest that ICT use by companies contributes to increasing their performance, especially the exporting ones. This study draws attention to the dependence of the performance improvement on the existence of required competences, the Net culture, the horizontal organizational structure, and the use of ICT by partners of the firm.

In this chapter, we study the problem of the bid–ask spread formation on option markets. The market microstructure literature tried to study the behavior of market makers, and the elements they take into account when they calculate the size and the quantities of their spread using three complementary theoretical approaches — transaction costs, inventory costs, and asymmetry information costs. In order to overlap the limits of existing models which are not able to integrate these three types of costs, we developed an empirical approach.

Our research of the French market shows that modeling an option bid–ask spread is first and foremost a question of evaluating this option, and, second, a problem of microstructure. Moreover, the existence of moderate asymmetry information costs shows that this market is not dominated by informed operators, contrary to the generally accepted ideas concerning this type of derivatives market. In addition, we have demonstrated that the stock market liquidity characteristics are transmitted to their option. So, the interactions between the stock and the option spread are strong and the liquidity of the stock market determines the efficiency of the option market.

Enterprise Resource Planning (ERP) systems have currently become tools that enable organizations to standardize business processes. They offer rich functionalities based on best practices. The purpose of this chapter is to study the impact of this standardization on organizations with reference to the different theoretical hypotheses linked to the relation Information Technology / organizational change and according to four firm's cases (Airports of Paris, Pechiney, France Telecom and L'oréal).

This chapter investigates whether macroeconomic and data transparency standards lead to lower borrowing costs in sovereign bond markets. We essentially show that emerging market countries which subscribed to the Special Data Dissemination Standard (SDDS) experienced a significant decline in borrowing cost proxied by sovereign yield spreads on secondary markets. However, the adherence of these markets to the Code of Good Practices on Transparency in Monetary and Financial Policies caused a significant increase in the yield spreads. There is no impact of the adherence to the Code of Good Practices in Fiscal Transparency on the changes of sovereign spreads. In addition, the results suggest that a debtor country's internal liquidity factor (measured by the total reserves to total external debt service ratio) and external liquidity conditions (measured by the yield on US long-term bond) are the most important determinants of emerging market spreads.

The following sections are included:

• INDEX