Journal of Risk

Farid AitSahlia

Warrington College of Business Administration, University of Florida

The current issue of The Journal of Risk continues to publish papers that relate directly to the recent financial crisis. It includes papers addressing various facets of risk management in the form of regulatory mandates and systemic risk, information decay in credit ratings, liquidity-constrained hedging of derivatives, and the apportionment of aggregate risk among constituents.

The first paper, by Sandra Gaisser, Christoph Memmel, Rafael Schmidt and Carsten S.Wehn, “Time dynamic and hierarchical dependence modeling of a supervisory portfolio of banks: a multivariate nonparametric approach”, contains an empirical evaluation of regulator-approved market risk models of eleven German banks and the implications of this evaluation for systemic risk. The study accounts for dynamic and cross-sectional dependence, which is especially critical in deteriorating market conditions. In contrast with similar recent studies that rely on the assumption of normally distributed asset returns, this study makes use of copulas, which are more flexible tools. Among their findings the authors highlight the decrease in bank portfolio dependence during times of improved economic conditions and associate increases with deteriorating markets.

The second paper, “Estimating future transition probabilities when the value of side information decays, with applications to credit modeling”, by Craig Friedman, Jinggang Huang andYangyong Zhang, addresses the general problem of aggregating various types of information where, due to differences in updating frequencies, an account of information decay needs to be made. The authors develop a model that employs classical entropy principles and apply it to credit rating transitions, demonstrating that their method is very competitive in terms of out-of-sample predictions. One of the salient features of modern financial markets is the preponderance of derivative contracts whose hedging is performed using generally liquid underlying assets. In neoclassical financial theory, derivative prices are unique and reflect market completeness with zero hedging costs. However, these contracts often trade infrequently and typically cannot be fully hedged without additional supporting capital. In “Markets, profits, capital, leverage and return”, by Peter Carr, Dilip B. Madan and Juan Jose Vicente Alvarez, the authors contribute to the recently developed theory of two-price markets by deriving explicit procedures for the evaluation of capital requirements, leverage and associated returns and profits.

The concluding paper, “Ordered contribution allocations: theoretical properties and applications”, by Patrick Cheridito and Eduard Kromer, deals with a general risk-allocation problem. A number of constituents, such as individual firms, traders or employees, affect uncertain payouts through their actions, with the resulting collective risk apportioned among them. While this problem has traditionally been dealt with under strict assumptions regarding the risk measure (for example, coherency, convexity and differentiability), the authors develop an approach that eschews such restrictions and is applicable to, among other risk measures, the widely adopted valueat- risk. As a second application the authors propose a nonlinear tax scheme to control the emission of environmental pollutants such as carbon dioxide.