Asset Shocks Research Articles

Semi-Metric Portfolio Optimization: A New Algorithm Reducing Simultaneous Asset Shocks

This paper proposes a new method for financial portfolio optimization based on reducing simultaneous asset shocks across a collection of assets. This may be understood as an alternative approach to risk reduction in a portfolio based on a new mathematical quantity. First, we apply recently introduced semi-metrics between finite sets to determine the distance between time series’ structural breaks. Then, we build on the classical portfolio optimization theory of Markowitz and use this distance between asset structural breaks for our penalty function, rather than portfolio variance. Our experiments are promising: on synthetic data, we show that our proposed method does indeed diversify among time series with highly similar structural breaks and enjoys advantages over existing metrics between sets. On real data, experiments illustrate that our proposed optimization method performs well relative to nine other commonly used options, producing the second-highest returns, the lowest volatility, and second-lowest drawdown. The main implication for this method in portfolio management is reducing simultaneous asset shocks and potentially sharp associated drawdowns during periods of highly similar structural breaks, such as a market crisis. Our method adds to a considerable literature of portfolio optimization techniques in econometrics and could complement these via portfolio averaging.

Market Efficient Portfolios in a Systemic Economy

Diversification vs. Diversity – How is the Efficiency of Markets Affected? Prices aggregate information that is dispersed in the economy; they thereby facilitate the allocation of scarce resources. Inefficiencies may arise from deviations of market prices from their fundamental values. In “Market Efficient Portfolios in a Systemic Economy”, Awiszus, Capponi, and Weber investigate the impact of the trade-off between diversity and diversification on inefficiencies in secondary markets due to asset illiquidity and leverage constraints of financial institutions. The authors identify two key determining factors. These are the systemic significance of the banks and the statistical properties of the fundamental asset shocks. Systemic significance is driven by the banks’ target leverage, their trading strategies, and the illiquidity characteristics of the assets. The paper demonstrates that portfolio diversification is typically not efficient. In fact, efficient portfolio holdings may strongly deviate from this standard paradigm, especially if the banks have similar characteristics.

Impact of household shocks on access to healthcare services in Kenya: a propensity score matching analysis

ObjectiveThis study examines the effects of household shocks on access to healthcare services in Kenya. Shocks are adverse events that lead to loss of household income and/or assets.Design and settingThe...

New Determinants of Sovereign Risk Premia: Identification through Asset Price Shocks, Credit Premia, and Financial Cycle Synchronization

Do asset price shocks and credit premia affect sovereign risk premia? Sovereign credit risk in developed countries was essentially non-existent prior to 2009. We find new factors suggesting that a part of sovereign risk premia is exogenously determined. We capture a novel phase synchronization among asset prices and credit premia that is associated with an increase in the cost of public debt. We start by showing that the financial and economic impact of credit premia, and asset price shocks have changed over time, even though the magnitude of the shocks is similar across different episodes. To explain this change, we suggest that the magnitude of the effect is different in 2008 because there is “phase synchronization” where financial cycles (a la Claessens, Kose, and Terrones, 2012) and credit cycles are synchronized in an unprecedented boom and bust episode. To test this hypothesis, we propose a novel econometric procedure, by introducing a Markov-Switching VAR model, and matching it with estimated asset shock episodes (a la Blanchard and Gali, 2009) and credit booms (Jorda, Schularick, and Taylor, 2013). Once we establish the relationship between the cycles and the financial and economic aggregates, we estimate impulse response functions to find that only during the phase synchronization the magnitude of the effect is strong with a clear sign across the whole time period and transmits to the sovereign credit market.

From agent-based modeling to actor-based reactive systems in the analysis of financial networks

We present a new framework for the analysis of financial networks, called Actor-based Reactive Systems (ARS), that pushes further the Agent-Based approach (ABM) by resorting to ideas coming from the study of distributed systems in computer science. Two distinctive features, namely a fundamentally different management of time and a fully decentralized control logic, have a profound impact in terms of expressiveness of analysis, flexibility of modeling, and efficiency of experimentation. To illustrate the feasibility of the framework, we develop a realistic case study by analyzing the systemic risk of a model of the European banking network with a nontrivial contagion procedure, that combines an initial asset shock with the negative feedback loop triggered by asset fire sales. We show that, compared to ABMs, ARSs bring about finer-grained analyses, with a greater degree of heterogeneity and adaptivity of economic agents. Moreover, the very low computational cost and the detailed account of the system’s execution support the design and the development of very flexible stress tests to rapidly experiment with many hypothetical scenarios in a test-oriented style.

Influence of Bloomberg’s Investor Sentiment Index: Evidence from European Union Financial Sector

A part of the financial literature has attempted to explain idiosyncratic asset shocks through investor behavior in response to company news and events. As a result, there has been an increase in the development of different investor sentiment measurements. This paper analyses whether the Bloomberg investor sentiment index has a causal relationship with the abnormal returns and volume shocks of major European Union (EU) financial companies through a sample of 85 financial institutions over 4 years (2014–2018) on a daily basis. The i.i.d. shocks are obtained from a factorial asset pricing model and ARMA-GARCH-type process; then we checked whether there is both individual and joint causality between the standardized residuals. The results show that the explanatory capacity of the shocks of the firm Bloomberg sentiment index is low, although there is empirical evidence that the effects correspond more to the situation of the financial subsector (banks, real estate, financial services and insurance) than to the company itself, with which we conclude that the sentiment index analyzed reflects a sectorial effect more than individual one.

Simulation of interactive contagion between depositors' panic and banking risk

AbstractContagion (spread of harmful idea) and control of bank risk have been an eternal topic in the field of financial research. In this paper, we firstly use the savings mechanism to combine the social network of depositors with the network of balance sheets in the banking system to build multiple networks for the banking industry. Secondly, aiming at the heterogeneity of depositors, construct an improved SIS model based on node attitudes to represent the decision‐making process of a bank run during the spread of panic emotions in social networks. Finally, three sets of simulation experiments were designed using a multi‐agent model to analyse the interaction between bank risk contagion and depositor panic contagion under initial asset shocks, the sensitivity of two types of risk contagion, and bank risk contagion under initial rumour shocks. Results show that: (i) The contagion of bank risks and the spread of panic emotions of depositors will affect each other, which will further expand the scope of the spread of bank risk and panic emotions; (ii) depositors in social networks are more likely to be affected by the negative emotions around them; (iii) The key to stabilizing the banking system, while sufficient liquidity can effectively help the banking system resist rumour attacks.

Did the 2008 Financial Crisis (Literally) Change Minds?

This paper investigated whether experiencing a major asset shock (30% or greater decrease in total assets) changed the cognitive health trajectories of older adults (aged 65+ at baseline)? There is a robust literature supporting a relationship between potentially modifiable environmental and individual risk factors and cognitive health and emerging literature supporting a relationship between physical health shocks and later-life financial stability in both the US and internationally. This analysis employed six waves of Health and Retirement Study Core Data (2006-2014) to estimate the causal effect of major asset losses in the period of the 2008 financial crisis. We matched respondents using a rich variety of covariates including education, race/ethnicity, income, total assets, chronic health conditions, depressive symptoms, frequency of physical activity engagement, and engagement with religious activities. Using both propensity score-matched growth curve and difference-in-differences models, we found a small, but significant, negative relationship between major asset shocks and total cognition scores. We also identified a significant overall negative effect on total cognition on all older adults in this sample regardless of exposure to asset shocks. Additionally, both the frequency of asset shock exposure and magnitude of effect on total cognition scores was larger for low-income African-American and Hispanic older adults. These findings suggest in part that recovery from large economic crises may be especially difficult for older adults occupying vulnerable socioeconomic positions and that such events may accelerate the cognitive decline of those who are at or near retirement when asset shocks occur.

When Faced with Income and Asset Shocks, Do Poor Rural Households in Vietnam Smooth Food Consumption or Assets?

Vietnamese rural households are exposed to severe covariate and idiosyncratic shocks. However, these households are remarkably resilient and have steadily increased real income and consumption over the survey period 2006 to 2012. To explain household strategies to cope with shocks we test three theoretical models: the Permanent Income Hypothesis (PIH), Complete Market Hypothesis (CMH), and Asset Smoothing Theory (AST). There is support for AST as households smooth productive assets rather than consumption; and for CMH as households smooth consumption against idiosyncratic, but not covariate shocks. There is no support for PIH.

Insurers as Asset Managers and Systemic Risk

Financial intermediaries often provide guarantees that resemble out-of-the-money put options, exposing them to tail risk. Using the U.S. life insurance industry as a laboratory, we present a model in which variable annuity (VA) guarantees and associated hedging operate within the regulatory capital framework to create incentives for insurers to overweight illiquid bonds (reach-for-yield). We then calibrate the model to insurer-level data, and show that the VA-writing insurers' collective allocation to illiquid bonds exacerbates system-wide fire sales in the event of negative asset shocks, plausibly erasing up to 20-70% of insurers' equity capital.

Structural GARCH: The Volatility-Leverage Connection

We propose a new model of volatility where financial leverage amplifies equity volatility by what we call the “leverage multiplier”. The exact specification is motivated by standard structural models of credit; however, our parametrization departs from the classic Merton (1974) model and is, as we show, flexible and accurate enough to capture environments where the firm’s asset volatility is stochastic, asset returns can jump, and asset shocks are non-normal. As a result, our model also provides estimates of daily asset returns and asset volatility. In addition, our specification nests both a standard GARCH and the Merton model, which allows for a simple statistical test of how leverage interacts with equity volatility. Empirically, the Structural GARCH model outperforms a standard GARCH model for approximately 75% of the financial firms we analyze. We then apply the Structural GARCH model to two empirical applications: the leverage effect and systemic risk measurement.

Household Shocks and Education Investments in Madagascar

AbstractThis paper investigates the impact of exogenous shocks to household income, assets and labour supply on children's school attendance in Madagascar. The analysis uses a unique data set with 10 years of recall data on school attendance and household shocks. We find that the probability of a child dropping out of school increases significantly when the household experiences an illness, death or asset shock. We propose a test to distinguish whether the impact of shocks on school attendance can be attributed to credit constraints, labour market rigidities, or a combination of the two. The results suggest that credit constraints, rather than labour market rigidities, explain the inability of households in Madagascar to keep their children in school during times of economic stress.

Are target leverage ratios stable? Investigating the impact of corporate asset restructuring

Abstract If firms balance the benefits and costs of leverage, then we might expect corporate asset shocks to trigger a change in corporate target leverage. We investigate the impact of corporate asset restructuring and find that target leverage after restructuring is reduced for downsizing firms and increased for upsizing firms. Changes in target leverage are stabilized by the second year after the restructuring event and are monotonic relative to the degree of restructuring. Decomposition analysis shows that corporate asset restructuring directly and significantly affects target debt ratios. Compared to control firms, downsizing firms adjust claims by repurchasing debt while upsizing firms issue debt securities. As expected, debt repurchases are associated with lower tax liabilities while debt issuance decisions correspond to lower growth proxies and are consistent with a higher adverse selection cost of issuing equity, positive leverage deficit, higher tax liabilities, and lower bankruptcy risk.

Effects of the Great Recession: Health and Well-Being

The existing evidence linking recessions to individual and population health presents a puzzle. Some studies show that people who experience the kinds of labor market, housing, and asset shocks that proliferate in recessions suffer negative health consequences, whereas other studies show that mortality rates fall when the economy worsens. This review synthesizes evidence from these distinct research traditions in light of emerging findings from the Great Recession of 2007–2009. It traces pathways by which macroeconomic changes “get under the skin” and generate contradictory aggregate- and individual-level consequences. Research on the longer-term health effects of recessions could be strengthened by integrating theoretical and analytical approaches from sociology. These include a multilevel perspective that considers how individuals cope with recessions as members of families and communities embedded in different policy environments, and attention to cascades of recessionary shocks, individuals' strategies for coping with them, and the way these intersect with health trajectories.

Structural GARCH: The Volatility-Leverage Connection

We propose a new model of volatility where financial leverage amplifies equity volatility by what we call the “leverage multiplier.” The exact specification is motivated by standard structural models of credit; however, our parameterization departs from the classic Merton (1974) model and can accommodate environments where the firm’s asset volatility is stochastic, asset returns can jump, and asset shocks are non-normal. In addition, our specification nests both a standard GARCH and the Merton model, which allows for a statistical test of how leverage interacts with equity volatility. Empirically, the Structural GARCH model outperforms a standard asymmetric GARCH model for approximately 74 percent of the financial firms we analyze. We then apply the Structural GARCH model to two empirical applications: the leverage effect and systemic risk measurement. As a part of our systemic risk analysis, we define a new measure called “precautionary capital” that uses our model to quantify the advantages of regulation aimed at reducing financial firm leverage.

Household Shocks and Education Investment in Madagascar

This paper measures the extent to which households in Madagascar adjust children’s school attendance in order to cope with exogenous shocks. We model the household’s decisions to enroll children in school, and remove them from school, and measure the impact on these decisions of shocks to household income, assets and labor supply. In order to explore these questions more fully, we use a unique dataset with ten years of recall data on school attendance and household shocks. We estimate hazard models of school entry and exit, and measure the effect of shocks on these decisions. The probability of dropping out of school is significantly increased when a child’s household experiences an illness, death or asset shock. The presence of a health and nutrition program in the local school is associated with earlier school entry and reduced probability of dropout among enrolled students.

Strengthening Banks' Portfolio Against Asset Shocks: A Genetic Computational Approach

This thesis investigates models of market risk assessment based on genetic algorithms, with specific reference to asset portfolio choice under volatile market conditions. It does so by developing computational simulations of asset portfolios, which are then subjected to stressful price events. A genetic algorithm functions as an optimising process, allowing portfolios to evolve towards a structure that is – on average – less fragile against asset shocks. The importance of this research is dictated by the grave outcomes of, for instance, the 2008 financial crisis: 371 commercial banks failed between 1/1/2008 and 1/7/2011 in the United States alone. Such events highlighted the need for the renovation of the financial risk framework supposed to at least partially shield banks from unexpected adverse events.A synthetic, computational model is constructed, where asset portfolios are structured so as to invest in four main asset categories: sovereign bonds, financial institutions bonds, corporate bonds and real estate. Each of the categories has an underlying non-normal probability distribution of prices, empirically derived by the literature. These are used to simulate volatile and adverse scenarios affecting the value of the portfolios. A genetic algorithm is designed to select, crossover and mutate, at each generation, the portfolios that best perform under the simulated conditions. After a number of generations, it is expected that one or more portfolios structures will be highlighted as the ones that best perform under adverse scenarios.The model is run three times with different sets of optimization constraints, each specifying the minimum relative proportion of portfolios to be dedicated to each asset category. All versions of the model indicate that the best performing portfolios structures under volatile conditions are the ones that are mainly composed by the asset category featuring less fat tails. The results of the model are checked for their robustness, by running versions with different sets of simulated scenarios and additional numbers of synthetic asset categories. Limitations of the design of the study are identified. The model lacks a simulation of the liability side of financial institutions, and its results are not tested on a systemic level, thus not shedding light on what consequences the indicated portfolio strategy for a single bank would have on the network of banks. Such issues will be addressed in future research.

Probability of living through a period of economic instability

Welfare Based on Assets, a Way to Smooth Out Economic Instability and Develop Children's Human Capital is a four-part series of reports that focuses on the relationship between economic instability (i.e., income shocks, asset shocks, home loss, and asset poverty) and children's human capital development. Collectively, these reports build on the compelling observation that the pattern low-income families walk into is a present time oriented or consumption based pattern of behavior; in contrast, the pattern higher income families walk into is future oriented or asset based. In this first paper we find that between 2005 and 2009 the probability of a low-income child living through an income shock is between 43% (major shock) and 55% (minor shock). In contrast, the chance of a high-income child experiencing an income shock is between 6% (major shock) and 15% (minor shock) during the same period. We also find that the probability that a child will experience a net worth asset shock close to doubles for a child living in a black or low-income family between 2005 and 2009 when compared to 2000 and 2004. Policy implications are discussed.

The effects of economic instability on children's educational outcomes

Abstract Welfare Based on Assets, a Way to Smooth Out Economic Instability and Develop Children's Human Capital is a four-part series of papers that focuses on the relationship between economic instability (i.e., income shocks, asset shocks, home loss, and asset poverty) and children's human capital development. Collectively, these reports build on the compelling observation that the pattern low-income families walk into is a present time oriented or consumption based pattern of behavior; in contrast, the pattern higher income families walk into is future oriented or asset based. In the third paper we find in most cases income shocks and asset shocks do not appear to be harmful to children's educational outcomes. However, children living in liquid and net worth asset poor families have lower academic achievement scores, high school graduation rates, college enrollment rates, and college graduation rates than children living in families that are asset sufficient. Overall, findings can be interpreted as suggesting that a bifurcated welfare system, with income-based programs for poor families and asset-based programs for higher income families, may provide higher income families with an educational advantage over low-income families and might ultimately help exacerbate educational inequalities in America.

An investigation of techniques for testing structural stability in banks: A comparative study

There has been a revival of fundamental Islamic values in several countries throughout the world. The basic characteristic of an Islamic banking system is the prohibition of the payment or receipt of a predetermined interest rate which is considered usury. The Islamic system substitutes predetermined interest rate with the principle of profit-loss sharing, which transforms banks into equity-based firms. The principle of profit-loss sharing seems to be the cure for instability. The traditional banking practice of paying depositors a fixed (predetermined) interest, regardless of whether or not the bank is doing well, prevents banks from instantaneously adjusting to potential asset shocks. Such rigidity can lead to possible financial instability. The Islamic interest-free banking system can provide immunity against bank failure and financial instability, because this system redistributes the consequences of uncertainty over all parties to a business. By spreading the same risk over more heads, the Islamic interest-free system would promote stability. Key words: Islamic banking system, traditional banking, financial instability, business,profit-loss sharing, depositors.