A Stochastic Dominance Approach to Financial Risk Management Strategies

14 Pages Posted: 2 Jul 2015

See all articles by Chia-Lin Chang

Chia-Lin Chang

National Chung Hsing University - Department of Applied Economics, Department of Finance

Juan-Angel Jiménez-Martin

Complutense University of Madrid

Esfandiar Maasoumi

Emory University

Teodosio Perez Amaral

Complutense University of Madrid - Facultad de Económicas y Empresariales

Date Written: April 1, 2014

Abstract

The Basel III Accord requires that banks and other Authorized Deposit-taking Institutions (ADIs) communicate their daily risk forecasts to the appropriate monetary authorities at the beginning of each trading day, using one of a range of alternative risk models to forecast Value-at-Risk (VaR). The risk estimates from these models are used to determine the daily capital charges (DCC) and associated capital costs of ADIs, depending in part on the number of previous violations, whereby realized losses exceed the estimated VaR. In this paper we define risk management in terms of choosing sensibly from a variety of risk models and discuss the optimal selection of the risk models. Previous approaches to model selection for predicting VaR proposed combining alternative risk models and ranking such models on the basis of average DCC, or other quantiles of its distribution. These methods are based on the first moment, or specific quantiles of the DCC distribution, and supported by restrictive evaluation functions. In this paper, we consider robust uniform rankings of models over large classes of loss functions that may reflect different weights and concerns over different intervals of the distribution of losses and DCC. The uniform rankings are based on recently developed statistical tests of stochastic dominance (SD). The SD tests are illustrated using the prices and returns of VIX futures. The empirical findings show that the tests of SD can rank different pairs of models to a statistical degree of confidence, and that the alternative (recentered) SD tests are in general agreement.

Keywords: Stochastic dominance, Value-at-Risk, daily capital charges, violation penalties, optimizing strategy, Basel III Accord, VIX futures, global financial crisis

JEL Classification: G32, G11, G17, C53, C22

Suggested Citation

Chang, Chia-Lin and Jiménez-Martin, Juan-Angel and Maasoumi, Esfandiar Essie and Perez Amaral, Teodosio, A Stochastic Dominance Approach to Financial Risk Management Strategies (April 1, 2014). Journal of Econometrics, Forthcoming, Available at SSRN: https://ssrn.com/abstract=2591620

Chia-Lin Chang

National Chung Hsing University - Department of Applied Economics, Department of Finance ( email )

Taichung, Taiwan
China

Juan-Angel Jiménez-Martin

Complutense University of Madrid ( email )

Complutense University of Madrid
Campus de somosaguas
Pozuelo de Alarcon, Madrid 28223
Spain
+34 91 3942355 (Phone)

HOME PAGE: http://www.ucm.es/fundamentos-analisis-economico2/jajm

Esfandiar Essie Maasoumi (Contact Author)

Emory University ( email )

1602 Fishburne Drive
Atlanta, GA 30322
United States

HOME PAGE: http://economics.emory.edu/home/people/faculty/Maasoumiesfandiar_Home.html

Teodosio Perez Amaral

Complutense University of Madrid - Facultad de Económicas y Empresariales ( email )

Madrid, 28223
Spain

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