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Open Access Publications from the University of California

Coleman Fung Risk Management Research Center Working Papers 2006-2013

The Center for Risk Management Research was established on July 1, 2013 as the successor to the Coleman Fung Risk Management Research Center. We are grateful for the generous support of Coleman Fung, founder of Open Link Financial, Inc. over the period 2007-2013, which permitted the establishment of the Center.

The Center focuses on the management of risk within the context of financial markets, including equity, commodity and fixed income markets, and derivatives on those markets. The Center's goal is to address the most important and pressing issues in risk management and portfolio management. This means fostering outstanding research, drawing on the best ideas and practices from the academic and practitioner communities, and collaborating with top individuals from both backgrounds. Research at the Center will be an interdisciplinary effort involving graduate students and researchers from a broad array of disciplines, including economics, statistics, finance, engineering, computer science and mathematics. It will seek to publish in the leading academic and practitioner journals, and to elevate the practice of risk management.

Cover page of Equity Risk Premium and Insecure Property Right

Equity Risk Premium and Insecure Property Right


How much of the equity risk premium puzzle can be attributed to the insecure property rights of shareholders? This paper develops a version of the CCAPM with insecure property rights (stochastic taxes). The model implies that the current expected equity premium can be reconciled with a coefficient of relative risk aversion of3:76, thus resolving the equity premium puzzle.

Cover page of Risk Without Return

Risk Without Return


Risk-only investment strategies have been growing in popularity as traditional investment strategies have fallen short of return targets over the last decade. However, risk-based investors should be aware of four things. First, theoretical considerations and empirical studies show that apparently distinct risk-based investment strategies are manifestations of a single eect. Second, turnover and associated transaction costs can be a substantial drag on return. Third, capital diversication benefits may

be reduced. Fourth, there is an apparent connection between performance and risk

diversication. To analyze risk diversification benets in a consistent way, we introduce the Risk Diversification index (RDI) which measures risk concentrations and complements the Herndahl-Hirschman index (HHI) for capital concentrations.

Cover page of In Search of a Statistically Valid Volatility Risk Factor

In Search of a Statistically Valid Volatility Risk Factor


Theory predicts that aggregate volatility ought to be a priced risk factor. In an influential study with more than 1000 citations on Google Scholar, Ang, Hodrick, Xing, and Zhang (2006) propose an ex post factor, FVIX, intended as a proxy for aggregate volatility risk. Their test validating FVIX relies on an OLS regression

of portfolio excess returns on FVIX and other independent variables over the data period February 1986 - January 2001. October 1987 is an outlier, in which FVIX exhibits a 26-sigma deviation. The inclusion of this outlier results in a reduction of the regression standard error by more than a factor of two, creating the appearance of statistical signicance when none is present. We explain how standard statistics

can be used to assess the suitability of a dataset for OLS regression.

Cover page of Efficient Monte Carlo Counterparty Credit Risk Pricing and Measurement

Efficient Monte Carlo Counterparty Credit Risk Pricing and Measurement


Counterparty credit risk (CCR), a key driver of the 2007-08 credit crisis, has become one of the main focuses of the major global and U.S. regulatory standards. Financial institutions invest large amounts of resources employing Monte Carlo simulation to measure and price

their counterparty credit risk. We develop efficient Monte Carlo CCR frameworks by focusing on the most widely used and regulatory-driven CCR measures: expected positive exposure (EPE), credit value adjustment (CVA), and effective expected positive exposure (eEPE). Our numerical examples illustrate that our proposed efficient Monte Carlo estimators outperform the existing crude estimators of these CCR measures substantially in terms of mean square error (MSE). We also demonstrate that the two widely used sampling methods, the so-called Path Dependent Simulation (PDS) and Direct Jump to Simulation date (DJS), are not equivalent in that they lead to Monte Carlo CCR estimators which are drastically different in terms of their MSE.

Cover page of Conditional Risk Premia in Currency Markets and Other Asset Classes

Conditional Risk Premia in Currency Markets and Other Asset Classes


The downside risk CAPM (DR-CAPM) can price the cross section of currency returns. The market-beta differential between high and low interest rate currencies is higher conditional on bad market returns, when the market price of risk is also high, than it is conditional on good market returns. Correctly accounting for this variation is crucial for the empirical performance of the model. The DR-CAPM can jointly explain

the cross section of equity, commodity, sovereign bond and currency returns, thus offering a unified risk view of these asset classes. In contrast, popular models that have been developed for a specic asset class fail to jointly price other asset classes.

Cover page of Finance at Center Stage: Some Lessons of the Euro Crisis

Finance at Center Stage: Some Lessons of the Euro Crisis


(from the introduction...)

Finance and financial markets were at the heart of the global economic crisis

that began in August 2007. Despite having subsided elsewhere by 2010, the global crisis

left an ongoing legacy of turbulence in the euro zone. My argument in this essay is that

the euro zone’s continuing turmoil, like that of the world economy in 2007‐09, is rooted

in financial vulnerabilities that were not well envisioned in the defenses set up by EMU’s

architects. If the euro is to survive, EMU’s institutions must evolve to overcome these

vulnerabilities. The necessary changes will have profound effects on the future shape of EMU, effects significant enough to require changes in EU political arrangements

alongside more technical financial reforms.

Cover page of Self-Enforcing Clawback Provisions in Executive Compensation

Self-Enforcing Clawback Provisions in Executive Compensation


A clawback provision is the right of a firm to recover from an executive’s compensation as the result of triggering events, such as a financial restatement. We argue that the adoption of clawback provisions may exacerbate a manager’s incentive to avoid financial restatements via earnings management. Only when the accounting verifiability is high, making earnings management very costly, can clawback provisions completely eliminate the manager’s incentive to misreport ex-ante; otherwise, clawback provisions stipulate a reduction of future executive compensation in the event of a financial restatement. We show firms still benefit from implementing clawback provisions, while earnings management is costless. This result may explain why companies voluntarily adopt clawback provisions, in spite of the detrimental effect of earnings management.