A Stochastic Dominance Approach to Financial Risk Management Strategies

Chia-Lin Chang, Juan Jimenez-Martin, Esfandiar Maasoumi and Teodosio Pérez-Amaral ()

No 2014-08, Documentos de Trabajo del ICAE from Universidad Complutense de Madrid, Facultad de Ciencias Económicas y Empresariales, Instituto Complutense de Análisis Económico

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 financial risk models. A previous approach to model selection for predicting VaR proposed combining alternative risk models and ranking such models on the basis of average DCC. This method is based only on the first moment of the DCC distribution, supported by a restrictive evaluation function. In this paper, we consider uniform rankings of models over large classes of evaluation 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. (search for similar items in EconPapers)
JEL-codes: C22 C53 G11 G17 G32 (search for similar items in EconPapers)
Pages: 33 pages
Date: 2014, Revised 2014-04
New Economics Papers: this item is included in nep-ban, nep-cba, nep-cfn, nep-ore and nep-rmg
Note: The authors are most grateful to Michael McAleer for many comments and suggestions. For financial support, the first author wishes to thank the National Science Council, Taiwan, and the second and fourth authors acknowledge the Ministerio de Economía y Competitividad and Comunidad de Madrid, Spain.
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Journal Article: A stochastic dominance approach to financial risk management strategies (2015)
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