A stochastic dominance approach to financial risk management strategies

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

Journal of Econometrics, 2015, vol. 187, issue 2, 472-485

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 (search for similar items in EconPapers)
JEL-codes: C22 C53 G11 G17 G32 (search for similar items in EconPapers)
Date: 2015
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (11)

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Related works:
Working Paper: A Stochastic Dominance Approach to Financial Risk Management Strategies (2014)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:econom:v:187:y:2015:i:2:p:472-485

DOI: 10.1016/j.jeconom.2015.02.032

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