Macrofinancial Risk Analysis / Edition 1

by Dale Gray, Samuel Malone

Overview

Macrofinancial risk analysis


Dale Gray and Samuel Malone


Macrofinancial Risk Analysis provides a new and powerful framework with which policymakers and investors can analyze risk and vulnerability in economies, both emerging market and industrial. Using modern risk management and financial engineering techniques applied to the macroeconomy, an economic value can be placed on the risks posed by inter-linkages between sectors, the risk of default of different sectors on their outstanding debt obligations quantified, and the value ex-ante of guarantees to private sector entities by the government calculated. This book guides the reader through the basic macroeconomic and financial models necessary to understand the framework, the core analytical tools, and more advanced contributions that will be of interest to researchers. This unique synthesis of ideas from finance and macroeconomics offers several original contributions to the theory of financial crises, as well as a range of new policy options for governments interested in achieving a better tradeoff between economic growth and macro risk.

Product Details

ISBN-13:	9780470058312
Publisher:	Wiley
Publication date:	04/28/2008
Series:	The Wiley Finance Series
Pages:	368
Product dimensions:	6.91(w) x 9.78(h) x 1.06(d)

About the Author

Dr. DALE GRAY is the Senior Risk Expert in the Monetary and Capital Markets Department of the International Monetary Fund (IMF). He is founder and President of Macro Financial Risk, Inc. (Mf Risk) a pioneer in the application of risk management tools to economies (board members include Robert Merton and Zvi Bodie). He has worked for investment banks, hedge funds, Moody’s Investors Service, IMF, World Bank, IFC as well as advising governments on macro risk analysis, management of sovereign wealth funds, and the design of risk mitigation strategies. He has worked on over thirty countries, is a frequent lecturer with numerous publications. He has a Ph.D. from MIT, MS from Stanford and is a certified Financial Risk Manager.

Dr. SAMUEL W. MALONE is a professor of finance at the IESA, a business school in Caracas, and director of ProAlea, Inc., a risk and strategy consultancy based in Latin America.  He holds a doctorate in economics from the University of Oxford, UK, and undergraduate degrees in mathematics and economics from Duke University, where he graduated Phi Beta Kappa with summa cum laude Latin honors. Elected to attend Oxford as a Rhodes Scholar representing the United States, Malone is also a four-time winner of the international Mathematical Contest in Modeling, an intensive problem-solving competition in which participants devise and write up solutions to real-world problems chosen by experts in government and industry. Author of several articles in applied mathematics and economics, he has consulted for the International Monetary Fund and the Inter-American Development Bank in Washington, DC.

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Table of Contents

Foreword xv

Preface xix

1 Introduction 1

Part I Overview of Finance, Macroeconomics, and Risk Concepts 7

2 An Overview of Macroeconomics, and Why the Theory of Asset Pricing and Contingent Claims Should Shape its Future 9

2.1 An overview of macroeconomics 10

2.2 How uncertainty is incorporated into macroeconomic models 13

2.3 Missing components in macro models: balance sheets with risk, default, and (nonlinear) risk exposures 15

2.4 Asset-pricing theory, financial derivatives pricing, and contingent claims analysis 17

2.5 Autoregression in economics vs. random walks in finance 19

2.6 Asset price process related to a threshold or barrier 21

2.7 Relating finance models and risk analytics to macroeconomic models 23

2.8 Toward macrofinancial engineering 24

2.9 Summary 25

References 26

3 Macroeconomic Models 29

3.1 The Hicks–Hansen IS-LM model of a closed economy 29

3.2 The Mundell–Fleming model of an open economy 33

3.3 A dynamic, stochastic, five-equation, small open economy macro model 38

3.4 Summary 42

References 42

4 Stochastic Processes, Asset Pricing, and Option Pricing 43

4.1 Stochastic processes 43

4.2 Itô’s lemma 46

4.3 Asset pricing: Arrow–Debreu securities and the replicating portfolio 47

4.4 Put and call option values 48

4.5 Pricing the options using the Black–Scholes–Merton formula 50

4.6 Market price of risk 52

4.7 Implications of incomplete markets for pricing 54

4.8 Summary 55

Appendix 4A Primer on relationship of put, call, and exchange options 55

Appendix 4B Physics, Feynman, and finance 57

References 57

5 Balance Sheets, Implicit Options, and Contingent Claims Analysis 59

5.1 Uncertain assets and probability of distress or default on debt 59

5.2 Probability of distress or default 60

5.3 Debt and equity as contingent claims 61

5.4 Payoff diagrams for contingent claims 62

5.5 Understanding why an implicit put option equals expected loss 63

5.6 Using the Merton model and Black–Scholes–Merton formula to value contingent claims 64

5.7 Measuring asset values and volatilities 68

5.8 Estimating implied asset value and asset volatility from equity or junior claims 68

5.9 Risk measures 71

5.10 Summary 72

References 72

6 Further Extensions and Applications of Contingent Claims Analysis 73

6.1 Extensions of the Merton model 73

6.2 Applications of CCA with different types of distress barriers and liability structures 74

6.3 Risk-adjusted and actual probabilities using the market price of risk, Sharpe ratios, and recovery rates 78

6.4 Moody’s-KMV approach 80

6.5 CCA using skewed asset distributions modeled with a mixture of lognormals 81

6.6 Maximum likelihood methods 84

6.7 Incorporating stochastic interest rates and interest rate term structures into structural CCA balance sheet models 85

6.8 Other structural models with stochastic interest rates 86

6.9 Summary 87

Appendix 6A Calculating parameters in the Vasicek model 87

References 88

Part II the Macrofinance Modeling Framework 91

7 The Macrofinance Modeling Framework: Interlinked Sector Balance Sheets 93

7.1 Contingent claim balance sheets for sectors 93

7.2 Measuring asset values and volatilities 98

7.3 Measuring risk exposures 100

7.4 Linkages in a simple four-sector framework 100

7.5 Integrated value and risk transmission between sectors 101

7.6 Policy effectiveness parameters in implicit options 105

7.7 Advantages of an integrated balance sheet risk approach 106

7.8 Summary 106

References 107

8 The Macrofinance Modeling Framework: A Closer Look at the Sovereign CCA Balance Sheet 109

8.1 CCA balance sheet for the government and monetary authorities 109

8.2 Sovereign distress 111

8.3 Calculating implied sovereign assets and implied sovereign asset volatility using CCA for the public sector balance sheet 111

8.4 Applications of the macrofinancial risk framework to sovereigns 115

8.5 Sovereign risk-neutral and estimated actual default probabilities on foreign-currency-denominated debt 117

8.6 Spreads on sovereign foreign currency and local currency debt 118

8.7 Breaking down sovereign assets into key components 122

8.8 Risk-based scenario and policy analysis using calibrated sovereign CCA related to spreads on foreign currency debt 123

8.9 Short-term and long-term government CCA balance sheets with monetary authority 124

8.10 Summary 126

Appendix 8A Value and volatility of local currency liabilities and base money 126

References 127

9 The Macrofinance Modeling Framework: Linking Interest Rate Models in Finance and Macroeconomics 129

9.1 Overview of interest rate term structure models in finance 129

9.2 Two early theories: liquidity preference and the market for loanable funds 131

9.3 Monetary policy, Taylor rules, and interest rates 131

9.4 Reconciling different perspectives on interest rate behavior 133

9.5 What to do when the monetary authority is linked closely to the government balance sheet 135

9.6 Summary 136

References 137

10 Macrofinance Modeling Framework: Financial Sector Risk and Stability Analysis 139

10.1 Calculating risk indicators for individual banks or financial institutions 139

10.2 Time series of financial system risk indicators 140

10.3 Snapshot of system risk 145

10.4 Expected loss as a portfolio of implicit put options 146

10.5 Using a structural Merton model with stochastic interest rates for capital adequacy estimates 149

10.6 Factor model to assess key drivers of system risk and for scenario analysis 150

10.7 Multifactor risk analysis using copulas 152

10.8 Household balance sheet risk 152

10.9 Linking banking sector loans to corporate, household, and other borrowers 153

10.10 Foreign-currency-denominated loans and the impact of the presence of foreign banks on banking system risk 154

10.11 CCA models, financial stability indicators and links to macro models 155

10.12 Summary 159

Appendix 10A CCA model for banks and borrowers with foreign-currency-denominated debt and lending spreads based on credit risk 160

References 161

11 Macrofinancial Modeling Framework: Extensions to Different Exchange Rate Regimes 163

11.1 Floating exchange rate regimes, interest rates, and the sovereign balance sheet 163

11.2 Fixed exchange rate regimes, interest rates and the sovereign balance sheet 167

11.3 The impact of capital flows on the CCA sovereign balance sheet 172

11.4 Role of quasi-public entities in exchange rate management 173

11.5 Summary 174

References 174

Part III Linking Macrofinancial and Macroeconomic Frameworks 175

12 Sovereign Reserve, Debt, and Wealth Management from a Macrofinancial Risk Perspective 177

12.1 Reserves adequacy and asset allocation: moving from simple rules to a national framework 177

12.2 CCA for a firm with a subsidiary and its wealth management 179

12.3 Constructing contingent claim balance sheets for the national economy 180

12.4 Macro risk and wealth management 181

12.5 Summary 184

References 185

13 Macrofinancial Modeling Framework: Relationship to Accounting Balance Sheets and the Flow of Funds 187

13.1 Economy-wide macro contingent claim balance sheets and risk exposures 187

13.2 Recovering traditional macroeconomic budget constraints and flow identities from CCA valuation equations when volatility is zero 191

13.3 Interlinkages between CCA balance sheets, flows, and risk premiums 195

13.4 Using the production function to link corporate and household assets 197

13.5 Macrofinance, macroeconomic flows, and the business cycle 198

13.6 Summary 199

Appendix 13A Cross-holding by households and financial sectors of contingent claims in other sectors 200

Appendix 13B Contingent claim values and returns of different sectors 201

References 202

14 Macrofinancial Risk Framework Linked to Macroeconomic Models 203

14.1 Adding risk analytics to the spectrum of macroeconomic models 203

14.2 The Mundell–Fleming model and default risk 204

14.3 Linking macrofinance outputs to DSGE models 206

14.4 Linking macrofinance outputs to dynamic, stochastic macroeconomic policy models 208

14.5 Linking macrofinance outputs to macroeconometric VAR models 215

14.6 An integrated policy framework 216

14.7 Summary 217

References 217

Part IV Crisis and Distress in Economies 219

15 Macroeconomic Models vs. Crisis Models: Why Nonlinearity Matters 221

15.1 Recent financial crises and crisis models 222

15.2 Summary 229

References 229

16 Sensitivity Analysis, Destabilization Mechanisms, and Financial Crises 231

16.1 Sensitivity analysis, the “Greeks”, and the valuation multiplier effect 232

16.2 The volatility leverage effect 236

16.3 Feedback between the forward rate and domestic interest rates on local currency debt 237

16.4 Feedback between local currency debt issuance and local currency spreads in the presence of contingent liability constraints 241

16.5 Summary 244

References 245

17 The Case of Thailand, 1996–1999 247

17.1 Background 247

17.2 A macrofinance analysis of the Thai crisis 249

17.3 Scenario analysis 253

17.4 Summary 255

Appendix 17A Banking and corporate sector risk analysis with scenarios 257

References 258

18 The Brazil Crisis of 2002–2003 259

18.1 Background 259

18.2 A macrofinance analysis of the Brazil crisis 261

18.3 Summary 266

References 266

Part V Macrofinancial Model Applications and Analytical Issues 267

19 International Shocks, Risk Transmission, and Crisis Prevention: Backdrop for Understanding the 2007–08 Global Financial Credit Turmoil 269

19.1 Changing global environment and global risk 270

19.2 Types of global shocks and the interaction with macrofinancial risk models 277

19.3 The international financial system and crisis prevention 281

19.4 Structuring an effective risk-management hierarchy from the international level down to the country authorities 282

19.5 Summary 283

References 283

20 Macro Risk Management: Ways to Mitigate, Control, and Transfer Risk in the Economy 285

20.1 Overview of ways to manage risk 285

20.2 Direct change in financial structure 287

20.3 Risk transfer 288

20.4 Management of guarantees 290

20.5 Longer-term risk management via institutional and policy change 293

20.6 Summary 294

References 294

21 Integrated Framework for Corporate and Sovereign Relative Value and Capital Structure Arbitrage 297

21.1 Capital structure arbitrage for firms and financial institutions 297

21.2 Credit and equity cycles 299

21.3 Sovereign capital structure relative value 300

21.4 Summary 302

References 302

22 Conclusions and New Directions for Macrofinance 303

22.1 Summary of conceptual issues 303

22.2 The roadmap for an integrated contingent claims analysis-macroeconomic Model 306

Reference 309

Appendix A Mundell–Fleming with a Risk Premium 311

A. 1 The model 311

A. 2 Equilibrium 315

A. 3 Monetary and fiscal policy 317

A. 4 Summary 321

References 322

Index 323