Iraj Fooladi

Credit risk management: a survey of practices

Purpose – Proposes to investigate the current practices of credit risk management by the largest US-based financial institutions. Owing to the increasing variety in the types of counterparties and the ever-expanding variety in the forms of obligations, credit risk management has jumped to the forefront of risk management activities carried out by firms in the financial services industry. This study is designed to shed light on the current practices of these firms. Design/methodology/approach - A short questionnaire, containing seven questions, was mailed to each of the top 100 banking firms headquartered in the USA. Findings - It was found that identifying counterparty default risk is the single most-important purpose served by the credit risk models utilized. Close to half of the responding institutions utilize models that are also capable of dealing with counterparty migration risk. Surprisingly, only a minority of banks currently utilize either a proprietary or a vendor-marketed model for the management of their credit risk. Interestingly, those that utilize their own in-house model also utilize a vendor-marketed model. Not surprisingly, such models are more widely used for the management of non-traded credit loan portfolios than they are for the management of traded bonds. Originality/value -The results help one to understand the current practices of these firms. As such, they enable us to make inferences about the perceived importance of the risks. The paper is of particular value to the treasurers intending to better understand the current trends in credit risk management, and to academics intending to carry out research in the field.

Designing an immunized portfolio: Is M-squared the key?

Abstract The theoretical and empirical properties of M -squared, a measure of cash flow dispersion used in designing duration-hedged portfolios, are examined. Contrary to prior research, minimizing M -squared is not independent of the stochastic process and the minimum M -squared portfolio is a ‘bullet’ only under a specific, convexity condition derived in the paper. Using a data base of default-free, Government of Canada bonds to set up minimum M -squared, duration-matching portfolios, we find that the convexity property does not hold in general and that minimum M -squared portfolios fail to hedge as effectively as portfolios including a bond maturing on the horizon date.

Duration for bonds with default risk

Abstract Does approximating duration estimates by ignoring default risk lead to error in the two major duration applications — measuring interest — rate price elasticity and immunization? We derive a general expression for duration in the presence of default risk based on Jonkharts term structure model (On the term structure of interest rates and the risk of default, Journal of Banking and Finance 3, 253–262, 1979) extended to encompass risk aversion. The model includes terms for default probabilities and default payoffs in each period as well as for a delay between the occurrence of default and the final default payoff. Our main conclusion is that practical duration applications involving bonds with default risk must employ duration measures adjusted for default risk.

Bond portfolio immunization: Canadian tests

Abstract Based on findings derived from a data base of default-and option-free Government of Canada bonds, our main conclusion is that duration-matching strategies succed in reducing interest rate risk more effectively than strategies that call for matching bond maturity to the length of the planning horizon. The present article stands alone in immunization research in establishing an advantage to duration matching even in the absence of term structure fitting. For this result to stand, care must be taken in the design of appropriate duration-matching strategies.

Risk management with duration analysis

Outlines the development of duration as a risk management tool for fixed income securities, shows how it is calculated and gives examples to illustrate its use in assessing risk exposure and immunizing bond portfolio returns against interest rate risk. Cites research confirming its effectiveness and goes on to discuss the application of duration gaps to balance sheet hedging (macrohedging) by financial institutions and the New Zealand government. Considers some complications of duration analysis due to convexity, stochastic process risk and default risk.

The Relative Valuation of Socially Responsible Firms: an Exploratory Study

Various aspects of “corporate social responsibility” (CSR) have recently captured the attention of researchers in the fields of economics and finance (Orlitzky et al. 2003; Statman 2005; Goss and Roberts 2006; Milevsky et al. 2006). This phenomenon follows more than a decade of research and dozens of studies published largely in the strategic management and business ethics literatures which have striven to explore the links between corporate social performance (variously defined) and corporate financial performance (Waddock and Graves 1997; Roman et al. 1999; Margolis and Walsh 2001; Orlitzky and Benjamin 2001). While one interpretation of these studies may be that the evidence for a causal, or even de facto link between social and financial performance remains elusive, another would be that the balance of evidence suggests that enhanced social performance may be a lagging indicator of effective management and therefore a leading indicator of future financial performance (Wheeler 2003). In their 2003 review of 52 studies internationally, Orlitzky and colleagues were somewhat unequivocal in judging the evidence as favoring social responsibility as a more likely benefit than impairment to investors.

A general theory of the competitive firm under undercertainty

The theory of the firm under uncertainty has been subject to an extensive study but, to the best of the authors knowledge, all studies are restricted to the situation in which either the output prices [e.g., Sandmo, 1971, pp. 6893; Batra & Ullah, 1974, pp. 537-48; and Hartman, 1975, pp. 1289-90] or the input prices [e.g., Okuguchi, 1977, pp. 25-30] are random. The purpose of this paper is to examine systematically the optimal behavior of the competitive firm facing uncertainty in both output and input prices. Although the complexity of the model is increased, greater generality is achieved by allowing all the prices to be uncertain. Not only have all previous papers looked at just one type of uncertainty, but also most of their results are derived assuming a decreasing absolute risk aversion utility function [e.g., Okuguchi, 1977, pp. 2530 and Sandmo, 1971, pp. 68-93]. In this paper, however, all the results are obtained under a weaker assumption of non-increasing absolute risk aversion. Moreover, the technique that is used to determine the marginal impact of uncertainty on the firms behavior may prove useful in other settings as well. In the second part, the overall impact of uncertainty on the optimal behavior of the firm is examined. The third part examines the effect of increased risk on the optimal behavior of the firm. In this part, the impact on the firms behavior of a mean-preserving increase in risk about the output price and input prices is examined separately. The supply function of the firm, i.e., the firms output response to a change in the expected price of output, and the effect of a

Emerging Markets and Financing with Preferred Stocks: The Case of Pacific Rim Countries

Points out that preference shares are much more heavily used in emerging economies than in advanced ones to finance new investment projects and develops a mathematical model to show the conditions under which companies are willing to issue them at a price which will attract investors. Outlines the tax systems in Taiwan, South Korea and New Zealand and uses the model to explain why companies in the former two countries issue preference share but New Zealand firms to not.