James Ming Chen

Measuring Market Risk Under the Basel Accords: VaR, Stressed VaR, and Expected Shortfall

Each of the most recent accords of the Basel Committee on Banking Regulation, known as Basel II, 2.5, and II, has embraced a different primary measure of market risk in global banking regulation: traditional value-at-risk (VaR), stressed VaR, and expected shortfall. After introducing the mathematics of VaR and expected shortfall, this note will evaluate how well the reforms embraced by Basel 2.5 and III - stressed VaR and expected shortfall - have addressed longstanding regulatory concerns with traditional VaR.Part I describes the calculation of VaR in its conventional form. For illustrative purposes, Part I will describe parametric VaR on a Gaussian distribution. Part II summarizes known weaknesses in VaR, from inherent model and estimation risk to VaR’s failure to perform under extreme economic stress and VaR’s failure to satisfy the theoretical constraints on “coherent” measurements of risk. Part III describes how to calculate expected shortfall as an extension of conditional VaR. It further describes how expected shortfall, but not VaR, provides a coherent measure of risk. Part III then reverses field. It explains how VaR, but not expected shortfall (or, for that matter, nearly every other general spectral measure of risk), satisfies the mathematical requirement of “elicitability.” Mathematical limitations on measures of risk therefore force regulators and bankers to choose between coherence and elicitability, between theoretically sound consolidation of diverse risks (on one hand) and reliable backtesting of risk forecasts against historical observations.

Biodiversity and Biotechnology: A Misunderstood Relation

Biodiversity and biotechnology, according to received wisdom, can scarcely coexist. The global south is home to most of earths threatened and endangered species, while the global north holds the capital and technology needed to develop this natural wealth. The south argues that intellectual property laws enable pharmaceutical companies and seed breeders in the industrialized north to commit biopiracy. Advocates for less developed countries urge legal parity for each sides source of value, either through a reduction in the protection accorded conventional forms of intellectual property or through formal recognition of traditional knowledge. By contrast, the United States has characterized the Convention on Biological Diversity as a threat to the global life sciences industry in general and to American life sciences companies in particular. Both sides magnify the significance of the dispute, having reached an apparent consensus that commercial exploitation of genetic resources holds the key to biodiversity conservation. I contest these conventional views of the relationship between biodiversity and biotechnology. Both sides of the debate have overstated the significance of bioprospecting. Commercial development aids biodiversity primarily by overcoming perverse economic incentives to consume scarce natural resources that may turn out to have greater value from a global, long-term perspective. It is erroneous to frame the issue as whether intellectual property in the abstract can coexist with the international legal framework for preserving biodiversity. I expose this fallacy through the application of three conceptual filters: genotypes versus phenotypes, genes versus memes, and pharmaceutical versus agricultural applications of biotechnology. To be sure, the notion of intellectual property is elastic enough to embrace all of the intangible assets at stake, including raw genetic resources, advanced agricultural and pharmaceutical research, and the ethnobiological knowledge that often transforms a locally useful organism into a globally valued application of biotechnology. It will not do, however, merely to acknowledge that intellectual property can be reshaped to embrace ethnobiological know-how and other forms of traditional knowledge. Whether traditional knowledge should be treated as an independent form of intellectual property presents an altogether distinct question. Ethnobiological knowledge should not be given proprietary status. As a general rule, intellectual property should be recognized only when it would spur innovation. With respect to biological knowledge already diffused within a traditional community, intellectual property confers no additional incentive to invent or discover. These ideas therefore belong in the global public domain.

Law on the Market? Abnormal Stock Returns and Supreme Court Decision-Making

Do judicial decisions affect the securities markets in discernible and perhaps predictable ways? In other words, is there “law on the market” (LOTM)? This is a question that has been raised by commentators, but answered by very few in a systematic and financially rigorous manner. Using intraday data and a multiday event window, this large scale event study seeks to determine the existence, frequency and magnitude of equity market impacts flowing from Supreme Court decisions. We demonstrate that, while certainly not present in every case, ”law on the market” events are fairly common. Across all cases decided by the Supreme Court of the United States between the 1999-2013 terms, we identify 79 cases where the share price of one or more publicly traded company moved in direct response to a Supreme Court decision. In the aggregate, over fifteen years, Supreme Court decisions were responsible for more than 140 billion dollars in absolute changes in wealth. Our analysis not only contributes to our understanding of the political economy of judicial decision making, but also links to the broader set of research exploring the performance in financial markets using event study methods. We conclude by exploring the informational efficiency of law as a market by highlighting the speed at which information from Supreme Court decisions is assimilated by the market. Relatively speaking, LOTM events have historically exhibited slow rates of information incorporation for affected securities. This implies a market ripe for arbitrage where an event-based trading strategy could be successful.

Progressive Taxation: An Aesthetic and Moral Defense

The power to tax is at once the power to create and the power to destroy. If the United States government hopes to discharge its primary duty as creator and protector of its citizens’ wealth, it must be willing to destroy wealth, from time to time, by redistributing it. More than any other tool, the means by which government finances and depletes its treasury affects the societal distribution of wealth. Differential taxation and targeted spending are the most significant and most effective means by which government can “gradually and continually...correct the distribution of wealth to prevent concentrations of power detrimental to the fair value of political liberty and fair equality of opportunity.” Redistribution and the attendant destruction of entrenched wealth serve as society’s ultimate weapons of “creative destruction.” Of the many forces that have propelled the United States to the economic, political, social, and military pinnacle of the modern world, its willingness to countenance radical technological and organizational upheaval probably ranks first. American prosperity depends on the federal government’s commitment to an economic environment in which citizens are able not only to amass large amounts of new wealth, but also to lose it in rapid and remorseless fashion.

The Vertical Dimension of Cooperative Competition Policy

Competition policy in the United States is formed at multiple levels, and the sovereigns that formulate this policy often clash with each other. A phalanx of state laws must be reconciled with federal policies designed to ensure a nationwide common market. The United States uses two bodies of law to reconcile federalism with a national policy favoring interstate competition. These two approaches - antitrust immunity and the dormant commerce clause - are antagonistic in practically every important detail. Whereas antitrust immunity protects state and local freedom to restrain trade, the dormant commerce clause adopts precisely the opposite solution of protecting a national interest in free trade. The tension between these bodies of law parallels the fundamental dilemma of international competition policy. The American experience in coordinating its conflicting sources of competition policy therefore informs comparable efforts in the European Union and on the world stage.

The Intertemporal Capital Asset Pricing Model

Conventional asset pricing models assume, rather unrealistically, that investors live for exactly a single time span, during which they will confront no potential changes in consumption preferences, liquidity needs, or tolerance for risk. Robert Merton’s intertemporal capital asset pricing model fills this theoretical gap. Among other applications, the intertemporal CAPM accommodates consumption smoothing across different life stages. The desire to preserve future investment or consumption opportunities may justify holding assets that counterbalance potential decline in more rewarding but riskier components of a portfolio.

Price-Level Regulation and Its Reform

Price-level, or “price-cap,” regulation offers an alluring alternative to the traditional technique of monitoring a regulated firm’s profits. Part II of this article contrasts price-level regulation with conventional cost-of-service ratemaking and with Ramsey pricing. Price-level regulation stands as a market-based, incentive-driven “third way” between traditional regulation and complete deregulation. Part III provides formal specifications of price-level regulation. Although some jurisdictions have set price caps according to operating cost and rate-of-return calculations that clearly parallel those steps in conventional ratemaking, this article will focus on price-level methodologies that combine an economy-wide measure of inflation with an x-factor reflecting total factor productivity within a regulated industry.Part IV addresses the simpler component of price-level regulation, the choice of an inflation index. Part V devotes detailed attention to the treatment of the x-factor by two federal ratemaking agencies, the Federal Energy Regulatory Commission (FERC) and the Federal Communications Commission (FCC). Closer examination of price cap methodologies adopted by FERC and the FCC suggests that price-level regulation based on inflation and an industry-specific X factor may be further streamlined. Part VI describes how price-level regulation might be accomplished through the application of a single, industry-specific index of input costs.

Sinking, Fast and Slow: Bifurcating Beta in Financial and Behavioral Space

Modern portfolio theory accords symmetrical treatment to all deviations from expected return, positive or negative. This assumption is vulnerable on both descriptive and behavioral grounds. Many of the predictive flaws in contemporary finance stem from mathematically elegant but empirically flawed Gaussian models. In reality, returns are skewed. The presumption that returns and volatility are symmetrical also defies human behavior. Losing hurts worse than winning feels good; investors do not react equally to upside gain and downside loss. Moreover, correlation tightening during bear markets, not offset by changes in correlation during bull markets, suggest that standard diversification strategies may erode upside returns without providing adequate protection during times of stress.This article outlines mathematical tools for calculating volatility, variance, covariance, correlation, and beta, not merely across the entire spectrum of returns, but also on either side of mean returns. It pays special attention to beta. Beta is a composite measure that reflects changes in volatility and in correlation as returns move across either side of their expected value. Beta’s separate components address the distinct managerial concerns arising from loss aversion (or upside speculation) and from changes in correlation under different market conditions. Bifurcating beta in financial space describes both phenomena and anticipates the behavioral response to volatility and correlation in falling markets — problems appropriately described as sinking, fast and slow.

Truth and Beauty: Finance in Econophysical Translation

espanolEn mi reciente texto, Econofisica y Valoracion de Precios Financieros: Escindiendo el Atomo del Riesgo Sistematico, se divide la Beta, unidad basica de riesgo sistematico en el modelo de valoracion de activos financieros, en componentes subatomicos (barionicos), por analogia con el modelo estandar de la Fisica de particulas. Este articulo presenta las ideas preliminares de la aplicacion de la Fisica a otras dimensiones de las Finanzas. Un enfoque mas completo abordaria la integracion de la Econofisica y la representacion espacial, desde la perspectiva de la valoracion de activos financieros, del co-movimiento de las empresas individuales, mercados de capitales y de la economia real con las dimensiones informacional y temporal de las finanzas. Este articulo tambien hace un esfuerzo en la representacion de las finanzas a traves de la Fisica en un amplio contexto tanto cientifico como estetico. EnglishMy recent book, Econophysics and Capital Asset Pricing: Splitting the Atom of Systematic Risk, splits beta, the capital asset pricing model’s basic unit of systematic risk, into subatomic (or “baryonic”) components, by analogy to the Standard Model of particle physics. This essay offers preliminary thoughts on the application of physics to other dimensions of finance. A more comprehensive approach would integrate Econophysics and Capital Asset Pricing’s spatial representation of comovement between individual firms, capital markets, and the real economy, with the informational and temporal dimensions of finance. This essay also places efforts at representing finance through physics in their broader scientific and aesthetic context.

The Impact of Relative Seniority between Bank Debt and Deposit on Bank Credit Spreads under Stressful Conditions

Using a new structural model of credit risk based on the normal instead of the lognormal firm value dynamics and market price implied asset value volatility as the model volatility input, we quantify the value of credit spreads of the four largest U.S. banks had their senior unsecured bonds ranked pari-passu with bank deposits under the market conditions from 2006 to 2015. Since 1994 senior bank bonds are subordinated to bank deposits in the event of liquidation. And during the financial crises of 2008-2009 and 2011, the maximum 5-year bank credit spread among the four largest banks was over 400 basis points for the senior/subordinated bank capital structure, whereas the maximum 5-year bank credit spread would be slightly above 100 basis points under the same stressful conditions for the pro-rata bank capital structure, where senior bank bonds and deposits have equal seniority. Thus, the pro-rata bank capital structure will enhance both the ability of banks to serve as credit intermediaries during financial crisis and the overall resiliency of the financial system.