Michael S. Gibson

Can Bank Health Affect Investment? Evidence from Japan

Does weakness in the banking sector adversely affect the real economy? If so, how large is the effect? In this article, the author answers these questions for Japan in 1991-92. He tests whether a firms investment is sensitive to the financial health of its main bank, controlling for stock market valuation and cash flow. Investment is lower by 30 percent at firms that have one of the lowest-rated banks as their main bank. Because the weakest banks deal with few firms, the estimated effect of the problems in the banking sector on the Japanese economy during this period is small. Copyright 1995 by University of Chicago Press.

Evaluating forecasts of correlation using option pricing

A forecast of the correlation between two asset prices is required to price or hedge an option whose payoff depends on both asset prices or to measure the risk of a portfolio whose return depends on both asset prices. However, a number of factors make it difficult to evaluate forecasts of correlation. We develop a forecast evaluation methodology based on option pricing, extending a technique that Engle et al. (1993) introduced to evaluate volatility forecasts. A forecast of the variance-covariance matrix of joint asset returns is used to generate a trading strategy for a package of simulated options. The most accurate forecast will produce the most profitable trading strategy. The package of simulated options can be chosen to be sensitive to correlation, to volatility, or to any arbitrary combination of the two. In an empirical application, we focus on the ability to forecast the correlation between two stock market indices. We compare the correlation forecasting ability of three more sophisticated models (two GARCH models and a two-state Markov switching model) and two simple moving averages. We find that the more sophisticated models produce better correlation forecasts than the simple moving averages.

An International Survey of Stress Tests

In the summer of 2000, central banks from the Group of Ten countries surveyed large international banks about their use of stress tests_a risk management tool that measures a firms exposure to extreme movements in asset prices. The survey findings highlight the risks that most concern financial institutions and clarify how these institutions use stress tests in their overall risk management programs.

'Big Bang' Deregulation and Japanese Corporate Governance: A Survey of the Issues

In November 1996, Japanese Prime Minister Hashimoto announced a Big Bang policy to deregulate Japanese financial markets. Following a period of planning, implementation of the Big Bang began in April 1998 when all remaining restrictions on foreign exchange transactions were removed. It is scheduled to continue through March 2001. A listing of the deregulation agenda is dominated by measures to remove restrictions on how banks and securities firms do business and allow cross-entry of banks, securities firms, and insurers into each others’ businesses (Table 12.1).

Measuring Counterparty Credit Exposure to a Margined Counterparty

Firms active in OTC derivative markets increasingly use margin agreements to reduce counterparty credit risk. Making several simplifying assumptions, I use both a quasi- analytic approach and a simulation approach to quantify how margining reduces counterparty credit exposure. Margining reduces counterparty credit exposure by over 80 percent, using baseline parameter assumptions. I show how expected positive exposure (EPE) depends on key terms of the margin agreement and the current mark-to-market value of the portfolio of contracts with the counterparty. I also discuss a possible shortcut that could be used by firms that can model EPE without margin but cannot achieve the higher level of sophistication needed to model EPE with margin.

The Implications of Risk Management Information Systems for the Organization of Financial Firms

Financial dealer firms have invested heavily in recent years to develop information systems for risk measurement. I take it as given that technological progress is likely to continue at a rapid pace, making it less expensive for financial firms to assemble risk information. I look beyond questions of risk measurement methodology to investigate the implications of risk management information systems. By examining several theoretical models of the firm in the presence of asymmetric information, I explore how a financial firms capital budgeting, incentive compensation, capital structure, and risk management activities are likely to change as it becomes less costly to assemble risk information. I also explore the likely effects of the falling cost of assembling risk information on a financial firms organizational structure. Two common themes emerge: centralization within the firm and increased disclosure of risk information outside the firm are both likely to increase.