Robert R. Bliss

Testing the stability of implied probability density functions

A card reader capable of automatically reading coded information from cards of at least two predetermined widths, the information being encoded in information fields that may vary in the length of columns and rows from card to card, such fields being referenced with respect to two predetermined orthogonal edges on each card. Movable stop fingers and a guiding edge facilitate aligned insertion of a card with respect to the two orthogonal edges. When a card is being advanced through the reader past a reading station, a circuit that is triggered by a column count wheel generates a signal each time that a column of information is in position to be read. This circuit is inhibited by switches that respond to cards of predetermined widths when the trailing edge of a card passes their position, the location of the switches having a predetermined relationship to the last line of coded information to be read on the individual type of card. The circuit can also be inhibited by a signal generated by an encoder upon its detection of an end of text code in the information field. The card reader is shut off at the end of each read cycle by an independent switch responsive to the trailing edge of all cards inserted into the reader.

Derivatives and Systemic Risk: Netting, Collateral, and Closeout

In the U.S., as in most countries with well-developed securities markets, derivative securities enjoy special protections under insolvency resolution laws. Most creditors are “stayed” from enforcing their rights while a firm is in bankruptcy. However, many derivatives contracts are exempt from these stays. Furthermore, derivatives enjoy netting and close-out, or termination, privileges which are not always available to most other creditors. The primary argument used to motivate passage of legislation granting these extraordinary protections is that derivatives markets are a major source of systemic risk in financial markets and that netting and close- out reduce this risk. ; To date, these assertions have not been subjected to rigorous economic scrutiny. This paper critically reexamines this hypothesis. These relationships are more complex than often perceived. We conclude that it is not clear whether netting, collateral, and/or close-out lead to reduced systemic risk, once the impact of these protections on the size and structure of the derivatives market has been taken into account.

The Elasticity of Interest Rate Volatility: Chan, Karolyi, Longstaff, and Sanders Revisited

This paper presents a careful reexamination of Chan, Karolyi, Longstaff, and Sanders (CKLS 1992). By redefining the possible regime shift period in line with evidence from known policy changes and past empirical research, we find evidence that contradicts the major results in their paper. The widely cited conclusion of their paper is that the elasticity of interest rate volatility is 1.5. CKLS also concluded that there was no structural shift in the interest rate process after October 1979. When the structural shift period is defined to be temporary and coincident with the Federal Reserve Experiment of October 1979 through September 1982, we find that there is strong evidence of a structural break. Furthermore, we find evidence that, contrary to CKLSs claim, a moderately elastic interest rate process can capture the dependence of volatility on the level of interest rates, while highly elastic models cannot. In particular, this study finds support for the square-root CIR process. These results are robust to changes in the short- rate data used and the treatment of outliers.

The Stability of Interest Rate Processes

This paper presents a careful reexamination of Chan, Karolyi, Longstaff, and Sanders (CKLS 1992). By redefining the possible regime shift period in line with evidence from known policy changes and past empirical research, we find evidence that contradicts the major results in their paper. The widely cited conclusion of their paper is that the elasticity of interest rate volatility is 1.5. CKLS also concluded that there was no structural shift in the interest rate process after October 1979. When the structural shift period is defined to be temporary and coincident with the Federal Reserve Experiment of October 1979 through September 1982, we find that there is strong evidence of a structural break. Furthermore, we find evidence that, contrary to CKLSs claim, a moderately elastic interest rate process can capture the dependence of volatility on the level of interest rates, while highly elastic models cannot. In particular, this study finds support for the square-root CIR process. These results are robust to changes in the short-rate data used and the treatment of outliers.

Option-Implied Risk Aversion Estimates: Robustness and Patterns

Cross-sections of option prices embed the risk-neutral probability densities functions (PDFs) for the future values of the underlying asset. Theory suggests that risk-neutral PDFs differ from market expectations due to risk premia. Using a utility function to adjust the risk-neutral PDF to produce subjective PDFs, we can obtain measures of the risk aversion implied in option prices. Using FTSE 100 and S&P 500 options, and both power and exponential utility functions, we show that subjective PDFs accurately forecast the distribution of realizations, while risk-neutral PDFs do not. The estimated coefficients of relative risk aversion are all reasonable. The relative risk aversion estimates are remarkably consistent across utility functions and across markets for given horizons. The degree of relative risk aversion declines with the forecast horizon and is lower during periods of high market volatility.

Comments on "Credit ratings and the BIS capital adequacy reform agenda"

The New Basel Capital Accord (Basel Committee on Banking Supervision, 1999) has the objective of making capital requirements ‘‘appropriately sensitive to the degree of risk in bank activities’’. This is important because the original Capital Accord (1998) has been widely criticized for the lack of risk sensitivity of the capital charges assessed against various types of loans. Many observers believe this has resulted in regulatory arbitrage on the part of banks, to the detriment of the quality of the assets banks hold on their books. The Basel Committee has proposed a standardized approach for determining risk-based capital using external ratings and two other approaches based on internal models for dealing with credit risk. 1 Altman et al. (2002) examines in detail whether the goal of ‘‘appropriate risk sensitivity’’ is met by the proposed risk weights of the standardized approach. The main conclusion of the Altman et al. paper and the underlying issues can be seen in Fig. 1, which plots the proposed risk weights and the historical (corporate bond) losses by rating. As the authors note, ratings Aaa through A have experienced virtually no defaults but are assigned weights of 20 (Aaa and Aa) and 50 (A) percent. More problematic, the proposed risk weights for Baa and Ba rated loans are both 100%, even though the loss experience for Ba is 10 times higher than for Baa. Finally, the B and below rated loans have risk weights only half-again as large as Baa rated loans, while the historical loss experience has been 55 times greater! Thus, the Basel proposal fails to capture the relative risks of the various ratings. Altman et al. Journal of Banking & Finance 26 (2002) 923–928