Journal of Risk

Philippe Jorion

University of California at Irvine

This issue of The Journal of Risk provides new insights into financial risk management. It contains two papers on credit risk and two papers on market risk, reflecting the evolving mix of current research in risk management.

    The first paper, “Estimating Expected Losses and Liquidity Discounts Implicit in Debt Prices”, by T. Janosi, R. Jarrow, and Y. Yildirim, was presented at the April 2002 International Conference on Credit Risk held at HEC-Montreal in collaboration with The Journal of Risk. This was a two-day conference solely devoted to recent developments in credit risk. With more than twenty papers on the program, the conference attracted a large audience and was widely viewed as a success. In their paper, the authors estimate a reduced-form model of liquidity and default risk using individual bond data. The paper attempts to explain the observation that credit spreads more than offset actuarial credit losses. The excess return can be viewed as a risk premium, or liquidity premium. The authors estimate five different liquidity premium models that depend on market- and bond-specific factors. They find that the best-performing liquidity premium model appears to be firm-specific, reflecting idiosyncratic risk instead of systematic risk. They also report that their best model fits the data quite well.

    The second paper, by M. B. Wise and V. Bhansali, “Portfolio Allocation to Corporate Bonds with Correlated Defaults”, deals with a related topic, which is the portfolio allocation to bonds that are expected to return a positive risk premium. The paper studies the allocation between cash and a corporate bond portfolio for varying levels of correlation among defaults and risk premiums. It develops approximations to the fractional allocation, which are simple and shown to be rather accurate.

    Next, in “Intra-Day Periodicity and Long-Run Volatility in Short-Sterling Futures”, D. G. McMillan and A. E. H. Speight study the volatility dynamics of short-term UK sterling futures at high frequency. While Garch models are widely used to model volatility dynamics, they cannot fit high-frequency and low-frequency data in a consistent fashion. One can use theoretical results to extrapolate intra-day Garch parameters from daily parameter estimates. The actual intra-day Garch parameters, however, have much lower persistence than implied from the temporal aggregation results. In other words, Garch parameters are not consistent across time. The authors suggest that a more complex process is at work, with both short-term and long-term dynamics. Taking both components into account appears to improve volatility forecasts.

    Finally, the paper by Jorion, “Fallacies About the Effects of Market Risk Management Systems”, takes another look at allegations that risk management systems contribute to increased volatility in financial markets, in particular during the Summer of 1998. The analysis starts with a review of the literature on the effect of financial engineering on financial markets. The evidence is that financial innovations reduce volatility in financial markets, but seem to be systematically blamed for the opposite effect. The paper also shows that VAR-based regulatory capital charges cannot plausibly have caused the volatility of 1998, due to their very slow responses to market movements. A new insight of this analysis is that the design of risk-sensitive systems involves a trade-off between accuracy in short-term volatility forecasts and stability in the capital risk charge.

    The mission of The Journal of Risk is to further our understanding of risk management. Contributions to the journal are welcome from academics, practitioners, and regulators in the field. With this in mind, authors are encouraged to submit full-length papers.