Risk Management and Financial Governance
This area focuses on the Pillars of the Basle II Agreement: firstly, it covers the management of credit risk, from the
perspective of capital requirements and the disclosure of information to the financial markets. Secondly, it focuses
on the financial institutions’ organizational structures and the way in which such institutions are governed.Most models assume that financial markets are efficient, yet the existence of durable disequilibria and the increasing set of paradoxes rising from the recent past necessitate the adoption of new tools describing the bounded rationality of human agents. The LSF develops theoretical and experimental works in this field in collaboration with external institutions.
Participating Researchers :
Georges HÜBNER
Hugues PIROTTE
The research carried out in the field of risk management spans the traditional fields established in the banking sector, namely credit, market and operational risks. This research axis follows the Pillars 1 and 3 of the Basel 2 Agreement: the management of credit risk, from the perspective of capital requirements, and the disclosure of information in financial markets (the rationale and the effects in terms of efficiency). Nevertheless, risk management not only involves the way in which information is received and incorporated by the financial institutions, it also depends on their organizational structure and on the way such financial institutions are governed.
Credit Risk and Default Prediction
As for credit risk, the research subjects are related to the term structure of credit risk premia for fixed income securities. The research focuses on the identification of the structure and the determinants of excess returns required by holders of debt instruments. In particular, the project aims at capturing the determinants of the term structure of the systematic price of credit risk for different classes of issuers. This notion is related to the difference between the behavior of actual credit spreads observed in the returns of risky bonds and the risk-adjusted credit spread used in the pricing estimations.
In another direction, a risk management project examines the impact of recovery rates, liquidity and other economic factors in the valuation of credit derivatives such as CDOs, CLOs and CDS, which are particularly popular tools for default risk hedging purposes. The identification of these factors and of their dynamics will enable market participants to get a deeper and a more accurate understanding of the determinants of their credit exposures and the adequate management of these types of risks in a global portfolio context
Financial Information and Market Efficiency
The first series of research projects will study the impact of the International Financial Reporting Standards (IFRS) framework on the information efficiency of financial markets. The emphasis on such a link is proving to be especially relevant within the scope of the current introduction of new accounting rules for European listed companies. The resulting conclusions will help in determining the response function to accounting information disclosed under the IFRS on various financial markets.
On the other hand, several studies have been carried out on hedge funds, with an in-depth examination of the risk factors explaining returns of modern alternative investments. The project aims at assessing the impact of higher moments than the variance of returns, on the one hand, and of replicated option-based strategies, on the other hand, on the return generating process of hedge fund returns. This topic has become a critical area of investigation in the research community, urged by the profession to detect whether the right asymmetry and the fat tail of their returns distributions ought to deserve a risk premium or not. As this industry is developing rapidly in the Luxembourg marketplace, especially within the funds of hedge funds industry, the results of this investigation could prove to be fruitful for the positioning of the Luxembourg School of Finance as an expert in the field.
Financial Governance
Since the initial studies of Coase and Williamson, the arbitration between transactional and organizational costs has played a major role in explaining the emergence of organized structures such as corporations. According to Grossman, such an approach should take place in a more general (or alternative) framework, where firms are viewed as typical contractors establishing hierarchical relationships where markets are incomplete. From that point of view, any organization is a contractual network, settling incentive mechanisms, which appear to be far removed from the “black box” described by the standard theory of the producer (Jensen). Such an approach would not be limited to industrial corporations but would also apply to financial institutions. The high level of diversity in the internal organization of banks, and the linkage between their different departments (commercial versus recovery units, for instance) respond to typical constraints. It is likely that different organizational models lead to various incentive mechanisms based on either soft or hard information (Godlewski and Godbillon [2005]). From the same point of view, the microstructure of the financial markets plays an important role in explaining the evolution of asset prices, and/or the relative performance of financial marketplaces.
LSF working papers related to this research axis
