CFA level 3 CFA level 3 CFA level 3 CFA level 3 CFA level 3 finquiz curriculum note, study session 14, reading 27

Risk Management INTRODUCTION managing risk i.e reducing, increasing, avoiding risk exposures etc Risk management is considered to be a critical component of the investment process Risk management is not only hedging risk rather, it involves RISK MANAGEMENT AS A PROCESS Risk management is a continuous process that involves: Proper identification of risks (i.e all callable bonds have call risk) Identification of the firm’s desired level of risk i.e determining risk tolerance Measurement of risks (i.e how to measure risk e.g duration to measure interest rate risk, beta to measure risk of stocks) Monitoring and adjusting the exposures to align actual risk exposures with desired target levels Risk governance structure can be centralized or decentralized 1) Centralized risk management system: In this system, the responsibility of risk management is put at the senior management level where it is supposed to belong It is also known as Enterprise Risk Management (ERM) • Allows economies of scale • Allows firm to recognize offsetting nature of different risk exposures • It considers risk exposures both in isolation and at portfolio level • In centralized system, risk management responsibility is on a level closer to senior management who are actually responsible for managing it • It provides an overall picture of the company’s risk position NOTE: • Some risks are preferred to be taken on a regular basis, some should be taken occasionally and some should be avoided altogether • The execution of transactions for managing risk is also a distinct process e.g for portfolios, it involves trade identification, pricing and execution RISK GOVERNANCE Risk governance is a process of setting risk management policies and standards for an organization The risk management process should be overseen by the senior management who is responsible for all organizational activities The quality of risk governance is determined by its transparency, accountability, effectiveness (achieving objectives), and efficiency (economical use of resources to achieve objectives) Risk governance is an important part of corporate governance Advantages: Risk should be taken in those areas in which business has expertise and competitive advantage (in order to earn profits) NOTE: It is important to note that due to less than perfect correlation between risk exposures, overall risk is less than the individual risks 2) Decentralized system: In this system, risk management responsibility is placed on individual business unit managers Each unit calculates and reports its exposures independently Advantage: It allows people closer to the actual risk taking to directly manage it Disadvantage: It does not take into account portfolio effects across different units Enterprise Risk Management (ERM): It is a centralized risk management system in which there is a firm-wide perspective on risk Effective ERM system typically incorporates the following steps: Identify risk exposures of the company Quantify each exposure in money terms Estimate risks Identify overall risk exposures of the firm as well as the contribution of each risk factor to overall risk Report risks periodically to senior management by establishing a proper process and determine capital allocation, risk limits and risk management policies Monitor compliance with policies and risk limits –––––––––––––––––––––––––––––––––––––– Copyright © FinQuiz.com All rights reserved –––––––––––––––––––––––––––––––––––––– FinQuiz Notes Reading 27 Reading 27 Risk Management Benefits of Enterprise-wide Risk Management (ERM): 1) It facilitates to put all firm’s risk on a comparable basis 2) It allows managing risk in diversified and global firms 3) It promotes discipline of collecting, storing and analyzing all positions both individually and at firmwide level 4) It helps in detecting fraud 5) It provides risk information to stakeholders 6) It facilitates firms to be more flexible as decisions are based on risk-return trade-off Main characteristics of an ERM system: • Centralized data warehouse: It collects and stores data in a technologically efficient manner from all business units • Risk analysis i.e market risk (using parametric, historical, Monte Carlo), stress testing, credit risk, Financial Risks: Risks that are derived from events in the external financial markets They include: i Market risks are associated with adverse movements in firm or portfolio values These risks are linked to supply and demand in various marketplaces It includes: a) Interest rate risk b) Exchange rate risk c) Equity price risk d) Commodity price risk ii Credit risk: It is the risk of loss that arises when a counterparty or debtor fails to perform or meet the obligation on the agreed terms OTC derivatives (unlike Exchange traded), are subject to credit risk as they contain no explicit credit guarantee • This risk arises in both initiating and liquidating transactions for both long and short positions but is particularly serious for liquidating transactions when there is a need to reduce exposure to avoid large losses • Liquidity risk is a serious problem and often is difficult to observe and quantify • Short squeezes: i.e start to buy in panic and price keeps on rising; thus increasing losses liquidity risk • Monitoring and evaluation • Decision making i.e reporting risk information to stakeholders and adjusting risks to a desired level Some risk governance concern of investment firms: • The risk manager is responsible for monitoring risk levels for all portfolio positions and portfolio as a whole and controlling the level of risk • It is generally recommended that risk manager should work together with the trading desks in the development of risk management specifications • For an effective risk governance system, the back office of an investment firm must be fully independent from the front office IDENTIFYING RISKS Following are the categories of risks: iii Liquidity risk: It is the risk that arises when a financial instrument cannot be purchased or sold without a significant price impact i.e unwinding a position may become costly or impossible FinQuiz.com Derivatives not help in managing liquidity risk because: They are usually no more liquid than the underlying Indicators of liquidity: a) Size of Bid-ask spread is used as an indicator of liquidity for traded securities i.e the bid-ask spread widens when markets are illiquid However, bid-ask quotations can be applied when trades are of small size b) Illiquidity ratio: It measures the price impact per $1 million traded in a day, expressed in % terms c) Transaction volume i.e the greater the average transaction volume, the more liquid the instrument However, there is no certainty that historical volume patterns will repeat themselves NOTE: Funding risk refers to a risk associated with the availability of cash Non-financial risks: It includes i Operational risk: It is the risk of loss that arises from failures in the company’s operating systems and procedures or from external events due to technological factors, human errors, natural disasters etc • These risks can be managed by using insurance contracts (which involves a transfer of risk) because these risks not have a developed derivative market • Most companies manage operational risks by monitoring their systems, taking preventive actions, and having a plan in place to swiftly respond if any adverse event occurs Reading 27 Risk Management ii Model risk: It is the risk that arises due to the use of incorrect valuation model or misapplication of the model iii Settlement risk (or Herstatt risk):It is the risk that arises when a counterparty defaults in its obligation while the other counterparty is paying These payments can be associated with the purchase and sale of cash securities i.e equities and bonds along with cash transfers executed for swaps, forwards, options and other types of derivatives • Exchange traded transactions (unlike OTC) not have settlement risk because all transaction take place between an exchange member and the central counterparty (clearing house) • Two-way payments involve settlement risk because one party could owe payment to its counterparty while that counterparty declares bankruptcy and fails to make its payments • Netting arrangements can be used to reduce settlement risk iv Regulatory risk: It is the risk associated with the uncertainty of how a transaction will be regulated and with the potential for regulations to change • Regulated markets face the risk that the existing regulatory regime may become harder, more restrictive or more costly • Unregulated markets face the risk of being regulated which results in costs and restrictions • Regulatory risk is difficult to estimate • Equities, bonds, futures and exchange traded derivatives markets usually are regulated at the federal level, whereas OTC derivative markets and transactions in alternative investments are loosely regulated • Regulatory risk and the degree of regulation vary widely from country to country • Regulatory risk is affected by the priorities of politicians and regulators • Derivatives may be regulated indirectly when they are used by regulated companies v Legal/contract risk: It refers to risk of loss arising that arises when the legal system fails to enforce a contract in which a firm has a financial stake vi Tax risk: Tax risk arises because of the uncertainty associated with tax laws i.e impact of level and type of taxation • E.g transactions exempt from taxation could later be found to be taxable • Equivalent combinations of financial instruments not have identical tax treatment • Like regulatory risk, tax risk is affected by the priorities of politicians and regulators vii Accounting risk: It arises from uncertainty associated with recording and accounting rules regarding FinQuiz.com transactions and risk of changes in these accounting rules and regulations • Accounting standards vary from country to country • Companies have to deal with trade-off between protecting proprietary information from competitors and adequately informing investors and the public Sovereign/political risk: Sovereign risk is a form of credit risk in which the borrower/debtor is the government of a sovereign nation • It involves current and a potential credit risk • Its magnitude has two components: Likelihood of default and the estimated recovery rate • It is relatively difficult to evaluate sovereign risk • Risk evaluation involves evaluating debtor nation’s asset/liability/cash flow, willingness, alternative means of financing etc Political risk: It is the risk associated with changes in the political environment i.e change in political regime or the potential impact of a change in party control in a developed nation Practice: Example 2, Volume 5, Reading 27 4.12 Other Risks 1) ESG Risk: It is the risk caused by environmental, social and governance factors • Environmental factors: Environmental factors include decisions related to products & services i.e process of production etc • Social factors: Social factors are related to company’s policies, practices regarding human resources, contractual arrangements and the workplace Risks include labor strikes etc • Governance factors: These factors include corporate governance policies and procedures 2) Performance netting risk: This risk arises when firm’s incentive is based on net performance whereas there are asymmetric incentive fee arrangements with the portfolio managers This risk occurs only in multi-strategy, multimanager environments Example: • Manager A generated positive $10 million returns while manager B generated $10 million loss • Firm’s net performance = 10 – 10 = Reading 27 Risk Management Solution: This risk can be managed by establishing absolute negative performance thresholds for individual accounts • Thus, firm does not get any incentive fee from the client • However, firm is required to pay manager A his incentive fee 5.1 FinQuiz.com 3) Settlement Netting risk: It refers to risk that arises when there are no “netting arrangements” i.e contract is based on “two-way payments” MEASURING RISK Measuring Market Risk • Volatility (represented by sigma σ) is measured by S.D • Volatility is preferred to describe portfolio risk for portfolios that contain instruments with linear payoffs • Relative volatility: The volatility of the deviation of a portfolio’s returns from benchmark portfolio returns is known as active risk, tracking risk, tracking error volatility or tracking error how interest rate sensitivity changes with changes in interest rates • Gamma measures the delta’s sensitivity to a change in the underlying’s value Market risk has two dimensions: Primary or first-order measures of risk: Sensitivity of the assets to the factor (e.g duration) These measures reflect the expected change in price of a financial instrument for a unit change in the value of another instrument Examples: • Beta measures sensitivity to market movements and is a linear risk measure • Duration for bonds • Delta for options (measures option’s sensitivity to a small change in the value of its underlying) • Volatility (Vega) measures the change in the price of an option for a change in underlying’s volatility o Options are very sensitive to a change in volatility due to their non-linear pay-off structure o Swaps, futures and forwards are much less sensitive to changes in volatility because they have linear pay-offs o Certain options may have risk associated with correlation • Time to expiration (theta) measures the change in the price of an option for a change in time to expiration (i.e day reduction in its time to expiration) Both theta and Vega are exclusively associated with options 5.2 Value at Risk Value at Risk (VAR): is the minimum loss that would be exceeded with a specified probability in a specified period Equivalently, it is the maximum loss that will not be exceeded with a specified confidence (1 – probability) in a specified period Characteristics: • VAR is considered as the financial service industry’s premier risk management technique • It is expressed in currency (e.g dollar terms) or in percentage terms • VAR can be used as a standalone risk measure or can be applied to a portfolio of assets • VAR represents a dollar value risk measure i.e translates the volatility in portfolio value in dollar value unlike other measurements of risk i.e beta and standard deviation • VAR measures Total Risk whereas beta measures Systematic (or Non-Diversifiable Risk) • It is easily used to measure the loss from Market risk, but it involves complexity in measuring the loss from credit risk and other types of exposures Secondary or second-order measures of risk: Change in the sensitivity to its respective factor (sensitivity) e.g convexity Examples: • Convexity for fixed-income portfolios measures Example: A one day VAR of $10mn using a probability of 5% means that there is a 5% chance that the portfolio could lose more than $10mn in the next trading day Reading 27 Risk Management FinQuiz.com To estimate Daily VAR, expected returns and S.D are adjusted as follows: Daily E(R) = Annual E(R) / 250 Daily S.D = Annual S.D / √250 Similarly, other conversions include: Monthly E(R) = Annual E(R) / 12 Monthly S.D = Annual S.D / √12 Daily E(R) = Monthly E(R) / 22 Daily S.D = Monthly S.D / √22 Three implications of this definition: VAR measures minimum loss only i.e the actual loss can be much greater than the specified amount VAR is associated with a given probability i.e 5%, 1% etc The lower the probability, the greater will be VAR in magnitude VAR is based on specified time period; thus it cannot be compared directly for different time intervals Generally, the longer the period, the greater is the potential loss But mostly, longer time periods increase VAR in a non-linear fashion NOTE: The objective of estimating VAR is to identify the probability distribution characteristics of portfolio returns 5.2.1) Elements of Measuring Value at Risk Three important decisions regarding VAR calculations: Selection of an appropriate probability: typically 5% or 1% is used • 1% is more conservative approach because it results in higher VAR • Different probabilities provide identical information for portfolios with linear risk characteristics • No rule exists for selection of probability Selection of an appropriate time period to match turnover or reporting period: e.g • Derivative dealers use one day • Banks use two weeks • Industrial firms use quarterly or annually o The longer the period, the greater the VAR in magnitude Selection of an appropriate modeling technique i.e analytical, historical method, Monte Carlo simulation technique Three Methods to Measure VAR 5.2.2) Analytical or variance-covariance method (Delta Normal Method) It assumes normally distributed portfolios The key to using the analytical method is to estimate the portfolio’s expected return and S.D of returns VAR = E(R) – z-value (S.D) Advantages: • • • • It is easy to calculate It is easy to understand It allows to model the correlation of risks It can be applied to any time period according to industry custom Disadvantages: • It assumes normal distribution Portfolios that contain options are not normally distributed In addition, real life returns often exhibit leptokurtosis Therefore, it tends to give poor results for portfolios with non-normal return distributions • It leads to understatement of actual magnitude and frequency of large losses for portfolios with excess kurtosis (fat tails) • It is difficult to estimate correlation between individual assets in large portfolios Implications of Using of Zero expected value in VAR estimation: • It leads to greater VAR because expected returns are typically positive for longer time horizons • It represents a more conservative approach as it leads to higher VAR • It avoids the problem to estimate expected return since E(R) = • It makes easier to adjust VAR for a different time period i.e short term VAR cannot be converted to long term VAR (or vice versa) * when average return is not zero *Conversion: Annual VAR = Daily VAR×√250 Delta-Normal Method: The problem associated with nonnormal distribution e.g in options can be solved by using option’s delta (delta = ∆ in option price / ∆ in underlying’s price) • We know that normally distributed random variable remains normally distributed when they are multiplied by a constant (i.e delta is constant here) ∆ in option price = ∆ in underlying price ì delta Reading 27 Risk Management ã This trick converts the non-normal distribution of option return into a normal distribution • However, delta is appropriate to use only for small changes in the underlying But when second-order effects (i.e gamma) are used to improve results, the relationship between the option price and the underlying price begins to approximate the true non-linear relationship This further creates problem in using normal distribution assumption Practice: Example 5, Volume 5, Reading 27 5.2.3) Historical Method or Historical Simulation Method This method uses actual historical returns from a userspecified period in the recent past i.e plotting these returns using a histogram or ranking these returns in descending order e.g if there are 100 observations of returns, 5% of 100 is Thus, VAR at 5% probability will be 5th worst return Note that if nth return is not a discrete number then average is taken Key assumption: Future returns will be the same as actual returns over some historical period Example: Total returns = 248 To calculate 5% VAR: 5% × 248 = 12 returns→ thus, VAR would be the 12th worst return in the observations Assume that after rankordering the data, the 12th worst return is -0.0294 If total value of portfolio is $50 million, then one-day VAR would thus be 0.0294 × $50,000,000 = $1.47 million FinQuiz.com Example: A year duration bonds, after year, will be of year maturity Using historical simulation requires using a 4year duration bond (probably held by someone else) NOTE: Total VAR is not simply the sum of individual VARs because risks of individual positions are less than perfectly correlated This is known as diversification effect It is equal to: Sum of individual VARs – Total VAR Practice: Example 6, Volume 5, Reading 27 5.2.4) Monte Carlo Simulation Method It generates random outcomes according to assumed probability distribution and a set of input parameters It examines outcomes given a particular set of risks In this method: • Random portfolio returns are generated • These returns are assembled into a summary distribution • From this distribution, it is determined that at which level the lower 5% (or 1%) of return outcomes occur • This value is then applied to portfolio value to obtain VAR Key assumption: common risk factors affect asset returns Advantages: • It is a non-parametric approach i.e it does not involve any assumption regarding probability distribution • It is easy to calculate and easy to understand • It can be applied to any time period according to industry custom Important to note: Both Monte Carlo and analytical methods provide identical results when sample size is large i.e sample VAR converges to the true population VAR when sample size increases Advantage: It does not require normal distribution assumption i.e any distribution can be used Disadvantages: Disadvantage: • It is based on historical data, which may not hold in the future This problem is also included in other two approaches • Characteristics of bonds and derivatives change over time; therefore, it is inappropriate to base results on historical data Historical simulation: In this approach, current weights are applied to a time-series of historical returns In this method, the history of a hypothetical portfolio using the current position is reconstructed It involves making a large number of assumptions regarding inputs of the return distributions and their correlations 5.2.5) “Surplus at Risk”: VAR as It Applies to Pension Fund Portfolios • Pension fund managers seek to enhance and protect the value of the fund surplus (plan assets – plan liabilities) • Pension fund managers apply VAR methodologies to the surplus by: o Treating the liability portfolio as a short position Reading 27 Risk Management and o Calculating VAR on the net position • All three VAR methodologies can be used by pension fund managers 5.3 The Advantages and Limitations of VAR Advantages of VAR: 1) It measures total risk 2) It quantifies the potential losses in simple and easy to understand terms 3) It is easily understood by senior management 4) It is a versatile measure of risk because it can be used to compare performance of different units with different risk characteristics 5) It can be used to allocate capital at risk Disadvantages of VAR: 1) VAR is difficult to estimate 2) VAR ignores information given in the tails of loss distribution i.e it does not tell the extent to which loss can exceed 3) The VAR estimate is sensitive to the assumptions made and to the method used Thus, different estimation methods produce different values 4) It gives a false sense of security that risk is measured and controlled properly 5) When wrong assumptions and models are employed, it may understate the magnitude and frequency of losses 6) VAR is difficult to apply in complex organizations 7) Portfolio VAR is not equal to sum of VAR from individual positions 8) It does not take into account the positive results into its risk profile; thus, it provides an incomplete picture of the overall exposures 9) VAR has an inherent limitation that distribution of past changes in market risk factors cannot provide accurate predictions of future market risk Back-Testing: Back testing refers to tests performed to evaluate whether VAR estimates prove accurate in predicting results FinQuiz.com Similarly, for the recent quarter, it is expected to exceed = 0.05 × 60 = days For recent month, it will be = 0.05 × 20 = day 5.4 Extensions and Supplements to VAR Incremental VAR: It is used to measure the incremental effect of an asset on portfolio VAR it incorporates the effects of correlation of an asset with the portfolio It is measured as follows: Incremental VAR=Portfolio’s VAR including a specified asset – Portfolio’s VAR excluding that asset Cash Flow at Risk (CFAR): It represents minimum cash flow loss that is expected to be exceeded with a given probability over a specified time period Earnings at Risk (EAR): It represents minimum earnings loss that is expected to be exceeded with a given probability over a specified time period • CFAR and EAR are used for companies that generate cash flows or profits/earnings but are not readily valued publicly Tail Value at Risk (TVAR) or Conditional Tail Expectation = VAR + expected loss in excess of VAR when such excess loss occurs 5.5 Stress Testing • VAR objective is to quantify potential losses under normal market conditions • Stress testing is used to analyze nonnormal/unusual conditions that could result in higher than expected losses It involves the following two approaches: 5.5.1) Scenario Analysis It is used to analyze portfolio under different scenarios Stylized Scenarios: • If the VAR is systematically “too low”, the model is underestimating the risk and there will be too many occasions where the loss in the portfolio exceeds the VAR • If the VAR is systematically “too high”, the model is over estimating the risk and there will be frequent changes in regulatory capital Example: Daily VAR at 5% is $1 million; then over year, a loss of at least $1 million is expected to exceed approximately 0.05 × 250 = 12.5 days If the results are quite different from that the model predicts, then the model is inappropriate and needs to be adjusted It involves simulating a change in at least one factor i.e interest rate, exchange rate, stock price or commodity price relevant to the portfolio There are industry standards of stylized scenarios as well Limitation: In stylized method, shocks are applied in a sequential fashion; it does not take into account their simultaneous effects Actual Extreme Events: The analyst measures the impact of actual past extreme events on portfolio value Reading 27 Risk Management Advantage: FinQuiz.com 5.6 Measuring Credit Risk It is useful to use when higher probability of extreme event is expected relative to the probability given by valuation models or historical time period Credit Risk: It is the risk associated with failure of counterparties to meet their obligations Hypothetical Events: There are two dimensions of credit risk: The analyst measures impact of events that never happened in the past or were assigned small probability in the past but can be expected to occur in future Probability of default: Limitations of Scenario Analysis: • Only provides information that loss will result in a given scenario but does not provide the probability of occurrence of that scenario • Different estimation methods produce different values • It is difficult to identify the sensitivity of a portfolio’s instruments to the designed scenarios • It requires analyst to have good skill and expertise Scenario analysis complements VAR because: VAR tells the minimum loss with a specified probability (assuming normal market conditions) but does not provide information regarding unusual events and underlying factors that would result in actual losses in excess of specific amount 5.5.2) Stressing Models This involves examining how well a portfolio performs under some of the most extreme market moves • It involves analyzing a range of possibilities rather than a single set of scenarios • It is computationally more difficult to perform Factor Push: It involves pushing the prices and risk factors of an underlying model in the most unfavorable way (that indicates extreme risk climate) and analyzing their combined effect on portfolio’s value • It is used as a complement to VAR because it gives actual loss in scenarios for which probability estimation is difficult • Limitation: It involves higher model risk Maximum Loss Optimization: It involves mathematically optimizing the risk variable/factor that will result in maximum loss to the portfolio’s value Worst case scenario analysis: It involves analyzing the impact of worst cases on portfolio’s value Stress tests are used to supplement VAR because VAR does not measure "event" (e.g., market crash) risk It refers to the probability that counterparty will default on its obligation It is present within every credit-based transaction Amount of loss: It is expressed in terms of recovery rate i.e fraction of total amount that is owed It is difficult to estimate credit risk compared to market risk because: • Default events are infrequent • There is lack of market data regarding such events • The inability to determine the correlation between different credit events There are two different time perspectives in credit risk: Jump-to-default/ current credit risk: It is the risk associated with immediate/current credit events i.e risk of not receiving payment that is currently due Potential Credit Risk: It is the risk associated with events that may occur in future i.e risk of not receiving future payment Cross-default Provision: It refers to a provision according to which if a borrower defaults on any outstanding credit obligations, the borrower ultimately defaults on all of them Credit VAR: Credit VAR refers to maximum loss that is expected to occur over a specified period with specified confidence level e.g amount of credit loss that will not be exceeded in one year with 99% certainty • In credit VAR the main focus is the upper tail unlike market VAR where focus is on the lower tail Credit VAR cannot be separated from market VAR due to the fact that credit risk results from gains on market positions held 5.6.1) Option Pricing Theory and Credit Risk According to this theory, credit risk can be explained as follows: A bond with credit risk can be viewed as: Default-free bond + implicit short put option Reading 27 Risk Management • A put option is written explicitly by the bondholders to the shareholders • This put option gives shareholders the right to fully discharge their liability by giving assets to bondholders despite the fact that those assets could be of less value relative to claim of bondholders 5.6.2) Credit Risk of Forward Contracts: Credit risk is faced by each party until contract is settled i.e forward contract has no current credit risk Market value of forward contract at a given time reflects the potential credit risk Market value indicates the amount of a claim that would be subject to loss when credit default occurs Value Long = Spot t – [Forward / (1 + r) n] When counterparty declares bankruptcy before contract expiration, then market value of a forward contract at the time of bankruptcy (if positive) represents the claim of non-defaulting counterparty 5.6.3) Credit Risk of Swaps A swap is equivalent to a series of forward contracts FinQuiz.com 5.6.4) Credit Risk of Options: Forward and swap contracts have bilateral credit risks Options have unilateral risks i.e the buyer of the option pays a cash premium at the initiation and owes nothing to the seller of the option unless he decides to exercise the option Options not have current credit risk until expiration like forward contracts American options have greater value because option holder has the right to exercise the option early Market price of option represents the amount at risk When seller of an option defaults before option expiration, value of an option represents claim of option buyer Value of the side held by the firm determines the treatment of derivative contract in bankruptcy: • When value to firm is negative, it is the creditor’s claim • When value to firm is positive, it is an asset of the firm At each periodic payment, current credit risk exists Market value of swaps at a given time reflects the potential credit risk In interest rate swaps and equity swaps, potential credit risk is largest during the middle period of the swap’s contract maturity period In currency swaps, potential credit risk is largest during the middle period and at the end of the life of the swap due to exchange of notional amount at the termination Swap ValueLong = PV inflows – PV outflows ࡲ࢕࢘࢝ࢇ࢘ࢊ ࢉ࢕࢔࢚࢘ࢇࢉ࢚ ࢜ࢇ࢒࢛ࢋࡸ࢕࢔ࢍୀ ቎ െ ܵ‫݁ݐܴܽ ݐ݋݌‬ ൫1 ൅ ܴ‫ܴܨ‬ி௢௥௘௜௚௡ ൯ ‫݁ݐܴܽ ݀ݎܽݓݎ݋ܨ‬ ሺ1 ൅ ܴ‫ܴܨ‬஽௢௠௘௦௧௜௖ ሻ ೃ೐೘ೌ೔೙೔೙೒ ೟೔೘೐ ೅೚೟ೌ೗ ೟೔೘೐ ೃ೐೘ೌ೔೙೔೙೒ ೟೔೘೐ ೅೚೟ೌ೗ ೟೔೘೐ ቏ ൈ ܰܲ When a party to which value is negative defaults → that value represents claim of counterparty When a party to which value is positive defaults → asset with positive market value is held by the defaulting party When counterparty defaults before a payment on swap is due, the claim of creditor will be either the market value at that time or the asset held by bankruptcy party in bankruptcy proceedings Practice: Example 8, Volume 5, Reading 27 Derivatives credit risk v/s Loans credit risk: Credit risk of derivatives is smaller relative to credit risk of loans because: • Unlike loans, derivatives e.g forwards, swaps have netting arrangements • Unlike loans, most of the derivative contracts not involve exchange of notional principal • Currency swaps involve exchange of notional amount; however, in case of default of counterparty, the amount owed to the defaulting party can serve as collateral 5.7 Liquidity Risk Liquidity adjusted VAR can be estimated to incorporate liquidity risk 5.8 Measuring Nonfinancial Risks Non-financial risks are difficult to estimate Therefore, these risks are managed by using insurance rather than measuring and hedging them Reading 27 Risk Management FinQuiz.com MANAGING RISK The key components of managing risk include: Effective risk governance model i.e Policies which • Determine overall responsibility of senior management • Effectively allocate resources among units • Separate revenue generation activities from controlling side of the business Appropriate systems and technologies i.e Methodologies used to implement policies Sufficient and suitably trained personnel to evaluate risk information and distribute this information to those responsible for proper decision making NOTE: • Return on capital = Profit ($) / Capital ($) • Return on VAR = Profit ($) / VAR ($) → higher return on VAR indicates that manager has outperformed on a risk-adjusted basis For Details refer to Reading 27, Curriculum, Volume Practice: Example 10, Volume 5, Reading 27 6.2 Managing Credit Risk Principles of Effective Risk Management: 1) Return cannot be generated without taking risks 2) Transparency i.e risk should be fully understood 3) Risk should be measured and managed by experienced people instead of mathematical models 4) Assumptions used in the valuation models should be critically analyzed 5) Proper communication of risks i.e risks should be discussed openly 6) Risk should be diversified to obtain consistent returns 7) A disciplined approach should be followed i.e should not take extreme positions 8) It is preferred to use common sense and be approximately right instead of precisely wrong 9) Investment decisions should be based on risk-return trade-off 6.1.1) Risk Budgeting Risk budgeting refers to allocating risk among units, divisions, portfolio managers or individuals in an efficient manner • Risk capital is allocated by the firm before the fact in order to provide guidance to the units, divisions etc on the acceptable level of risk that a given unit/division can undertake • Generally, total sum of risk capital allocated to individual units is greater than the risk budget of the firm as a whole because of the impact of diversification • Risk budgeting is used to allocate funds to portfolio managers according to their Information ratios (IRs) Note: It is recommended to use correlationadjusted IR (to evaluate manager’s ability to add value) to eliminate the effect of asset class correlations Ways to manage Credit Risk: 6.2.1) Reducing Credit Risk by Limiting Exposure Credit risk can be reduced/managed by limiting exposure to a single party e.g single broker 6.2.2) Reducing Credit Risk by Marking to Market It involves recalculating forward or swap price after party to which value is negative pays out the party to which value is positive It is important to note that option contracts are not marked to market because in options value is always positive to one party of the contract Option credit risk is managed by using collateral 6.2.3) Reducing Credit Risk with Collateral Credit risk can be reduced by requiring parties to a contract to post collateral 6.2.4) Reducing Credit Risk with Netting By using netting arrangements credit risk can be reduced as it results in lower amount of money that must be paid It is useful in reducing credit risk in the following cases: • Payment netting • Close out netting: It refers to a situation when after netting, defaulting party ultimately has a claim on non-defaulting party (i.e in spite of being bankrupt, party has claim on other party) This scenario assumes that the non-defaulting party owes the defaulting party a greater amount • Cherry picking: It refers to a practice when bankrupt party attempts to enforce favorable contracts while neglects non-profitable contracts It is important to note that netting arrangements are effective only when they are recognized by the legal system Reading 27 Risk Management 6.2.5) Reducing Credit Risk with Minimum Credit Standards and Enhanced Derivative Product Companies: It involves setting minimum credit standards and undertaking business with SPVs to reduce credit risk • EDPCs are highly capitalized and are willing to hedge their own derivative positions • EDPCs have higher credit rating relative to parent because EDPCs are not liable for the parent company’s debts Sortino Ratio: It uses minimum acceptable return as threshold and downside deviation as a measure of risk Sortino Ratio = ୑ୣୟ୬ ୮୭୰୲୤୭୪୧୭ ୰ୣ୲୳୰୬ି୑୧୬୧୫୳୫ ୟୡୡୣ୮୲ୟୠ୪ୣ ୰ୣ୲୳୰୬ ሺ୑୅ୖሻ ୈ୭୵୬ୱ୧ୢୣ ୢୣ୴୧ୟ୲୧୭୬ Limitation: It assumes normal distribution of returns and provides inaccurate results if this assumption is violated • Both Sortino and Sharpe ratios are useful and give detailed idea of risk-adjusted return when used together instead of in isolation • The higher the Sortino ratio, the more attractive the investment will be 6.2.6) Transferring Credit Risk with Credit Derivatives: Credit risk can be transferred by using credit derivatives i.e CDS, total return swap, credit spread options, credit spread forwards etc Credit derivatives can be used to eliminate or assume credit risk FinQuiz.com Risk Adjusted Return on Capital (RAROC): It is stated as: Total return Swap: • Asset owner pays seller total return on reference asset • Seller pays asset owner floating rate i.e LIBOR + spread • In these types of transactions, seller (dealer) bears both credit risk and interest rate risk NOTE: Credit risk is one-sided risk RAROC = ୉୶୮ୣୡ୲ୣୢ ୰ୣ୲୳୰୬ ୭୬ ୟ୬ ୧୬୴ୣୱ୲୫ୣ୬୲ ୡୟ୮୧୲ୟ୪ ୟ୲ ୰୧ୱ୩ where, Capital at risk is the capital required for credit risk, market risk or operational risk • The higher the RAROC, the more attractive the investment will be • RAROC is compared against historical RAROC, expected RAROC or benchmark RAROC Return over Maximum Drawdown (RoMAD): Practice: Example 11, Volume 5, Reading 27 It is stated as: RoMAD = 6.3 Performance Evaluation Performance Measures: Sharpe Ratio: It uses risk-free rate as the minimum return threshold and S.D as a measure of risk Sharpe Ratio = ୑ୣୟ୬ ୮୭୰୲୤୭୪୧୭ ୰ୣ୲୳୰୬ିୖ୧ୱ୩ି୤୰ୣୣ ୖୟ୲ୣ ୉୶୮ୣୡ୲ୣୢ ୰ୣ୲୳୰୬ ୭୬ ୟ୬ ୧୬୴ୣୱ୲୫ୣ୬୲ ୧୬ ୟ ୥୧୴ୣ୬ ୷ୣୟ୰ ୫ୟ୶୧୫୳୫ ୢ୰ୟ୵ୢ୭୵୬ • Using maximum drawdown as a measure of risk is more intuitive compared to S.D as a measure of risk because it deals with concrete numbers • However, like S.D., it assumes normally distributed returns • The higher the RoMAD, the more attractive the investment will be 6.4 Capital Allocation ୗ.ୈ ୭୤ ୮୭୰୲୤୭୪୧୭ ୰ୣ୲୳୰୬ୱ • The higher the Sharpe ratio, the more attractive the investment will be Advantage: • It is based on sound financial theory • It is most widely used performance measure Limitation: It assumes normal distribution of returns, which is not appropriate in case of portfolio that contains options and other instruments with non-symmetric payoffs Every business unit has a target marginal risk-adjusted return for new investments where marginal risk-adjusted return refers to change in firm’s risk-adjusted return when a unit invests one more dollar Goal of Capital Allocation: The goal is to make marginal contributions to return = marginal contributions to risk i.e Setting capital requirements: Following are the types of position limits: 1) Nominal position limits: In this approach, the amount of capital that the individual portfolio or business unit can use in a specified activity is defined by the firm Reading 27 Risk Management • The exposure is defined in terms of amount of money exposed in the markets • The defined nominal position can be replicated by an individual using other assets e.g using options Advantages: • Easy to understand • Easy to monitor Disadvantages: • It ignores effects of correlation and offsetting nature of risks 2) VAR based position limits: In this approach, capital is allocated based on pre-assigned VAR limit Advantages: • This measure takes into account portfolio size, diversification and leverage • It facilitates the measurement of the business unit’s risk exposures in a comparable manner • It plays an important role in effective capital allocation • It is adjusted automatically to changes in volatility Limitation: • The effectiveness of VAR based limits depend on effectiveness of VAR calculation • Sum of VAR of individual positions is not equal to portfolio VAR i.e it can be > portfolio VAR Therefore, sum of individual VARs cannot be used to obtain “maximum” overall VAR 3) Maximum loss limits: It involves establishing a maximum loss limit for each business (risk-taking) unit Rule: It should be both large enough to meet performance objectives and small enough to meet objective of preservation of capital • Setting maximum loss limits ensures that the total maximum loss never exceeds firm’s capital • However, these limits can be violated in case of extreme market conditions FinQuiz.com 4) Internal capital requirements: It refers to the level of capital specified by the management of the firm that is considered appropriate for the firm When regulatory capital requirements are higher relative to internal capital requirements, they overrule internal capital requirements • They have traditionally been specified in terms of capital ratio (ratio of capital to assets) • Modern tools permit a more thorough approach If decrease in value of an asset is greater than value of capital, firm is considered insolvent Examples: • 1% probability of insolvency over a one-year horizon is acceptable • Capital must be at least one-year aggregate VAR at 1% probability level Using aggregate VAR takes care of correlations Stress tests can be done in case of unusual conditions • When normally distributed returns can be assumed, required capital can be stated in terms of S.D 5) Regulatory capital requirements: It involves meeting regulatory capital requirements When demanded by regulations, these regulatory capital requirements must be included as a part of overall capital allocation process of firm Limitations: • Meeting regulatory capital requirements is a difficult process • Regulatory requirements are at times inconsistent with rational capital allocation objectives Recommended Approach: The most effective approach to capital allocation involves combination of different methodologies with dual objective of profit maximization and capital preservation NOTE: • All position limits must be revised periodically with the change in risk-return expectations • Position limits should not be changed in response to temporary changes in risk • Position limits are adjusted gradually to incorporate permanent changes in risk Reading 27 6.5 Risk Management Psychological and Behavioral Considerations Implication of behavioral aspects of portfolio management in risk management: • Risk takers behave differently during different points of the portfolio management cycle Their behavior depends on: o Recent performance o Risk characteristics of their portfolios o Market conditions Risk management process can be improved when ERM system and senior management take steps to avoid conflicts of interest between management which is responsible for allocating risk and portfolio managers who make investment decisions This can be done through effective monitoring and designing efficient performance incentive schemes Practice: End of Chapter Practice Problems for Reading 27 & FinQuiz Item-set ID# 7441 FinQuiz.com ... has outperformed on a risk-adjusted basis For Details refer to Reading 27, Curriculum, Volume Practice: Example 10, Volume 5, Reading 27 6.2 Managing Credit Risk Principles of Effective Risk Management:... performance incentive schemes Practice: End of Chapter Practice Problems for Reading 27 & FinQuiz Item-set ID# 7441 FinQuiz. com ... further creates problem in using normal distribution assumption Practice: Example 5, Volume 5, Reading 27 5.2 .3) Historical Method or Historical Simulation Method This method uses actual historical