2018 Study Session # 14, Reading # 27 “RISK MANAGEMENT” RG = Risk Governance ERM = Enterprise Risk Management CG = Corporate Governance DB = Defined Benefit ESG = Environmental, Social Governance INTRODUCTION Identification, measurement & control of risk are key to the investment process Risk management framework is applicable to the management of both enterprise & portfolio risk Identify which risks are worth taking on a regular or occasional basis & which should be avoided altogether VAR = Value at Risk EAR = Earning at Risk CR = Credit Risk IR = Information Ratios RAROC = Risk-Adjusted Return on Capital RISK MANAGEMENT AS A PROCESS Risk management ⇒ a continuous process involving the identification of exposures to risk, establishing appropriate ranges for exposures, measurement of these exposures & the execution of appropriate adjustments when required Risk management is a continuous processes (subject to evaluation & revisions) not just an activity Risk management process of a hypothetical business enterprise: Nonfinancial Risk The Company Financial Risk Set Policies & Procedures Information/Data Define Risk Tolerance Information/Data Derivatives Identify Risks Execute Risk Mgmt Transactions Non-Derivatives Measure Risks Identify Appropriate Transactions Adjust Level of Risk Price Transactions Execute Transactions Measure Risks Identify Source(s) of Uncertainty Select Appropriate Model Determine Market Price or Value Determine Model Price or Value Compare Attractively Priced Not Attractively Priced Execute Transaction Seek Alternative Transaction Copyright © FinQuiz.com All rights reserved 2018 Study Session # 14, Reading # 27 RISK MANAGEMENT AS A PROCESS Risk management process to portfolio management: Companies hedge risk that arises from areas in which they have no expertise or comparative advantage &hedge tactically where they have an edge (e.g primary line of business) Risk management involves risk modification RISK GOVERNANCE RG ⇒process of setting overall policies & standards for risk management is called RG RG is of good quality if it is transparent, effective, efficient & accountable Risk Governance Structure Centralized Decentralized Single risk management group to monitor & control risk Also called ERM or firm wide risk management Risk management by individual business unit managers Benefit Benefits People closer to actual risk taking are allowed to manage it Economies of scale Allows a company to recognize the offsetting nature of distinct exposures Enterprise-level risk estimates may be than individual units (risk-mitigating benefits of diversification) Consider each risk factor to which a firm is exposed (in isolation & in terms of any interplay) Effective RG is possible only if the organization has effective CG Steps in effective ERM system: Identify individual risk factors Quantify exposure in monetary terms Use these inputs in a risk estimation model (e.g VAR) Identify overall risk exposures & contribution of each risk factor to overall risk Process of risk reporting to senior management Monitor compliance with policies & risk limits Effective ERM systems have centralized data warehouses, which may require a significant & continuing investment Copyright © FinQuiz.com All rights reserved 2018 Study Session # 14, Reading # 27 IDENTIFYING RISKS Effective risk management requires the separation of risk exposures into specific categories that reflect their distinguishing characteristics Financial risk ⇒ risk derived from events in the external financial markets Nonfinancial risk ⇒ all other forms of risk Taxes Accounting Legal Regulations Liquidity Risk Nonfinancial Risks The Company Settlement Financial Risks Market Risk (interest rate, exchange rate, equity prices & commodity prices risk) Model Operations 4.1 Market Risk Market risk ⇒ risk associated with IR, exchange rates, stock prices & commodity prices Market risk is linked to supply & demand in various marketplaces DB plan measures market exposure in asset/liability management context 4.2 Credit Risk Credit risk ⇒ risk of loss caused by counterparty’s failure to make a promised payment Development of credit derivatives has blurred the lines b/w credit risk & market risk Before OTC credit derivative recognition, bond portfolio managers & bank officers were the primary credit risk managers 4.3 Liquidity Risk Liquidity risk ⇒ risk of concession in financial instruments price because of the market’s potential inability to efficiently accommodate the desired trading size In case of short squeezing, liquidity may completely dry up in the market For illiquid underlying, derivatives market may also be illiquid Size of the bid-ask spread is an imprecise measure of liquidity risk (because it is suitable only for small trade size) Complex liquidity measures are available to address the issue of trading volume Liquidity risk is difficult to observe & quantify Copyright © FinQuiz.com All rights reserved Credit Risk 2018 Study Session # 14, Reading # 27 4.4 Operational Risk Operational risk ⇒ risk of loss in a company’s internal (systems & procedures) or from external events The risk can arise from: Human errors (unintentional errors or willful misconduct) Computer breakdown (hardware, software problems) Act of God (only cash compensation for losses can be covered through insurance) Rogue trader ⇒ trader that assumes irresponsibly level of risk or engaged in unauthorized transactions or some combination of both Companies manage operational risk by monitoring their systems, taking preventive actions & having a plan in place to respond if such events occur 4.5 Model Risk Model risk ⇒ risk that model is incorrect or misapplied (often valuation models) Inappropriate model ⇒ chances of loss & control over risk is impaired Investors must scrutinize & validate all models they use 4.6 Settlement (Herstatt) Risk Settlement risk ⇒ risk that one party could be in process of paying the counterparty while the counterparty is announcing bankruptcy Transactions b/w exchange members & clearing house removes settlement risk Netting arrangement reduces settlement risk Transactions with foreign exchange component: Do not lend themselves to netting Parties are unaware of each other The risk is called Herstatt risk (bank Herstatt default) Risk can be mitigated through continuously linked settlement (simultaneous payments) 4.7 Regulatory Risk Risk associated with the uncertainty of how a transaction will be regulated or potential for regulation change Regulation is a source of uncertainty (risk that existing regulatory regime will ∆ or unregulated market will become regulated) Regulatory risk is difficult to estimate due to ∆ in political parties & regulatory personnel Equivalent combinations of cash & derivative securities are not regulated in the same way or by the same regulator 4.8 Legal/Contract Risk Legal/contract risk ⇒ possibility of loss arising from failure of legal system to enforce a contract in which an enterprise has a financial stake Dealers should be very careful when writing contracts with their counterparties (due to their advisory nature) Contract law is often federally or nationally governed 4.9 Tax Risk Uncertainty associated with tax laws Tax policy often fails to keep pace with innovations in financial instruments Equivalent combination of financial instruments may be subject to different tax treatments Copyright © FinQuiz.com All rights reserved 2018 Study Session # 14, Reading # 27 4.10 Accounting Risk Uncertainty about transaction recording & potential for accounting rules & regulations to∆ Historically accounting standards varied from country to country (more disclosure requirements in some countries than others) Accounting risk can be reduced by hiring personnel with latest accounting knowledge (accounting risk will always remain) 4.11 Sovereign and Political Risks Sovereign risk; Form of credit risk involving sovereign nation’s borrowing Current credit risk & potential credit risk Its magnitude involves likelihood of default & the estimated recovery rate Willingness & ability to repay Political risk ⇒ risk of ∆ in the political environment 4.12 Other Risks ESG Risk Performance Netting Risk Environmental risk ⇒ leads to variety of –ve financial & other consequences Social risk ⇒ risk regarding policies & practices of human resources, contractual arrangements & work-place Governance risk ⇒ flaws in CG policies & procedures Performance netting risk; Applies to firms that fund more than one strategy Firm will receive fee only if net +ve performance Firm will pay its portfolio managers on the basis of individual performance Asymmetric incentive fee arrangements with portfolio managers Firms may have to pay its portfolio managers when firm’s revenue is zero Settlement Netting Risk Risk of netting arrangement on profitable transactions for the benefit of creditors challenged by liquidator of counterparty in default Risk is mitigated by netting agreements that can survive legal challenge MEASURING RISK 5.1 Measuring Market Risk Exposure of actively traded financial instrument prices to ∆ in IR, exchange rates, equity prices & commodity prices Volatility (S.D) is a statistical tool to describe market risk Adequate description of portfolio risk Suitable for instruments with linear payoffs Portfolio’s exposure to losses due to market risk: Primary or 1st order measures of risk ⇒ adverse movement in a key variable (linear) 2nd order measures ⇒∆ in sensitivities (curvature) Examples of primary risk measures are β (for stocks), duration (for bonds) & delta, vega & theta (for options) Examples of 2nd order measures are convexity & Gamma Copyright © FinQuiz.com All rights reserved 2018 Study Session # 14, Reading # 27 5.2 Value at Risk VAR: Probability-based measure of loss potential for a company, fund, portfolio, strategy or transactions Expressed either in % or in units of currency Easily & widely used to measure loss from market risk but can also be used to measure credit risk & other exposures (subject to greater complexity) Can be described as a minimum or maximum VAR VAR implication: It measures minimum loss The probability, the VAR in magnitude VAR has a time element ( the period, the VAR) 5.2.1 Elements of Measuring Value at Risk Establishing an appropriate VAR measure requires a no of decisions about the calculation structure Three Important Decisions in VAR Picking a Probability Level Choosing the Time Period Selecting a Specific Approach The probability, more conservative the VAR estimate is Linear risk characteristic portfolios, two probability levels (e.g 5% & 1%) will provide identical information Optionality or nonlinear risks, select the more conservative probability threshold VAR magnitude is directly related to time interval selected Relationship is nonlinear Three standardized methods for estimating VARs (discussed below) 5.2.2 The Analytical or Variance-Covariance Method Assumptions ⇒ portfolio returns are normally distributed Standard normal distribution ⇒ expected value of zero & a SD of Conversion of a nonstandard normal distribution to a standard normal distribution: ܱ ݐݏ݁ݎ݁ݐ݊ܫ ݂ ݁݉ܿݐݑ− ݊ݎݑݐܴ݁ ݊ܽ݁ܯ ܵܦ ܸ = ܴܣሾܴ^ − ሺܼሻሺߪ ሻሿܸ Estimation of expected returns& SD of returns is key to using analytical method If we are comfortable with normal distribution assumption & accuracy of our estimates, we can confidently use the analytical method for a different time period by adjusting the avg returns & SD accordingly (e.g annual VAR can be converted to daily VAR by dividing avg return & SD to 250 (trading days)) VAR (usually daily VAR) can also be estimated by assuming an expected return of zero Two advantages: No need to estimate E(R) which is harder to estimate than volatility Easier to adjust VAR for a different time period(݁ ݃ ܽ݊݊√ܴܣܸ ݕ݈݅ܽܦ = ܴܣܸ ݈ܽݑ250) Advantage/Disadvantage of Analytical Method Advantage Simple method Disadvantage Normal distribution assumption often does not hold (e.g.in options) Copyright © FinQuiz.com All rights reserved 2018 Study Session # 14, Reading # 27 5.2.3 The Historical Method Collect the historical return & identify the return below which 5% or 1% of returns fall No constraint to use normal distribution If different portfolio composition, than what actually had in the past to calculate historical VAR, it is more appropriate to call the method a historical simulation Advantage ⇒ non parametric Disadvantage ⇒ relies completely on past data (also a problem with other methods but not so acute) 5.2.4 The Monte Carlo Simulation Method MCS produce random portfolio returns that are assembled into a summary distribution from which we can determine at which level the lower 5% (or 1%) of return outcomes occur MCS does not require a normal distribution MCS is a more flexible approach & even suitable for portfolios containing options As sample size sample VAR converge to population VAR MCS require extensive commitments of computer resources 5.2.5 Surplus at Risk": VAR as It Applies to Pension Fund Portfolios Pension fund managers apply VAR methodologies to the surplus (rather than their asset portfolio) Managers express their liability portfolio as a set of short securities & calculate VAR on net position (any VAR methodology can apply) 5.3 The Advantages and Limitations of VAR VAR’s Imperfections VAR’s Attractions Can be difficult to estimate Different estimation methods can provide different results If assumptions are not accurate, VAR often underestimates magnitude or frequency of worst returns Portfolio VAR is not simply the sum of individual position’s VAR VAR provides an incomplete picture of overall exposure (ignore +ve results) Back testing should be applied to check method’s accuracy VAR estimate is not suitable for organization with complex structure Quantify loss in simple terms Easily understood by senior management May be a requirement of regulatory body VAR is a versatile measure VAR is often paired with stress testing VAR results are input dependent Copyright © FinQuiz.com All rights reserved 2018 Study Session # 14, Reading # 27 5.4 Extensions and Supplements to VAR Incremental VAR ⇒ effect on portfolio VAR by including & excluding an asset Provide extremely limited picture of the asset’s or portfolio’s contribution to risk Cash flow at risk & EAR ⇒ with a given probability & over a specified time period, the minimum CF (earnings) that we expect to be exceeded Useful for companies that generate CF or earnings but not readily valued in a publicly traded market Tail VAR ⇒VAR plus the expected loss in excess of VAR, when such additional loss occurs 5.5 Stress Testing Stress testing is used to supplement VAR as a risk measure VAR assumes potential losses under normal market conditions while stress testing identifies additional losses due to unusual circumstances Approaches in Stress Testing 5.5.1 Scenario Analysis 5.5.2 Stressing Models Evaluating a portfolio under different scenarios Effect of large movements in a key variable on portfolio’s value Stylized scenarios ⇒ simulating a movement in at least one primary market force (e.g IR, exchange rate etc.) Problem ⇒it assumes that shocks tend to be applied to variables in a sequential fashion (in reality, shocks often happen simultaneously) Actual extreme events ⇒ put the portfolio through price movements resulting from the events that occurred in the past Hypothetical events⇒ that have never happened in the markets (difficult to analyze & confusing outcomes) When a series of appropriate scenarios is established, the next step is to apply them to the portfolio (consider assets’ sensitivities to the underlying risk factors) Use an existing model & apply shocks to the model inputs in some mechanical way Range of possibilities rather than a single set of scenarios Computationally demanding Factor push ⇒ push risk factors & prices of a model in most disadvantageous way & to work out the combined effect on the portfolio value Model risk is present Max Loss optimizations ⇒ mathematically optimizing the risk variable that will produce the maximum loss Worst-case scenario analysis ⇒ examines the expected worst case 5.6 Measuring Credit Risk Credit risk ⇒ risk that the party owing money to another will be unable to meet its obligation CR has two dimensions: Probability of default Amount of loss Empirical data set on credit losses is quite limited with respect to time perspective, credit losses can be current or potential credit losses Cross-default provision ⇒ borrower’s default on any outstanding credit obligation is considered default on all outstanding credit obligations Credit or default VAR ⇒ reflects the probability of minimum loss during a certain time period Credit VAR can’t be separated from market VAR & focus on upper tail of the distribution of market returns More accurate measures of default probability & recovery rate ⇒ & more accurate credit VAR Estimating credit VAR is complicated because: Credit events are rare & harder to estimate CR is less easily aggregated than market risk Correlations b/w CR of counterparties must be considered Copyright © FinQuiz.com All rights reserved 2018 Study Session # 14, Reading # 27 5.6.1 Option-Pricing Theory and Credit Risk A bond with CR can be viewed as: Default free bond plus Short put option written by bondholders for shareholders (this put option reflects shareholders right of limited liability) Traditional put-call parity with a little bit changes can be used to draw 5.6.1option-Pricing Theory and Credit Risk value of implicit put option Value of put option is the difference b/w default-free bond & bond subject to default 5.6.2 The Credit Risk of Forward Contracts Each party assumes the other’s CR No current CR exists prior to expiration (no payments are due) If the counterparty with –ve value declares bankruptcy before the contract expiration, the claim of non-defaulting counterparty is market value of forward contract at the time of bankruptcy 5.6.3 The Credit Risk of Swaps CR is present at a series of points during the contract’s life MV of contract can be calculated at any time to reflect potential CR CR of IR & equity swaps is largest during the middle of a swap’s life In case of currency swaps, the CR is greatest b/w a midpoint to the end of the swap’s life 5.6.4 The Credit Risk of options Options have unilateral CR (after paying premium credit risk accrues entirely to the buyer) European options ⇒ no current CR until expiration ⇒ significant potential CR American option ⇒ current CR if holders decide to exercise option early Credit risk on derivative transaction tends to be quite small relative to that on loan 5.7 Liquidity Risk Cost of an illiquid instrument can be measured through bid-ask spread Instruments that trade very infrequently at any price give illusion of volatility) Practitioners often liquidity-adjust the VAR estimates 5.8 Measuring Non-Financial Risks These risks are very difficult to measure ⇒ usually lack of observable distribution of losses related to these factors Techniques like extreme value theory is used if possible to model sources of risk but these techniques are input dependent 5.8.1 Operational Risk Well publicized losses at financial institutions (e.g rogue employees theft) have put operational risk justifiable into the forefront Banks can measure their operational risk through Basel II Copyright © FinQuiz.com All rights reserved 2018 Study Session # 14, Reading # 27 MANAGING RISK Key components: Effective risk governance model Systems & technology to provide timely& accurate risk information to decision makers Trained personnel to evaluate risk information Risk management is just a good common business sense 6.1 Managing Market Risk ERM system identifies appropriate risk tolerance levels Taking too little risk is as much problematic as taking too much risk (e.g possible rewards) 6.1.1 Risk Budgeting Risk budgeting ⇒ efficient allocation of capital risk across various units of an organization or portfolio managers Risk Budgeting Organization Perspective Portfolio Management Context Allocation of an acceptable level of risk to various departments of an organization In addition to VAR, risk can also be allocated based on individual transaction size, amount of working capital needed etc If correlation among departments is < 1, the sum of risk budgets for individual units > than organizational risk budget Asset class correlation adjusted IR can determine the optimal tracking risk allocation Investment manager’s allocation is positively related to his correlation adjusted IR Risk budget allocation should be measured in relation to risk to surplus (assets – liabilities) 6.2 Managing Credit Risk Estimating default probability is difficult Credit risk is not symmetric & normally distributed (downside only) thus not easily measured & controlled using SD & VAR 6.2.1 Reducing Credit Risk by Limiting Exposure Not lend too much money to one entity Not engage in too many derivative transactions with one counterparty 6.2.2 Reducing Credit Risk by Marking to Market Credit risk can be reduced through marking to market an OTC derivative contract OTC options are not marked to market (one sided +ve value) Credit risk of option is normally handled by collateral Copyright © FinQuiz.com All rights reserved 2018 Study Session # 14, Reading # 27 6.2.3 Reducing Credit Risk with Collateral Collateral posting is widely accepted as credit exposure mitigant Collateral requirements are based on market values & participants credit ratings 6.2.4 Reducing Credit Risk with Netting Payment netting credit risk by the amount of money that must be paid Netting in the event surrounding a bankruptcy is referred to as closeout netting Cherry picking ⇒ bankrupt company attempting to enforce contracts that are favorable to it while walking away from those that are unprofitable 6.2.5 Reducing Credit Risk with Minimum Credit Standards and Enhanced Derivative Product Companies Companies will not business with an organization of low credit quality EDPCs are SPVs, which are used by banks to control their exposure to rating downgrades 6.2.6 Transferring Credit Risk with Credit Derivatives Credit default swap ⇒ protection buyer pays the protection seller in return for the right to receive a payment from the seller in case of specific credit event Total return swap ⇒ protection buyer pays the total return in return for floating rate payments Protection seller exposed to credit & IR risk Credit spread option ⇒ yield spread of a reference obligation & over a referenced benchmark Credit spread forward ⇒forward contract on yield spread Credit derivatives are used to eliminate as well as to assume credit risk 6.3 Performance Evaluation Risk adjusted performance is a critically important capital allocation tool (homogenous units of exposure assumption) as measured against sensible benchmarks Methodologies for Risk-Adjusted Performance Sharpe Ratio This ratio measures excess mean return over Rf per unit of total risk SD assumes normal distribution therefore it is not suitable for portfolios containing options RAROC ா௫௧ௗ ௧௨ ௩௦௧௧ ௧ ௧ ௦ Capital at risk can be calculated in a variety of ways & can take a no of different forms Copyright © FinQuiz.com All rights reserved 2018 Study Session # 14, Reading # 27 Methodologies for Risk-Adjusted Performance Return over Maximum Drawdown Sortino Ratio Max drawdown ⇒ largest difference b/w a high watermark & subsequent low Portfolio managers should not be penalized for +ve volatility (as in Sharpe ratio) Downside deviation ⇒ rate of return volatility below the minimum acceptable return (MAR) ܴܱ= ܦܣܯ ௩ ௧௨ % ௗ௪ௗ௪ the ratio, the better it is ܵ= ݅ݐܽݎ ݊݅ݐݎ (ெ ௧ ௧௨ିெோ) ௪௦ௗ ௗ௩௧ If MAR is Rf then the only difference b/w Sharpe ratio & Sortino ratio is due to denominator If non-normal distribution = Sharpe ratio & Sortino ratio behave much in similar way Sharpe ratio is preferred in finance theory 6.4 Capital Allocation In addition to capital preservation, risk management has become a vital component for risk taking enterprises Risk management is a vital input into a capital allocation process Most effective approach to capital allocation ⇒ appropriate combination of these methodologies: Methodologies for Capital Allocation Nominal, Notional, or Monetary Position Limits VAR-Based Position Limits Capital that a portfolio or business unit can use in a specified activity Advantages: Easy to understand & calculate Nominal position can be taken by using other assets (e.g derivatives) Disadvantages: Ignore effects of correlation & offsetting risks Not suitable in risk-control perspective In notional limits a VAR limit serves as a proxy for capital allocation Advantage ⇒ appropriate for risk control process Problem ⇒ dependent on VAR’s effectiveness Maximum Loss Limits Determine a maximum loss limit Max loss limit should be determined carefully (preserve capital & not constrained in meeting investment objectives) Internal Capital Requirements Capital, the management believes to be appropriate for the firm If regulatory capital requirement is , overrule internal requirements Traditionally, capital ratio was used to specify internal capital requirements Modern approach ⇒ firm will be insolvent if in asset is > than value of capital VAR based capital requirement has an advantage over regulatory capital requirement ⇒ it considers correlations Regulatory Capital Requirements May be inconsistent with rational capital allocation scheme Part of overall allocation process whenever demanded by overall allocation process Copyright © FinQuiz.com All rights reserved 2018 Study Session # 14, Reading # 27 6.5 Psychological and Behavioral Considerations Behavioral aspects have two implications of risk management: At different points in portfolio management cycle, risk takers may behave differently Risk management can be better implemented if these dynamics could be modeled Copyright © FinQuiz.com All rights reserved ... assumption often does not hold (e.g.in options) Copyright © FinQuiz. com All rights reserved 2018 Study Session # 14, Reading # 27 5.2 .3 The Historical Method Collect the historical return & identify... risk of option is normally handled by collateral Copyright © FinQuiz. com All rights reserved 2018 Study Session # 14, Reading # 27 6.2 .3 Reducing Credit Risk with Collateral Collateral posting... instruments may be subject to different tax treatments Copyright © FinQuiz. com All rights reserved 2018 Study Session # 14, Reading # 27 4.10 Accounting Risk Uncertainty about transaction recording