Ch 17 - Risk Control Flashcards
Risk-free return
The rate at which money is borrowed or lent when there is no credit risk
Why is a risk-free rate unlikely to occur in reality
Shared currencies (euro) or currencies that are tied closely to another (like the dollar) - so can’t necessarily just print money in order to repay debts
Currency risk and inflation risk are other risks that effect government bonds etc
Advantages of asset liability modelling
Encourages investors to formulate explicit objectives
- Quantifiable and measurable performance target
- Defined performance horizons
- Quantified confidence levels for achieving the target
Feedback between model output and the setting of the objectives
Can monitor the success of the strategy or model by means of regular valuations
Deterministic ALM - *check past papers (or Assignment X5) for more in-depth explanation
Based on a single set of assumptions about future experience
Scenario modelling is then required to test whether the assets are of the right type
Stochastic ALM
Allows for the random nature of some of the model parameters
-Key parameters are random variables with a given mean and defined probability distribution
Typically depending upon
- Past values of itself
- Present and past values of other economic and/or investment variables (i.e. correlations)
Main risks with ALMs
Model risk – risk that the model structure is wrong
Parameter risk – risk that the model parameters, such as expected future return, are incorrectly specified
Other actuarial techniques that may be used to develop an appropriate investment strategy and that take into account the liabilities
Matching
Immunisation
Deterministic ALM (possibly with scenario modelling)
Stochastic ALM
Mean-variance portfolio theory applied to the surplus
List Financial Risks
Market risk Credit risk Liquidity risk Operational risk Relative performance risk
Market risk definition
Risk relating to changes in the value of the portfolio due to movements in the market value of the assets held
Credit risk definition
Risk that a counterparty to an agreement will be unable or unwilling to fulfil their obligations
Operational risk definition + examples (5)
Risk of loss due to fraud or mismanagement within the fund management organisation itself
e.g. disasters
Fraud and theft
Human error
Third-party dependencies
Internal control problems
Liquidity risk definition (2)
Risk of not having sufficient cash to meet operational needs (/liabilities) at all times
For financial services institutions it is the risk of not being able to raise funds at a reasonable cost at all times
Relative performance risk definition
Risk of under-performing comparable to institutional investors
Controls for market risk
Define risk and modelling the risk
Systems, reporting and benchmarks (risk monitoring system)
Load differences
Load ratios
What to do if developing a risk monitoring system
Automated Understandable Prior Reports Documented Independent Output = quantifiable
Controls for credit risk
Limiting the creditworthiness of the counterparties
Limiting the total exposure to each counterparty
Using credit derivatives
Controls for operational risk
Depends on good management practices
- established and documented chains of (internal and external) reporting and responsibility
- those with responsibility should have suitable qualifications and experience
- separation of “front office” and “back office” functions
- management understands the nature of complex deals undertaken by traders
Controls for liquidity risk
Cash budgeting / short-term financial planning are techniques that can be used for identifying and measuring liquidity risk
Gap analysis
Duration analysis
Gap Analysis - what is net liquid assets equal to?
Level of liquid assets – volatile assets
Weakness of gap analysis
Does not quantify the potential cost or impact of such a gap under stressing conditions such as an increase in the cost of finance
Duration analysis - LRE
Liquidity duration or liquidity risk elasticity (LRE) considers the impact of changes in market conditions
Process of duration analysis (2 steps)
Calculate the PV of assets and liabilities using the “cost of funds” rate as the discount rate
Measure the change in the market value of the institution’s equity (LRE) from a change in the cost of funds (due to an increase in the risk premium to raise money)
If LRE is negative then…
the duration of assets is longer than that of liabilities
Higher duration means that the value of assets will drop by more when interest rates increase
Therefore, will want to shorten the maturity of assets and lengthen liabilities to increase liquidity
Controls for relative performance risk
Can be measured and controlled in the same way as market risk (just compare to peers rather than whole market)
Commercial matching
Index tracking
Difficulties in assessing relative performance risk
Identifying an appropriate peer group
Obtaining reliable and accurate data on the performance of competitors
Making appropriate allowance for the risk of positions taken
Immunisation
Investment of assets in such a way that the PV(Assets) - PV(Liabilities) is immune to a general small change in the rate of interest.
Theoretical and practical problems with Immunisation
AIFRM DTF Ella
Assets of suitably long DMT may not exist
Interest rate changes must be small
Flat yield curve is assumed and level interest rate changes at all terms
Rebalancing constantly in practice (for DMT and convexity)
Mismatching profits removed apart from a small second-order effect
Dealing costs are ignored in theory (from ARM notes but not in F105)
Fixed monetary liabilities is the aim for immunisation generally
Timing of proceeds and outgo may be uncertain
Amounts of the liabilities (and some assets as pointed out below) may not be known with certainty
Equities and property are ruled out as investments even though they have high expected returns, due to their uncertain returns (from ARM notes but not in F105)
Opportunity set
Set of combinations of means and variances that the investor is able to obtain by constructing portfolios of the available securities
Efficient frontier
Set of efficient portfolios in the E-V space
A portfolio is efficient if there is no other portfolio with either a higher mean and the same or lower variance, or a lower variance and the same or higher mean.
Optimal portfolio
The portfolio that maximises the investor’s expected utility as a function of the mean and variance of investment returns
Indifference curves
Join points of equal expected utility in E-V space
