Chapter 18: Overall risk control

Question 1

Financial risks faced by institutional investors

Answer 1

• Market risk
• Credit risk
• Operational risk
• Liquidity risk
• Relative performance risk

Question 2

Market risk

Answer 2

The risk relating to changes in the value of a portfolio due to movements in the market value of the assets held

Question 3

Credit risk

Answer 3

The risk that a counterparty to an agreement will be unable or unwilling to fulfill their obligations

Question 4

Operational risk

Answer 4

The risk of loss due to fraud or mismanagement within the fund management organisation itself

Question 5

Liquidity risk

Answer 5

Risk of not having sufficient cash to meet operational needs at all times.

For financial services institutions it is the risk of not being able to raise funds (by having access to cash balances, borrowing or through sale of assets) at a reasonable cost at all times.

Question 6

Relative performance risk

Answer 6

The risk of underperforming comparable institutional investors

Question 7

Stages for monitoring and controlling market risk

Answer 7

1. Defining market risk
2. Modelling risk
3. Systems, reporting and benchmarks (risk monitoring system)
4. Load differences
5. Load ratios

Question 8

Defining market risk

Answer 8

• Suitable measure may be VaR.
• Returns and losses may be measured in absolute terms or relative to some suitable benchmark such as an index, median fund or value of the liabilities
• Timescale chosen depends on the institution

Question 9

Value at Risk (VaR)

Answer 9

The maximum loss in the value of the fund, with a probability of p% that may be suffered by an institution as a result of market risk over some time period of t.

Question 10

Modelling the market risk

Answer 10

• Establish a model that will allow the risk at any point to be calculated
• Mean variance framework requires the expected returns, variance and covariance of all the assets in the portfolio
• Desirable feature of any model used is that the factors that determine the risk level are understandable

Question 11

Ways in which allowance may be made for non-normal investment returns

Answer 11

• using non-normal distributions for investment returns - i.e. one that incorporates fat tails and/or negative skewness
• retaining the normal distribution, but adjusting upwards the standard deviation of returns to indirectly allow for fat tails and/or negative skewness

Question 12

Load difference

Answer 12

Specifies the range over which the percentage allocation to a specific class can vary, e.g. limiting overseas equities to between 5% and 15% of the total portfolio

Question 13

Load ratio

Answer 13

Specifies the maximum variation of the allocation to a specific asset class expressed as a percentage of the benchmark allocation to that class.

This has the effect that a constant load ratio permits smaller absolute variation in the lower weighted asset classes

Question 14

Desirable features and requirements when developing a market risk monitoring system

Answer 14

• Give up-to-date reporting of risk exposure
• Reporting should be done on regular basis
• Standard/automated data input procedure so that changes are captured quickly
• Managers should be able to see the effects of their proposed actions
• Regular reporting to senior management
• Risk factors understandable to fund managers and users of the system
• Monitoring personelle should be independent of fund managers
• Output should be quantifiable
• Risk control system clearly documented

Question 15

Monitoring and controlling credit risk

Answer 15

• Controlling creditworthiness of counterparties with which institution deals
• Monitor and limit credit exposure to any single counterparty

Question 16

Monitoring and controlling operational risk

Answer 16

Depends on good management practices including having established and documented chains of reporting and responsibility. Those with responsibility should have suitable qualifications and experience

Areas highlighted:

• Need for management to understand the nature of the complex deals undertaken by traders
• Need for seperation of ‘front office’ and ‘back office’ functions

Question 17

Monitoring and controlling liquidity risk

Answer 17

• Cash budgeting / short-term financial planning are techniques that can be used to identify and manage liquidity risk
• Gap analysis
• Duration analysis

Question 18

Gap analysis

Answer 18

Balance sheet model of liquidity useful for establishing liquidity policies and operating limits.

• Assets classified as liquid or illiquid
• Liabilities classified as stable or volatile

Liquidity gap/net liquid assets defined as:

Level of liquid assets - Level of volatile liabilities

• Allowance should be made for liquidation costs

Question 19

Main problem with Gap analysis

Answer 19

The liquid gap approach does not quantify the potential cost or impact of such a gap under stress situations such as an increase in the cost of finance

Question 20

Duration analysis

Answer 20

Liquidity duration/liquidity risk elasticity (LRE) consider the impact of changes in market conditions.

Process consists of 2 steps:

1. Calculate PV of assets and liabilities using the cost of funds’ rate as the discount rate
2. Measure the change in market value of the institutions equity (LRE) from a chnage in the cost of funds (due to increase in risk premium paid to raise money)

Question 21

LRE interpretation

Answer 21

If LRE is zero, the institution has zero liquidity risk.

Negative LRE = duration of assets longer than duration of liabilities. Higher duration means the value of the assets will drop by more when interest rates increase

If LRE is sharply negative, it may pay the institution to shorten the maturity of its assets and lengthen the maturity of its liabilities = increasing liquidity

Question 22

Monitoring and controlling relative performance risk

Ways to minimise relative performance risk

Answer 22

Can be measured and controlled in the same way as market risk is except that performance is measured relative to performance of competitors rather than in absolute terms or relative to the whole market

Ways to minimise relative performance risk:

• commercial matching - holding similar investment portfolios to competitors
• index tracking

Question 23

Major difficulties when attempting to assess relative performance risk

Answer 23

• identifying appropriate peer group against which to compare investment performance
• obtaining reliable and accurate data on the performance of competitors
• making appropriate allowance for the risk of positions taken

Question 24

Mean variance portfolio theory

AKA modern portfolio theory (MPT)

Application falls into which two parts?

Answer 24

Specifies a method for an investor to construct a portfolio that gives the maximum expected return for a specified level of risk, or minimum risk for a specified expected return

Application falls into two parts:

1. Definition of the properties of the portfolios available to the investor - opportunity set
2. Determination of how the investor chooses one out of all the feasible portfolios in the opportunity set

Question 25

Assumptions of mean-variance portfolio theory

Answer 25

• All expected returns, variances and covariances of pairs of assets are known
• Investors make their decisions based purely on basis of expected return and variance
• Investors are non-satiated
• Investors are risk-averse
• There is a fixed single-step time period
• No taxes or transaction costs
• Assets may be held in any amounts, i.e. short selling is possible, we can have infinitely many divisible holdings and there are no maximum investment limits

Question 26

Opportunity set

Answer 26

Set of combinations of means and variances that the investor is able to obtain by constructing portfolios containing the available securities

Question 27

Other key factors that may influence investment decision in practice (which are ignored in MPT)

Answer 27

• suitability of asset(s) for an investor’s liabilities
• marketability of the asset(s)
• higher moments of the distribution of the returns such as skewness and kurtosis
• taxes and investment expenses
• restrictions imposed by legislation
• restrictions imposed by the fund’s trustees

Question 28

Efficient portfolio

Answer 28

Assumptions that allow for the definition of an efficient portfolio:

• Investors are never satiated - given level of risk they’ll always prefer a portfolio with a higher return over a lower return
• Investors dislike risk - for given level of expected return they will prefer the portfolio with lower level of risk to one with a higher level of risk

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 same or higher mean

Question 29

Efficient frontier

Answer 29

The set of efficient portfolios in expected return-standard deviation space

Question 30

Optimum portfolio

Answer 30

One that has a risk/return profile that is on the efficient frontier at a point where an indifference curve is tangential.
I.e. the portfolio that maximises the investor’s expected utility as a function of the mean and variance of investment returns

Question 31

Indifference curves

Answer 31

Join points of equal expected utility in the expected return-standard deviation space

Question 32

Asset liability model

Answer 32

Investor’s objectives usually stated with reference to assets and liabilities.

Setting investment strategy to control risk of failing to meet objectives – A method considering variation in assets simultaneously with variation in liabilities is needed

• Done by constructing model to project asset proceeds and liability outgo into the future
• Outcome of investment strategy examined with model and compared to investment objectives
• Investment strategy adjusted in light of results obtained and repeated until optimal strategy found.

Important: Assumptions made when constructing the model are consistent with each other

Question 33

Advantages of asset liability modelling

Answer 33

Encourages investors to formulate explicit objectives

• Quantifiable and measurable performance target
• Defined performance horizons
• Quantified confidence levels for achieving the target

Likely feedback between model output and the setting of the objectives

Can monitor the success of the strategy or model by means of regular valuations

Question 34

Risk-free rate of return

Answer 34

The rate at which money is borrowed or lent when there is no credit risk, so that money is certain to be repaid

Question 35

Asset assumed to be risk-free and why

Answer 35

Assets issued by national governments in their own currency.

• National governments can always print money to ensure debts are fully paid.
• Concept is only valid in a closed economy where all financial transactions are in the currency of that economy
• 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
• Printing money deflates its value against other currencies
• Holder of the overseas government debt may not receive a return that’s free of currency risk, or risk free in real terms if inflation rates in overseas territory and domestic economy of the holder differ