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

Value at Risk (VaR)

Answer 7

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 8

Load difference

Answer 8

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 9

Load ratio

Answer 9

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 10

Desirable features and requirements when developing a market risk monitoring system

Answer 10

• 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 11

Gap analysis

Answer 11

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 12

Liquidity risk elasticity (LRE)

Answer 12

Liquidity duration/liquidity risk elasticity (LRE) considers 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 institution’s equity (LRE) from a change in the cost of funds (due to increase in risk premium paid to raise money)

If LRE is zero, the institution has zero liquidity risk (by this measure). 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 13

Mean variance portfolio theory

AKA modern portfolio theory (MPT)

Application falls into which two parts?

Answer 13

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 14

Assumptions of mean-variance portfolio theory

Answer 14

• 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 15

Opportunity set

Answer 15

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

Question 16

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

Answer 16

• 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 17

Efficient portfolio

Answer 17

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 18

Efficient frontier

Answer 18

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

Question 19

Optimum portfolio

Answer 19

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 20

Indifference curves

Answer 20

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

Question 21

Advantages of asset liability modelling

Answer 21

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 22

Risk-free rate of return

Answer 22

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