Reading 28 Flashcards
Market Liquidity
aka asset liquidity - refers to how quickly an asset can be sold at a fair price
Funding liquidity risk
risk of being unable to meet financial obligations when due. funding and market liquidity are connected.
Denominator effect
the risk that portfolio allocations to illiquid assets increase due to capital calls
return smoothing
results from investments in illiquid assets, such as private equity and real estate, held for long time periods in private markets. the lack of transactions in these illiquid private markets creates a valuation problem. portfolio values are based on appraisal estimates that lag true values - smoothing creates a false picture of volatility by applying a downward bias
Impact of smoothing data
in a rising market: asset values and return estimates are too low, leading to falsely low return volatility
in a falling market, asset values and return estimates are too high, leading again to a false picture of low volatility
the common impact of smoothing on return volatility is that it appears low, creating a false impression of lower risk. assets with smoothed returns appear to have lower correlations with the rest of the portfolio.
proxies for smoothed data
- use public market equivalents for private markets eg use small cap equities as a proxy for private equity
- unsmooth the illiquid asset returns - ie bring back the true volatility by removing the first and higher order serial correlations in observed returns.
capital calls
private equity investments call for investor capital in stages, with investors receiving capital calls, often at short notice, making liquidity planning more difficult.
top down risk perspective
set by the CIO - defined the overall risk tolerance, return objectives and overall investment guidelines for the institution. ERM framework, etc.
Bottom up risk perspective
taken by the investment team tasked with implementing the investment strategy. involves measuring, monitoring, and reporting risk exposures of individual portfolios and asset classes.
portfolio level risk
function of the correlations and covariances of the assets in the portfolio.
VaR
estimate of unexpected loss of an asset or portfolio, at a given confidence level for a given holding period. unexpected losses are low frequency, high severity events.
what does 95% VaR of 1 million USD mean?
- confidence level is 95%, meaning we assume than 95% of the time, the maximum loss will be $1m
- significance level is 5%, also known as the error rate, meaning that 5% of the time, the loss will be larger than the $1m estimate (fall into the catastrophic loss category)
Stress testing and scenario analysis
business models estimate future revenues, costs and earnings using realistic assumptions today, stress testing explores how changes in assumptions affect business revenues, costs and earnings. a business model may look attractive in normal market conditions, however conditions may change.
Stress testing
identifies critical factors driving the success and probability of a business and explores how unexpected changes in critical factors impact revenues, costs and earnings. stress testing is a form of “what if” analysis, helping to understand critical vulnerabilities and aiding contingency planning.
scenario analysis
explores historical, current and hypothetical events that may affect business, eg climate change
maximum drawdown
greatest drop in net asset value measured from a high to a low over a specific time period
Characteristics of a valid benchmark?
SAMURAI criteria
1. Specified in advance
2. appropriate and consistent with the manager’s investment style
3. measurable
4. unambiguous, able to clearly identify the securities
5. reflective of current investment opinions
6. accountable, accepted by the manager
7. investible, possible to replicate passively
Allocation drift
the drift away from the desired strategic asset allocation. regular rebalancing strategies are agreed on to bring the portfolio back in line with the strategic asset allocation.
Principles for responsible investing (PRI)
voluntary framework developed in 2006 by the UN in collaboration with the investment community, to incorporate ESG issues into investment analysis and decision-making. A key theme of the framework is for investors to be active owners engaging with portfolio firms and seeking ESG disclosures.
Universal ownership
A concept that applies to large institutional investors such as pension funds and SWFs that create large well-diversified portfolios. The concept of being a universal owner is that, in large portfolios, these investors have their share of both winners and losers from externalities.
2015 Paris Climate Agreement
encouraged countries and companies to reduce or eliminate carbon emissions in order to limit global temperature increases to 2 degree Celsius above pre-industrial levels. Individual countries determine their own nationally determines contributions (NDCs), which are pledges towards reducing their national carbon emissions.
Inevitable policy response (IPR)
research estimating when (not if) governments and policymakers will make the necessary regulatory changes to deliver the climate change needed to meet the objectives set in the Paris Agreement.
Climate transition risk
risk of being too slow to transition to the new zero-carbon world, effectively left behind with an outdated business model
Types of physical climate risk
- acute physical risk: wildfire, hurricane, etc
- chronic physical risks: rising sea levels, rising temperatures
Task Force on Climate Related Financial Disclosures (TCFD)
encourages organizations including banks, asset managers and asset owners to make climate relatex disclosures within existing reporting requirements.
Headline Risk
reputational damage from being associated with exploitation of local workers
direct versus indirect investment - whats the impact on liquidity?
indirect reduces liquidity
Disadvantages of direct investment
1, direct investment in private asset classes require a dedicated and experienced in-house team. it is challenging and expensive to attract and retain the high quality, in house talent.
- direct investments in private asset classes may have higher concentration risks due to challenges in scaling up portfolio investment to achieve high levels of diversification. higher concentration risks increase idiosyncratic risks associated with each individual investment.
advantages of long term direct investment
- control over assets
- increased portfolio liquidity due to control of exits
- avoids paying fund management fee
- access to more detailed information as a business owner
disadvantages of long term direct investment
- concentrated positions
- additional liabilities
- attracting, retaining and compensating in house expertise
advantages of long term indirect investment in illiquid assets
- no need for in house team and costs
- limited liability of funds invested
disadvantages of long term indirect investment
- pay fund management fees
- no control over portfolio assets
- lower liquidity due to no control over timing of exits
what is the effect of increase in confidence level on VaR?
increases conditional VaR
who sets the risk tolerance in ERM?
CIO
What are the steps of enterprise risk management
- identify risks
- measure risks
- mitigate and manage risks
- monitor risks
- report risks
- do strategic analysis and planing
Explain the concept of a “just” transition
relates to social risks. Fairness, justice and equality are important principles for everyone. Business decisions can have impacts on employees, local communities and entire towns and cities. “Just transitions” ensure that support and communication is provided to assist people impacted and minimize the negative impacts of transitions.
Steps of managing liquidity risk
- Establish liquidity risk policy guidelines
- Assess current liquidity
- Project future expected cash flows
- Stress test future liquidity needs
- Set an emergency liquidity contingency plan
