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
