Risk Budgeting in Investment Management

Question 1

Compare absolute and relative risks.

Answer 1

Absolute Risk:
Risk of an absolute dollar loss over a given time horizon
Sometimes called asset risk, with relevant rate of return

Relative Risk:
Risk of a dollar loss in fund relative to its benchmark

Question 2

Compare policy-mix risk and active management risk.

Answer 2

Policy-mix risk:

• Risk of a dollar loss owing to the policy mix of the selected fund
• Risk from passive strategy of investing in benchmark

Active-management risk:

• Risk of a dollar loss owing to total deviations from the policy mix

Question 3

Define funding risk.

Answer 3

Funding risk - risk that assets will not be able to cover liabilities

Question 4

List three causes of increased risk/VaR in actively managed portfolios

Answer 4

1. Active manager taking more risk: Any exceedence of the VAR limit should be flagged and monitored closely
2. Different managers making similar bets: Occurs when multiple portfolio managers increase their allocations to a particular sector
3. More volatile markets: VaR can increase if the current investments themselves are just getting more volatile

Question 5

What is the role of a global custodian in a centralized risk management system?

Answer 5

The global custodian would aggregate reports to give a consolidated picture of the total exposure of the fund

Question 6

Describe two ways in which VaR can help manage risk

Answer 6

Designing guidelines for investment limits

• Traditional manager guidelines are based off of limits on notionals or limits on sensitivities
• However, these traditional limits are not enough because they do not involve correlations or risk variations, and do not deal well with leverage or hedges
• Solution: VaR-based position limits can help overcome many of the drawbacks of these traditional limits/guidelines

Help with strategic asset allocation in the investment management process

• Traditional strategic asset-allocation is based on a mean-variance optimization, which can fail to recognize the effects of marginal adjustments from the selected portfolio
• Solution: VaR can be helpful for asset allocation because they can help quantify the impact on portfolio risk that adding a specific position can have on the fund

Question 7

Describe how to calculate an information ratio (IR).

Answer 7

It is active return divided by active risk

Question 8

Define tracking error.

Answer 8

Tracking error (TE) - active return minus the benchmark return

Question 9

State the optimization result for risk budgeting across active managers.

Answer 9

The optimization result is X_iw_i = IR_i*(w_p/IR_p)

Question 10

RiskMetrics Nine Key Principles of Risk Management

Answer 10

1. There is no return without risk
2. Be transparent (all risks should be fully understood)
3. Seek experience
4. Know what you don’t know
5. Communicate
6. Diversify (diversify the risks of the company)
7. Show discipline (requires a rigorous and consistent approach to risk management)
8. Use common sense
9. Return is only half

Question 11

Critical Components of Risk Budgeting in a Fund Management Company

Answer 11

1. Performance stopouts: Maximum amount a portfolio can lose over a period
2. Working capital allocations: Allocate a specific amount of working capital to each portfolio manager
3. VaR limits: Set the maximum VaR for each portfolio
4. Scenario analysis limits: Each portfolio manager must demonstrate that losses under specific scenarios are within thresholds
5. Position concentration limits: A maximum amount that can be invested in a single position
6. Leverage limits: Maximum amount of leverage allowed
7. Liquidity limits: Positions limits as a maximum percentage of daily volume, open interest, etc

Question 12

Ways to Manage Credit Risk

Answer 12

1. Limiting exposure
2. Marking to market
3. Collateral
4. Netting Risk Exposures
5. Minimum Credit Standards and Enhanced Derivative Product Companies
6. Transferring Credit Risk with Credit Derivatives

Question 13

Risk-Adjusted Performance Evaluation Metrics

Answer 13

1. Sharpe Ratio
2. Sortino Ratio
3. Risk-Adjusted Return on Capital
4. REturn over Maximum Drawdown

Question 14

Methods of Measuring Capital

Answer 14

1. Nominal, notional, or monetary position limits: The actual amount of money exposed in the markets
2. VaR-based position limits
3. Maximum loss limits: Specifies the maximum amount a firm is willing to lose in a risk-taking unit
4. Internal capital requirements: Specify the level of capital that management believes is appropriate for the firm
5. Regulatory capital requirements