Risk Monitoring and Performance Measurement Flashcards
(19 cards)
What is VaR?
Largest loss possible for a certain level of confidence over a specific period of time
Tracking Error
The SD of excess returns, where excess return is portfolio return less benchmark return
Also known as tracking risk
When dealing with portfolios, if Risk relative to budget is too high
VaR level increases, and this is active management
If risk is very low, VaR is low, and this is passive management (or less active management)
A measure that can be used to determine the relative amount of discretion that can be taken by the portfolio manager
Tracking Error
What is VaR and Tracking Error used for checking
VaR: to determine capital allocation
Tracking Error: to determine the level of Active Management
The dimensions of an effective risk management process
Risk Planning
Risk Budgeting
Risk Monitoring Risk
Risk planning objectives for an entity to Consider
- Setting expected return (E(Rp)) and volatility goals (Sigma) (using scenario analysis)
- Defining quantitative measures of success and failure (ROE and RORC)
- Generalizing how risk capital will be utilized to meet the entity’s objectives (minimum RORC and RORC correlations)
4.Defining the difference between events that cause ordinary damage vs serious damage (low frequency high severity vs high frequency low severity)(seeking external insurance vs self insurance: cost benefit analysis) - Identifying mission critical resources inside and outside the entity and discussing what should be done in case those are jeopardized.
Risk budgeting
Risk budget quantifies the risk plan. There needs to be structured budgeting process to allocate risk capital to meet the entity’s objectives and minimize deviations from the plan. Comes with a reasonable return expectation, and an estimate of variability around that expectation.
RORC
Return on Risk Capital
Quantitative methods to risk budgeting
- Set minimum acceptable levels of RORC and ROE (determine if there is sufficient compensation for the risks taken)
- Apply mean variance optimization to determine the weights for each asset class
- Simulate the portfolio performance based on the weights and for several time periods. (perform sensitivity analysis)
Risk monitoring
Done for checking variances from budget
Within an entity’s internal control environment, if any significant variances from budget, ensure there are no threats to meeting its ROE and RORC targets.
Risk Management Unit
A Risk Management Unit monitors an investment management entity’s portfolio risk exposure and ascertains that the exposures are authorized and consistent with the risk budgets previously set.
How to check if the manager is generating a forecasted level of tracking error that is consistent with the target?
Forecasted tracking error is an approximation of the potential risk, how much variance is acceptable, and how much variance requires immediate action
What is style drift?
Basically, a manager is supposed to invest in value stocks, but he is investing in growth stocks, that is a style drift.
Style drift may manifest itself in a value portfolio manager who attains the overall tracking error target but allocates most of the risk in growth investments.
What is liquidity duration and why is it needed?
Measuring portfolio liquidity is a priority in stress testing. One potential measure is liquidity duration. It is an approximation of the no of days necessary to dispose of a portfolio’s holdings without a significant market impact (without significantly changing the mkt price of the security).
LD=Q/(0.1 X V)
Q-> No. of shares of the security
V -> daily volume of the security
LD=Q/(0.1 X V), what does the 0.1 refer to?
It means that the market price will not be impacted if a maximum of 10.0 percent trading volume is traded in a day
What is Goldman Sachs Management’s color zones?
Green Zone: Identifies instances of actual tracking error or performance that are outside of normal expectations.
Yellow Zone: Something which always happens but is not acceptable
Red zone: Doesn’t happen often and needs investigation
What does an RMU do?
It monitors an investment management firm’s risk exposure and ascertains that exposures are authorized and consistent with risk budgets previously set.
