VaR and Risk Budgeting in Investment management Flashcards
(23 cards)
What is risk budgeting?
It is a top down process that involves choosing and managing exposures to risk.
This is allocation of risk, and here, risk is allocated to individual positions on a predetermined fund risk level (basically risk adjusted returns)
Which is mainly the sell side and buy side?
Sell side is investment banks (with developed VaR techniques), and buy side is investors (started to use VaR)
Leverage constraints for institutional investors
They have much stronger constraints with respect to leverage, and therefore they have a much lower need to control downside risk
The Investment Process
- Determine the long term strategic asset allocations.
- Choose the manager, and review his activities periodically, and analyze tracking error
How to determine the long term strategic asset allocations?
- Through Mean variance portfolio optimization.
- Reliance on passive indices and benchmarks.
What are hedge funds?
A very heterogeneous class of assets that include a variety of trading strategies.
They use a lot of leverage, and more similar to the sell side of the industry. They also have liquidity and transparency risks.
What are the problems from liquidity risk in hedge funds?
- Potential Loss from having to liquidate too quickly.
- Difficulty in measuring exact value.
- Lowers the volatility of historical prices as well as the correlations of the positions.
What is absolute or asset risk?
Total possible loss over a horizon
What is relative risk?
This is measured by excess return, which is the dollar loss relative to a benchmark.
What is Funding Risk?
Refers to being able to meet the obligations of an investment company. This is the risk that the value of assets will not be sufficient to cover the liabilities of the fund.
The level of this risk varies dramatically across different types of investment companies. Defined pension plans have the highest of this kind of risk.
What is the focus of Funding Risk?
Focus is SURPLUS, which is the difference between the value of the assets and the liabilities and the change in the surplus, which is the difference between the change in the assets and the liabilities.
Surplus = Assets - Liabilities
Return on Surplus = Return on Assets - return on liabilities X Liabilities/ Assets
What is Surplus at Risk? (SaR)
When assets and liabilities change by different amounts, this affects the surplus, and the resulting volatility of the surplus is a source of risk. If the surplus turns negative, additional contributions will be required. This is called SURPLUS AT RISK (SAR).
What is one answer to dealing with Surplus at Risk?
Immunize the portfolio by making the duration of the assets equal to that of the liabilities. This may not be possible, as either the investments may not be available, or the assets may give lower return.
Important formula for calculating surplus at risk
Var(A-L)=Var(A) + Var (L) - 2 X Cov (A,L)
Sar at (1-alpha) significance = Expected Surplus - SD(surplus)(from last formula) X Z(alpha)
If managers tend to make the same style shifts in the fund
It will increase management risk
What is plan sponsor risk?
This is an extension of surplus risk, and relates to those who ultimately bear responsibility for the pension fund.
Economic risk is the variation in the total economic earnings of the plan sponsor.
Cash flow risk is the variation of contributions of the fund. Being able to absorb fluctuations in cash flow allows for a more volatile risk profile.
When there is an increase in overall risk of portfolio, we should ask
Has the manager exceeded her risk budget?
Are managers taking too many of the same style bets?
Have markets become more volatile?
Monitoring the risk of actively managed portfolios, can identify the reasons of changes in risk
Three explanations involve
1. Manager taking more risk
2. Different managers taking similar bets (assumed diversification is false)
3. More volatile markets
What are global custodians?
The custodian can combine reports on changes in positions with market data to produce forward looking risk measures.
Firms with large asset bases do not have custodians because
1) cheaper, cost spread over large scale asset
2) more control
3) better VaR estimates
Weight of portfolio managed by manager i
IR(i) X (portfolio’s tracking error)/(IR X Managers tracking error)
Using VaR to monitor risk is important for a large firm with many types of managers because
It can help catch rogue traders and detect changes in risk from changes in benchmark characteristics
VaR can be used to compose better guidelines for investment companies by
Relying less on notionals
Focusing more on overall risk
