READING 31: Risk Management

Businesses need to take risks in areas in which they have expertise and possibly a comparative
advantage in order to earn profits, and minimize risks wherever and whenever they lack
comparative advantages. Risk management can entail taking risk as well as reducing risk.

RISK MANAGEMENT AS A PROCESS

The risk management process is as follows: (1) set policies and procedures, (2) define risk tolerance,
(3) identify risks, (4) measure risks, and (5) adjust the level of risk.

RISK GOVERNANCE

Risk governance is the process of setting risk management policies and standards for an
organization. The risk management process must be overseen by senior management.

 Under a centralized system, a single risk control unit is responsible for all risk management
activities.
o Centralization brings risk control closer to the key decision makers in the organization.
o Centralization enables the organization to better manage its risk budget by recognizing the
diversification embedded across business units.
 Under a decentralized system, each business unit is responsible for its own risk control.
o Decentralization places risk control in nearer proximity to the source of risk taking.
o Decentralization does not account for portfolio effects across units.

Centralized risk management is also called enterprise risk management (ERM).

 In ERM, risk factors are considered both in isolation and in relation to each other.
 Effective ERM systems always feature centralized data warehouses, where a company stores all
pertinent risk information in a technologically efficient manner.

Effective risk governance for investment firms:

 The trading function must be separated from the risk management function.
 An individual or group that is independent of the trading function must monitor the positions
taken by the traders or risk takers and price them independently.
 The risk manager should work with the trading desks in the development of risk management
specifications.
 The back office must be fully independent from the front office, so as to provide a check on the
accuracy of information and to forestall collusion.
IDENTIFYING RISKS

I. Financial Risks

1. Market Risk

Market risk includes interest rate risk, currency risk, equity market risk, and commodity risk. Market
risk is linked to supply and demand in various marketplaces.

2. Credit Risk

Credit risk is the risk of loss caused by a counterparty or debtor’s failure to make a promised
payment.

3. Liquidity Risk

Liquidity risk is the risk that a financial instrument cannot be purchased or sold without a significant
price impact.

 Liquidity risk is present in both initiating and liquidating transactions, for both long and short
positions, but can be particularly acute for liquidating transactions.
 Derivatives usually do not help in managing liquidity risk because the lack of liquidity in the spot
market typically passes right through to the derivatives market.

Indicators of liquidity:

• The bid–ask spread widens when markets are illiquid. However, bid-ask quotations apply only to
specified, usually small size, trades.
• The illiquidity ratio measures the price impact per $1 million traded in a day, expressed in
percentage terms.
• The greater the average transaction volume, the more liquid the instrument. However, there is
no certainty that historical volume patterns will repeat themselves.

II. Non-Financial Risks

1. Operational Risk

Operational risk is the risk of loss from failures in a company’s systems and procedures or from
external events (e.g., computer breakdowns, human errors, natural disasters, or terrorist actions).

 Some companies manage operational risk by using insurance contracts.

 Most companies manage operational risk by monitoring their systems, taking preventive actions,
and having a plan in place to respond if such events occur.
2. Model Risk

Model risk is the risk that a model is incorrect or misapplied.

3. Settlement (Herstatt) Risk

When settling a contract, settlement risk is the risk that one party could be in the process of paying
the counterparty while the counterparty is declaring bankruptcy.

 Exchange-traded transactions do not have settlement risk because all transactions take place
between an exchange member and the central counterparty.
 Two-way payments in OTC markets involve settlement risk. Netting arrangements can reduce
this risk.

4. Regulatory Risk

Regulatory risk arises from the uncertainty of how a transaction will be regulated and the potential
for regulations to change.

5. Legal/Contract Risk

Legal/contract risk is the risk of loss arising from the legal system’s failure to enforce a contract in
which an enterprise has a financial stake.

6. Tax Risk

Tax risk arises from the uncertainty associated with tax laws. Transactions exempt from taxation
could later be found to be taxable, and equivalent combinations of financial instruments are not
always subject to identical tax treatment.

7. Accounting Risk

Accounting risk arises from the uncertainty of how a transaction should be recorded and the
potential for accounting rules and regulations to change.

8. Sovereign and Political Risk

Sovereign risk is a form of credit risk in which the borrower is the government of a sovereign nation.
Political risk is the risk associated with changes in the political environment.
III. Other Risks

1. EGS Risk

EGS risk is the risk to a company’s market valuation resulting from ESG factors.

 Environmental risk arises from operational decisions related to products, services, and
production processes.
 Social risk arises from policies and practices regarding human resources, contractual
arrangements, and the workplace.
 Governance risk arises from corporate governance policies and procedures.

2. Performance Netting Risk

Performance netting risk is the risk of loss where the net performance of a group of managers
generates insufficient fee revenue to fully cover contractual payout obligations to all managers with
positive performance.

 Performance netting risk applies to entities that fund more than one strategy and have
asymmetric incentive fee arrangements with managers.
 An investment entity need not be flat or down on the year to experience netting-associated
losses.
 Performance netting risk can be managed by establishing absolute negative performance
threshold for individual accounts and aggressively cutting risk for individual managers at
performance levels at, near, or below zero.

3. Settlement Netting Risk

Settlement netting risk refers to the risk that a liquidator of a counterparty in default could challenge
a netting arrangement so that profitable transactions are realized for the benefit of creditors. Such
risk is mitigated by netting arrangements that can survive legal challenge.

MEASURING RISK

I. Measuring Market Risk

Standard deviation is often used to describe the risk of portfolios that contain instruments with
linear payoffs. Some applications (e.g., indexing) focus on active risk or tracking error.

Traditional measures of market risk include linear approximations such as beta, duration, and delta
as well as second-order estimation techniques such as convexity and gamma.
For products with option-like characteristics, techniques exist to measure the impact of changes in
volatility (vega) and the passage of time (theta). Sensitivity to movements in the correlation among
assets is also relevant for certain types of instruments.

II. Value at Risk (VaR)

Value at Risk (VaR) is an estimate of the minimum loss that is expected to be exceeded with a given
probability over a specified time period. VaR is usually expressed either as a percentage of value or
as a nominal amount.

Implications of VaR:

• VaR measures minimum loss only. The actual loss can be much greater than the specified
amount.
• VaR is associated with a given probability. The lower the probability, the greater VaR will be in
magnitude.
• VaR is based on a specified time period. VaRs cannot be compared directly unless they share the
same time interval. The longer the period, the greater VaR will be in magnitude.

Total VaR is less than the sum of individual VaRs when a company’s risk exposures are less than
perfectly correlated (Diversification effect = Total VaR – Sum of individual VaRs).

1. The Analytical or Variance-Covariance Method

The analytical method assumes that returns are normally distributed.

VaR = (μ𝑃 − 𝑧 × σ𝑃 ) × 𝑉𝑃

• z for a 5% VaR is 1.65, and z for a 1% VaR is 2.33.

• For monthly/weekly/daily VaR, divide the annual μ𝑃 by 12/52/250 and the annual σ𝑃 by

√12/√52/√250.
• Given an expected return of zero, independent daily returns, and a 250-day year:

250
Annualized VaR = n-day VaR × √
n

• An increase in expected return would result in a lower VaR, while an increase in the correlation
would increase the portfolio standard deviation, which would result in a higher VaR.
• The analytical method is suitable for portfolios with simple, linear characteristics, particularly
those with a limited budget for computing resources and analytical personnel.
• There is a 1%/5% chance that the portfolio will lose at least ? in a day/week/month/year.
Some approaches using the analytical method assume an expected return of zero.

 This assumption is acceptable for daily VaR calculations because expected daily return will tend
to be close to zero.
 This assumption offers a slightly more conservative result for longer time horizons because
assuming a zero expected return will result in a larger projected loss and VaR will be greater.
 This assumption makes it easier to adjust VaR for a different time period.

Characteristics of the analytical method:

 The analytical method uses readily available data and simple calculations.
 The analytical method assumes that returns are normally distributed. Distributions can deviate
from normality because of skewness and kurtosis.
 The analytical method is inappropriate for portfolios with options. The return distributions of
options and other derivatives are far from normal, and it is very difficult to calculate a covariance
because options have different dynamics at different points in their life cycle.

2. The Historical Method

The historical method estimates VaR from data on a portfolio’s performance during a historical
period.

 The returns are ranked, and VaR is obtained by determining the 5% or 1% worst returns.
 The historical method is simple and non-parametric. It requires minimal probability distribution
assumptions compared with other methods.
 The historical method applies historical price changes to the current portfolio. VaR estimates
derived from past data might not be relevant in the future.
 Bonds and most derivatives behave differently at different times in their lives, requiring current
pricing parameters to be adjusted to simulate their current characteristics.
 The historical method is suitable for complex portfolios containing options and time-sensitive
bonds.
 Of 240 returns, the 1% worst are the 2.4 worst returns. The 1% VaR would be the second worst
return, or the average of the second- and third-worst returns.

3. The Monte Carlo Simulation Method

Monte Carlo simulation uses a probability distribution for each variable of interest and a mechanism
to randomly generate outcomes according to each distribution.

 The outcomes are ranked, and VaR is obtained by determining the 5% or 1% worst outcomes.
 The Monte Carlo and analytical method should provide identical results when the sample size is
sufficiently large.
 The Monte Carlo simulation method does not require a normal distribution and can handle
complex relationships among risks.
 The Monte Carlo simulation method typically would not be a wise choice unless it were
managed by an organization with a portfolio of complex derivatives that is willing to make and
sustain a considerable investment in technology and human capital.

4. Surplus at Risk

Pension fund managers seek to enhance and protect the fund surplus. They typically apply VaR
methodologies to the surplus by expressing their liability portfolio as a set of short securities and
calculating VaR on the net position.

III. The Advantages and Limitations of VaR

Advantages of VaR:

• VaR is simple, easy to understand, and widely accepted.

• VaR is adaptable to a variety of uses, such as allocating capital.

Disadvantages of VaR:

• VaR can be difficult to estimate, and different estimation methods can give different values.
• VaR can give a false sense of security that risk is measured and controlled properly.
• VaR often underestimates the magnitude and frequency of the worst returns.
• VaR for individual positions does not generally aggregate in a simple way to portfolio VaR.
• VaR fails to incorporate positive results into its risk profile.
• It can be difficult to calculate VaR for a large complex organization with many exposures.

Back testing refers to the process of determining whether VaR estimates prove accurate in
predicting results by comparing the number of violations of VaR thresholds with the figure implied
by the selected probability level.

IV. Extensions and Supplements to VaR

 Incremental VaR (IVaR) measures the incremental effect of an asset on the VaR of a portfolio.
 Cash flow at Risk (CFaR) is the minimum cash flow loss that is expected to be exceeded with a
given probability over a specified time period.
 Earnings at Risk (EaR) is the minimum earnings loss that is expected to be exceeded with a given
probability over a specified time period.
 Tail Value at Risk (TVaR), also known as the conditional tail expectation, is the VaR plus the
expected loss in excess of VaR, when such excess loss occurs.

V. Stress Testing

Stress testing is used to test for losses under extreme market conditions. It is the natural
complement to VaR analysis, which is used to test for losses under normal market conditions.

Scenario analysis is the process of evaluating a portfolio under different scenarios.

• Stylized scenarios involve simulating a change in at least one risk factor relevant to the portfolio
(e.g., interest rate, exchange rate, stock price, or commodity price). One problem is that the
shocks tend to be applied to variables in a sequential fashion and their simultaneous effects are
not taken into account.
• Actual extreme events can be used in scenario analysis to measure their impacts on the
portfolio. This approach might be useful when the occurrence of extreme events has a higher
probability than that given by the probability model or historical time period used in developing
VaR.
• Hypothetical events are events that have never happened in the markets or events that are
assigned a small probability. Hypothetical events can also be used to create scenarios.

Stressing models can be used to examine how well a portfolio performs under some of the most
extreme market moves. This approach emphasizes a range of possibilities rather than a single set of
scenarios, but it is more computationally demanding.

• Factor push involves pushing the prices and risk factors of an underlying model in the most
disadvantageous way and working out the combined effect on the portfolio’s value.
• Maximum loss optimization involves optimizing mathematically the risk variable that will
produce the maximum loss.
• Worst-case scenario analysis involves examining the worst case that is actually expected to
occur.

VI. Measuring Credit Risk

Credit risk has 2 dimensions, the probability of default and the associated recovery rate.

• Current credit risk (jump-to-default risk) is the risk that amounts currently due will not be paid.
• Potential credit risk is the risk that amounts due in the future will not be paid.
A cross-default provision stipulates that if a borrower defaults on any outstanding credit obligations,
the borrower is in default on them all.

Credit VaR reflects the minimum credit loss with a given probability over a specified time period.

 Credit VaR cannot be separated from market VaR because credit risk arises from gains on market
positions held.
 Credit VaR focuses on the upper tail whereas market VaR focuses on the lower tail.
 Credit VaR must take into account the complex interaction of market movements, the possibility
of default, and recovery rates.
 Credit VaR is difficult to aggregate across markets and counterparties.

The credit risk of derivatives is considerably less than the credit risk of loans because:

 With the exception of currency swaps, the notional principal is never exchanged in a swap.
 Even with currency swaps, the risk is much smaller than on a loan. If a counterparty defaults on a
currency swap, the amount owed to the defaulting counterparty serves as a type of collateral.
 On forward and swap transactions, the netting of payments makes the risk extremely small.

1. Option-Pricing Theory and Credit Risk

A bond with credit risk can be viewed as a default-free bond plus an implicit short put option on the
assets written by the bondholders for the stockholders. This put option is called the stockholder’s
right of limited liability, which allows the stockholders to fully discharge their liability by turning over
the assets to the bondholders, even though those assets could be worth less than the bondholders’
claim.

2. The Credit Risk of Forward Contracts

Credit risk in a forward contract is assumed by the party to which the market value is positive.

 The market value of the forward contract is the current value of the future claim one party has
on the other, reflecting the potential credit risk of the contract. Current credit risk only arises
when the contract is at its expiration.
 If the party to which the value is negative defaults, the counterparty has a claim of that value. If
the party to which the value is positive defaults, the defaulting party holds an asset with the
positive market value.
 The value of the long position in a forward contract:
𝐹(0, 𝑇)
𝑉𝑡 (0, 𝑇) = 𝑆𝑡 −
(1 + 𝑟)𝑇−𝑡
 The value of the long position in a currency forward contract on the foreign (base) currency:
𝑆𝑡 𝐹(0, 𝑇)
𝑉𝑡 (0, 𝑇) = 𝑇−𝑡
−
(1 + 𝑅𝐹𝐶 ) (1 + 𝑅𝐷𝐶 )𝑇−𝑡

3. The Credit Risk of Swaps

Credit risk in swaps is similar to credit risk in forward contracts.

 The market value represents the present value of the payments owed to the party minus the
present value of the payments the party owes. The party holding the positive market value
assumes the credit risk at that time.
 For interest rate and equity swaps, credit risk is greatest near the middle of the swap term
because at that point, the credit profile of the counterparties may have changed for the worse
and the magnitude and frequency of expected payments between counterparties remain
material.
 For currency swaps with payment of notional principal, credit risk is greatest between the
middle and the end of the swap term because of the exchange of notional principals at maturity.

4. The Credit Risk of Options

Options have unilateral credit risk.

 The seller faces no credit risk as the buyer pays the option premium immediately and in full,
while the buyer faces the risk that the seller will not meet their obligations in the event of
exercise.
 The market value of the option is the current value of the future claim the buyer has on the
seller. The buyer faces potential credit risk equal to the market value of the option, and faces
current credit risk when the option is exercised.
 American options do have the potential for current credit risk while European options do not.

VII. Liquidity Risk

VaR assumes that positions can be sold at their trading or estimated market value. Because some
assets are far more liquid than others in practice, liquidity-adjusted VaR can be estimated to
incorporate liquidity risk.

VIII. Measuring Nonfinancial Risks

Nonfinancial risks are intrinsically very difficult to measure. Some of these risks are more suitable for
insurance than measurement and hedging.
MANAGING RISK

I. Managing Market Risk

Risk budgeting is the process of establishing policies to allocate the finite resource of risk capacity to
business units that must assume exposure in order to generate return.

 Risk capital is allocated before the fact in order to provide guidance on the acceptable amount of
risky activities that a given unit can undertake. Management can compare the profits generated
by each unit with the amount of capital and risk employed.
 Risk budgets are often expressed in terms of allocated capital and the acceptable level of risk,
expressed in dollar amounts of VaR.
 The sum of risk budgets for individual units will typically exceed the risk budget for the
organization as a whole because of the impacts of diversification.
 Risk budgeting has also been applied to allocating funds to investment managers according to
their expected information ratios. Correlation-adjusted information ratios should be used to
eliminate the effect of asset class correlations.
 An organization might allocate risk based on VaR limits, performance stopouts, working capital
allocations, scenario analysis limits, risk factor limits, position concentration limits, leverage
limits, or liquidity limits.
 Calculations:
o Return on capital = Profit $/Capital $
o Return on VaR = Profit $/VaR $

II. Managing Credit Risk

1. Reducing Credit Risk by Limiting Exposure

Credit risk can be managed by limiting the amount of exposure to a given party.

2. Reducing Credit Risk by Marking to Market

Both futures markets and OTC derivatives markets use marking to market to manage credit risk.

 When a forward contract or swap calls for marking to market, the party for which the value is
negative pays the market value to the party for which the value is positive. Then the fixed rate
on the contract is recalculated.
 OTC options usually are not market to market because their value is always positive to one side
of the transaction. Option credit risk is normally handled by collateral.
3. Reducing Credit Risk with Collateral

Credit risk can be managed by requiring the posting of collateral.

 Futures markets require that all market participants post margin collateral.
 Many OTC derivative markets have collateral posting provisions, with the collateral usually
taking the form of cash or highly liquid, low-risk securities.
 In addition to market values, collateral requirements are sometimes also based on factors such
as participants’ credit ratings.

4. Reducing Credit Risk with Netting

Netting involves the reduction of all obligations owed between counterparties into a single cash
transaction that eliminates these liabilities. Netting is a common feature used in two-way contracts
with a credit risk component, such as forwards and swaps.

 Payment netting reduces the credit risk by reducing the amount of money that must be paid.
 Closeout netting refers to the bankruptcy process where two counterparties agree to net the
market values of all of their contracts to determine one overall value owned by one party to the
other.
 Cherry picking involves a bankrupt company attempting to enforce contracts that are favorable
to it while walking away from those that are unprofitable.

5. Reducing Credit Risk with Minimum Credit Standards and Enhanced Derivative Product
Companies

Credit risk can be managed by setting minimum credit standards or using enhanced derivatives
products companies (EDPCs).

 EDPCs tend to be heavily capitalized and are committed to hedging all of their derivatives
positions. As a result, these subsidiaries almost always receive the highest credit quality rating.
 If the parent goes bankrupt, the EDPC is not liable for the parent’s debts. If the EDPC goes
bankrupt, the parent is liable for an amount up to its equity investment. Hence, an EDPC
typically has a higher credit rating than its parent.

6. Transferring Credit Risk with Credit Derivatives

Credit risk can be managed by transferring it to another party using credit derivatives.

 In a credit default swap, the protection buyer pays the protection seller in return for the right to
receive a payment from the seller in the event of a specified credit event.
 In a total return swap, the protection buyer pays the total return on a reference obligation in
return for floating-rate payments. The protection seller is exposed to both credit risk and
interest rate risk.
 A credit spread option is an option on the yield spread of a reference obligation and over a
referenced benchmark.
 A credit spread forward is a forward contract on a yield spread.

III. Performance Evaluation

Mean portfolio return − Risk-free rate

Sharpe ratio =
Standard deviation of portfolio return

 The Sharpe ratio uses standard deviation of portfolio return as the measure of risk.
 The Sharpe ratio can be inaccurate when applied to portfolios that contain options or other
instruments with significant nonlinear risks.

Expected return on capital

Risk-adjusted return on capital (RAROC) =
Capital at risk

 RAROC uses capital at risk (defined in various ways) as the measure of risk.
 The company may require that an investment’s expected RAROC exceed a benchmark level.

Average return in a given year

Return over Maximum Drawdown (RoMAD) =
Maximum drawdown

 RoMAD uses maximum drawdown as the measure of risk.

 Maximum drawdown is the largest difference between a high-water mark and a subsequent low.

Mean portfolio return − MAR

Sortino ratio =
Downside deviation

 The Sortino ratio measures risk using downside deviation, which computes volatility using only
returns below a minimum acceptable return (MAR).
 Like the Sharpe ratio, the Sortino ratio assumes that returns are normally distributed.

IV. Capital Allocation

The most effective approach to capital allocation involves combination of different methodologies
with the dual objective of profit maximization and capital preservation.

• All position limits must be revised periodically with the change in risk-return expectations.
• Position limits should not be changed in response to temporary changes in risk.
• Position limits are adjusted gradually to incorporate permanent changes in risk.
1. Nominal, Notional, or Monetary Position Limits

The enterprise defines a nominal position limit that the individual portfolio or business unit can use
in a specified activity, based on the actual amount of money exposed in the markets.

 Nominal position limits are easy to understand and monitor.

 Nominal position limits may not capture effectively the effects of correlation and offsetting risks.
Furthermore, an individual may be able to work around a nominal position using other assets
(e.g., options) that can replicate a given position.

2. VaR-Based Position Limits

The enterprise assigns a VaR limit as a proxy for allocated capital.

• VaR-based position limits allocate capital in units of estimated exposure and thus act in greater
harmony with the risk control process.
• VaR-based position limits are only as effective as the VaR calculation. In addition, the relation
between overall VaR and the VaRs of individual positions is complex and can be counterintuitive.

3. Maximum Loss Limits

The enterprise establishes a maximum loss limit for each of its risk-taking units.

• The maximum loss limit must be large enough to enable the unit to achieve performance
objectives but small enough to be consistent with the preservation of capital.
• The maximum loss limit must represent a firm constraint on risk-taking activity.
• Extreme market discontinuities can cause maximum loss limits to be breached.

4. Internal Capital Requirements

Internal capital requirements specify the level of capital appropriate for the firm.

• Traditionally, internal capital requirements have been specified in terms of the capital ratio (the
ratio of capital to assets).
• Modern tools permit a more rigorous approach. If the value of assets declines by an amount that
exceeds the value of capital, the firm will be insolvent. If a 1% probability of insolvency over 1
year is acceptable, capital must equal at least 1-year aggregate VaR at the 1% probability level.
• If the company can assume a normal return distribution, the required amount of capital can be
stated in standard deviation units (e.g., 1.96 standard deviations would reflect a 0.025
probability of insolvency).
• A capital requirement based on aggregate VaR takes account of correlations. Furthermore, the
VaR-based recommendation can be stress tested to account for extraordinary shocks.

5. Regulatory Capital Requirements

Many institutions (e.g., securities firms and banks) must meet their regulatory capital requirements.

• Such requirements are sometimes inconsistent with rational capital allocation schemes.
• When regulatory capital requirements are higher relative to internal capital requirements, they
overrule internal capital requirements.

V. Psychological and Behavioral Considerations

Implications of behavioral aspects of portfolio management in risk management:

 Risk takers may behave differently at different points in the portfolio management cycle. Risk
management would improve if these dynamics could be modeled.
 It is important to establish a risk governance framework that anticipates the points in a cycle
when the incentives of risk takers diverge from those of risk capital allocators.