Introduction

Risk management is a central component of asset allocation and portfolio management. Asset allocators and portfolio managers must be familiar with risk management. Manager must understand the risks of securities that they invest in and examine the risk management processes of companies that may have issued those securities.

A number of questions arise in the process of developing a rigorous risk management process:

• What is an efficient process for identifying the risks present in the investment environment?
• What are the effective methods for measuring risk exposures of available investments?
• What are the effective policies to managing the risk exposures of securities added to the portfolio?
• What are the rewards for assuming the various risks that may affect a portfolio’s performance?
• How much risk should the portfolio assume and how should risk exposure of the portfolio be managed through various market cycles.

INGARM has developed expertise to offer introductory as well as advanced courses exploring these questions while offering applied and practical solutions through its instructional material.

Types of Risk

Portfolio managers must be familiar with various types of risks that could impact the performance of their portfolios. Two broad categories of risks affect performance of portfolios and companies: Financial Risk and Nonfinancial risks. Each of these two categories consist of several types of risks.

Financial Risks

• Market Risks: These risks arise from unexpected changes in market conditions. These are associated with unexpected changes in interest rates, exchange rates, stock prices, and commodity prices. Each of these risks may require a different approach to measuring and managing risk. For example, volatility or Value at Risk are suitable for measuring and managing equity risk, while duration and convexity are suitable for fixed income instruments.
• Credit Risks: These risks are associated with losses resulting from nonperformance by a counter party. Historically, credit risk has been associated with loan markets. However, given the rise of over the counter derivatives during the past three decades, credit risk has become even more important and its management requires sophisticated techniques.
• Liquidity Risk: This is the risk that a financial instrument cannot be purchased or sold without a significant concession in price because of the market’s potential inability to efficiently accommodate the desired trading size. In some cases, the market for a financial instrument can dry up completely, resulting in a total inability to trade an asset. Global financial crisis of 2007-2008 brought liquidity risk to the forefront and highlighted the dynamics nature of liquidity risk as it responds to changes in market conditions.

Nonfinancial Risk

• Operational Risk: This risk is associated with losses from failures in a company’s systems and procedures or from external events. These risks can arise from computer breakdowns (including bugs, viruses, and hardware problems), human error, employees’ misconducts, breakdowns in security processes and events completely outside of companies’ control, including “acts of God” and terrorist actions.
• Model Risk: This is the risk that a model is incorrect or misapplied; in investments, it often refers to valuation models. Model risk exists to some extent in any model that attempts to identify the fair value of financial instruments, but it is most prevalent in models used in derivatives markets. Since the development of the seminal Black–Scholes–Merton option-pricing model, both derivatives and derivative pricing models have proliferated. The development of so many models has brought model risk to prominence.
• Regulatory Risk: This is the risk associated with the uncertainty of how a transaction will be regulated or with the potential for regulations to change. Equities (common and preferred stock), bonds, futures, and exchange-traded derivatives markets usually are regulated at the federal level, whereas OTC derivative markets and transactions in alternative investments (e.g., hedge funds and private equity partnerships) are much more loosely regulated.
• Political Risk: Asides from regulatory risk, which arises from unexpected changes in government policies, political risk may present itself in terms of credit risk associated with financial transaction involving sovereign states.

INGARM instructional material and readings offer clear guidelines and discussions regarding each of these risks. Various techniques for measuring and managing these risks along with real world examples are presented.

Measuring Risk

Measuring risk is the first step in managing the risk of an investment. Academics and practitioners have developed a number of methods for measuring the risk associated with various securities.

• Volatility: This is perhaps to most widely used measure of risk. It measures the uncertainty associated with performance of an investments around the average outcome.
• Duration: Measures the sensitivity of bonds to small changes in interest rates.
• Delta: Measures the sensitivity of a derivative security to changes in its underlying security.
• Beta: Measures the sensitivity of a security to market wide risk. Most commonly it is used to measure the sensitivity of equity oriented securities or investment strategies to changes in broad indices representing equity markets.
• Value at Risk (VaR): Measures the loss that a portfolio manager does not expect to see exceeded with a given level of confidence.
• Extended Value at Risk: These measures of risk apply the VaR concept to measure risks associated with earnings, cash flows and credit lines (credit VaR).

Managing Risk

Having established methods for the identification and measurement of risk, we turn our attention to a critical stage of any solid risk management program: that of managing risk. RiskMetrics Group (www.riskmetrics.com) identifies the following nine principles of effective risk management:

• There is no return without risk. Rewards go to those who take risks.
• Be transparent. Risk should be fully understood.
• Seek experience. Risk is measured and managed by people, not mathematical models.
• Know what you don’t know. Question the assumptions you make.
• Communicate. Risk should be discussed openly.
• Diversify. Multiple risks will produce more consistent rewards.
• Show discipline. A consistent and rigorous approach will beat a constantly changing strategy.
• Use common sense. It is better to be approximately right than to be precisely wrong.
• Return is only half the equation. Decisions should be made only by considering the risk and return of the possibilities.