Risk Management CHAPTER 12

Transcription

1 Risk Management CHAPTER 12

2 Concept of Risk Management Types of Risk in Investments Risks specific to Alternative Investments Risk avoidance Benchmarking Performance attribution Asset allocation strategies Diversification strategies

3 Risk Management Risk refers to future uncertainty of events that can hinder an organisations growth and profitability. Risk management is the process of identifying, measuring, managing, assessing, and prioritizing risks facing an organisation followed by a balanced, coordinated and economic application of resources to evaluate, minimize, monitor, and control the probability and/or impact and thus, expected loss from unfortunate events or to maximize the realization of opportunities. The objective is not to eliminate the risk, but it is to reduce its probability of unexpected events so that the organization s objectives are met.

4 Risk Management There are two types of events: negative events (risks or threats) and positive events (opportunities). Strategies to manage threats: avoiding the threat, reducing probability of the threat by adopting mitigation strategies, transferring all or part of the threat to another party, And even retaining some or all of the potential or actual consequences of a particular threat.

5 Concept of Risk Management Types of Risk in Investments Risks specific to Alternative Investments Risk avoidance Benchmarking Performance attribution Asset allocation strategies Diversification strategies

6 Types of Risk Systematic Risk Unsystematic risk

7 Systematic Risk Systematic risk is also referred to as market risk or un-diversifiable risk. This risk affects all the market participants, be it individuals or companies, simultaneously (the extent of affect depends on the nature of their business). It cannot be controlled by any market participant. This risk cannot be reduced by diversification but can surely be hedged. It is measured in terms of Beta.

8 Types of Systematic Risk Interest Rate Risk It is the risk that the interest rates in the market will fluctuate and thus, lead to a change in the value of the investments. This risk particularly affects debt securities as they carry the fixed coupon rate over the life of the bond. Interest rate risk can be further classified into: Price Risk Reinvestment Risk

9 Types of Systematic Risk Market Risk It can be defined as the as the risk of facing losses due to changes/movements in the market affecting the performance of all the financial instruments. The types of market risk are: absolute, relative, directional, non-directional, basis and volatility. Inflation Risk - It is the risk that the increase in the prices of securities will lead to a decrease in the purchasing power. It is not desirable to invest in securities during an inflationary period.

10 Unsystematic Risk It is also known as company specific risk or diversifiable risk. It arises due to internal factors of a company that are specific to that particular company only. It is micro in nature as the risk is limited to a particular company. Therefore, the companies can put in place mitigation strategies to reduce the probability of their occurrence. Investing in a large number of stocks diversifies the unsystematic risk.

11 Types of Unsystematic Risk Business Risk - It is the risk of inability to sell or dispose the asset/security at their market value. Credit Risk - It is the risk that a company will not be able to timely pay the interest or principal of its debt obligations. Components of credit risk are: recovery rate risk, sovereign risk and settlement risk. Operational Risk These are the risks arising in the day-to-day operations of the company. It occurs due to breakdowns in the internal procedures, people, policies and systems. The types of operational risk are: model risk, people risk, legal risk and political risk.

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13 Concept of Risk Management Types of Risk in Investments Risks specific to Alternative Investments Risk avoidance Benchmarking Performance attribution Asset allocation strategies Diversification strategies

14 Risks in Alternative Investments Hedge Funds They engage in leverage and other speculative investment practices that may increase the risk of investment loss. They are highly illiquid and are not always required to provide periodic pricing or valuation information to investors. They may involve complex tax structures and delays in distributing important tax information and are not subject to regulatory requirements with respect to disclosure of financial information. They also charge high fees and are not transparent about the strategies used. The performance can be very volatile.

15 Risks in Alternative Investments Private Equity The standard deviation of private equity returns has been noticed to be higher than the returns of equity index, indicating greater risk with private equity. The portfolio companies are revalued infrequently, and thus, the reported standard deviations and correlations with equity index returns may be inaccurate. The choice of fund manager is of utmost importance as the differences between the top and bottom quartile managers are significantly large that persist over time. Other risks include regulatory, liquidity, diversification, etc.

16 Risks in Alternative Investments Real Estate The value of real estate is correlated to global and domestic economic factors, markets and interest rate levels. They are subject to changes in regulations of an economy. The degree of leverage used by the manager also has a bearing on the total risk and his ability to identify correct real estates and his understanding ability of regulations makes the choice of manager very important. The performance reported by indices may not be appropriate.

17 Risks in Alternative Investments Commodity Sharpe Ratios for commodities have been low due to the high volatility of commodity prices and lower returns over time. The demand for commodities is affected by global economic conditions and life cycles. The supply of commodities is affected by production and cost of maintaining the inventory. In case of agricultural commodities, the supply is greatly affected by the weather which can lead to price volatility. Commodity users thus need to analyse the market conditions, make forecasts of demand and supply and keep a watch on government policies.

18 Biases Selection Bias - It occurs when only those funds are included in the selected sample that have survived over the years and not the funds that have ceased to exist due to closure, merger or poor performance. This is done to inflate the performance attribute of the managers or advisors. Backfill Bias - When the performance of a fund is added to performance database months or years after its inception it is known as backfill bias. New managers usually are entered into a database after a period of good performance, when entry seems particularly alluring. During periods of bad performance, fewer managers join databases, and therefore bad performance is rarely backfilled into the averages.

19 Concept of Risk Management Types of Risk in Investments Risks specific to Alternative Investments Risk avoidance Benchmarking Performance attribution Asset allocation strategies Diversification strategies

20 Risk Avoidance Risk avoidance is the elimination of hazards, activities and exposures that can negatively affect an organization's assets. This can be achieved by removing the risky assets, hedging or countering threats. The complete removal of risk is very rarely possible and thus risk avoidance strategies are prepared in a way to avoid damaging events with dire consequences. Risk avoidance and mitigation can be achieved through policy and procedure, training and education and technology implementations.

21 Methods of Risk Avoidance Avoidance through setting of policies and procedures Avoidance through training and education Avoidance through application of technology

22 Concept of Risk Management Types of Risk in Investments Risks specific to Alternative Investments Risk avoidance Benchmarking Performance attribution Asset allocation strategies Diversification strategies

23 Benchmarking Benchmarking is identifying the best of investment practices by companies or/and advisors in the industry and comparing one s own performance against it. The dimensions measured by benchmarking are quality of the investment, time period, cost and the return earned. A benchmark is a standard against which a security's or an advisor s performance is compared.

24 Benchmark Selection Process Individual profile: The first step in selecting a benchmark model is determining an individual s profile on the basis of RRTTLLU- Risk, Return, Liquidity, Time, Tax, Legal and Unique. Asset Allocation: Next an asset allocation strategy needs to be adopted on the basis of the investor s profile. Since most people have diversified portfolios, the allocation should include multiple asset classes. The advisor needs to identify the stocks to be included and their percentage allocation along with the frequency of rebalancing.

25 Costs of Benchmarking Indirect cost Time cost Benchmarking database cost

26 Advantages of Benchmarking Helps improve the existing work model Increased competition Improved quality of work Improved performance Cheaper

27 Limitations of Benchmarking It is just a mere identification. It shows quantitative results only. Performance of benchmarking depends on implementation.

28 Concept of Risk Management Types of Risk in Investments Risks specific to Alternative Investments Risk avoidance Benchmarking Performance attribution Asset allocation strategies Diversification strategies

29 Performance Attribution Performance Attribution or Investment Performance Attribution is a set of technique that performance analysts use to explain why a portfolio's performance was different from its benchmark. This difference between the portfolio return and the benchmark return is known as the active return. It is the value added by the active management.

30 Performance Attribution It attempts to distinguish which of the two factors of portfolio performance, superior stock selection or superior market timing, is the source of the portfolio s overall performance. This method compares the total return of the manager s actual investment holdings with the return for a predetermined benchmark portfolio and decomposes the difference into two components: factor return and security selection return.

31 Concept of Risk Management Types of Risk in Investments Risks specific to Alternative Investments Risk avoidance Benchmarking Performance attribution Asset allocation strategies Diversification strategies

32 Asset Allocation It is the application of an investment strategy that aims to strike a balance between risk and reward by adjusting the proportion of each financial instrument in an investment portfolio as per the investor's risk and reward objectives, and investment time frame. Establishing an appropriate asset mix s a dynamic, expensive and time consuming process that plays a key role in determining a portfolio's overall risk and return. The asset mix should reflect the investor goals and objectives.

33 Asset Allocation Strategies Strategic Asset Allocation Constant- Weighting Asset Allocation Tactical Asset Allocation Dynamic Asset Allocation Insured Asset Allocation Core-Satellite Asset Allocation

34 Asset Allocation Strategic Asset Allocation This method of asset allocation involves selection of financial instruments based on their expected returns. This strategy is essentially a buy and hold strategy that is expected to give required return over a period of time. The drawback of this strategy is that it is static and thus, unable to take advantage of positive opportunities that may be available.

35 Asset Allocation Constant Weighting Asset Allocation This approach involves continuous evaluation and rebalancing of the portfolio of an investor. Tactical Asset Allocation Tactical asset allocation strategy can be described as creating an asset mix with the objective of having an expected return in the long-term. This strategy is flexible i.e. the asset mix can be altered in the short-run upon recognition of positive opportunities for a higher expected return.

36 Asset Allocation Dynamic Asset Allocation This is an active asset allocation strategy in which the mix of assets are continuously adjusted to movements in the markets. With this strategy, an investor will keep close track of the market of different financial instruments and try to take advantage of even the smallest of opportunities. Insured Asset Allocation It involves setting of benchmark for a minimum expected return from the investment strategy that acts as an insurance. The return is not allowed to be lower than the benchmark.

37 Asset Allocation Core-Satellite Asset Allocation It contains a 'core' strategic element making up the most significant portion of the portfolio, while applying a dynamic or tactical 'satellite' strategy that makes up a smaller part of the portfolio.

38 Concept of Risk Management Types of Risk in Investments Risks specific to Alternative Investments Risk avoidance Benchmarking Performance attribution Asset allocation strategies Diversification strategies

39 Diversification Diversification can be described as reducing concentration of the portfolio from a very few financial instruments to a number of instruments of different sectors and kinds by having a proportionate concentration in each according to the individual risk and return needs. Risk can never be reduced down to zero. It helps an investor reach his long-term financial goals while minimizing the risk component.

40 Diversification Effective asset allocation will see one s investment funds split across multiple asset classes to help balance risk and provide stable potential rewards. It is advised to balance financial investments across different industry sectors. By splitting the portfolio across sectors, one can help balance the unsystematic risk of these industries in a better, and reduce their impact on the portfolio. Higher risk companies may be defined by their share price volatility, high levels of debt, etc. and can be profitable investments. However, it is advised that these investments should only represent a limited proportion of the portfolio.

41 Diversification The portfolio theory tells us that after investing in different financial instruments, one is very close to optimal diversification and having about 30 different investments reduces the unsystematic risk to almost zero. Depending on what type of investor one is, he may have a higher or lower tolerance for risk in his portfolio. Whether the market is bullish or bearish, maintaining a diversified portfolio is essential to any long-term investment strategy.

42 Better risk management may be the only true necessary element of success in banking. Alan Greenspan

43 THANK YOU