LO 68.6: Apply VaR to check compliance, monitor risk budgets, and reverse

LO 68.6: Apply VaR to check compliance, monitor risk budgets, and reverse engineer sources of risk.
There are many types of risks that can increase dramatically in a large firm. For example, the rogue trader phenomenon is more likely in a large firm. This occurs when a manager of one of the accounts or funds within the larger portfolio deviates from her guidelines
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Topic 68 Cross Reference to GARP Assigned Reading – Jorion, Chapter 17
in terms of portfolio weights or even trades in unauthorized investments. Such deviations from compliance can be very short-term, and regular reporting measures may not catch the violations.
Risk management is necessary for all types of portfolioseven passively managed portfolios. Some analysts erroneously believe that passive investing, or benchmarking, does not require risk monitoring. This is not true because the risk profiles of the benchmarks change over time. In the late 1990s, a portfolio benchmarked to the S&P 500 would clearly have seen a change in risk exposures (e.g., an increase in the exposure to risks associated with the high- tech industry). A forward-looking risk measurement system would pick up on such trends.
Monitoring the risk of actively managed portfolios should help identify the reasons for changes in risk. Three explanations for dramatic changes in risk are (1) a manager taking on more risk, (2) different managers taking similar bets, and (3) more volatile markets. Thus, when there is an increase in the overall risk of a portfolio, top management would want to investigate the increase by asking the following questions.
Has the manager exceeded her risk budget? VaR procedures and risk management can allocate a risk budget to each manager. The procedures should give an indication if and why the manager exceeds the risk budget. Is it a temporary change from changes in the market? Has the manager unintentionally let the weights of the portfolio drift so as to increase risk? Or, more seriously, has the manager engaged in unauthorized trades?
Are managers taking too many of the same style bets? If the managers are acting independently, it is possible that they all start pursuing strategies with the same risk exposures. This could happen, for example, if all managers forecast lower interest rates. Bond managers would probably begin moving into long-term bonds, and equity managers would probably begin moving into stocks that pay a high and stable dividend like utility companies and REITs. This would drastically increase the interest rate risk of the overall portfolio.
Have markets become more volatile? If the risk characteristics of the entire market have changed, top management will have to decide if it is worth accepting the volatility or make decisions to reduce it by changing the target portfolio weights.
VaR can also be reverse engineered by utilizing the VaR tools outlined in the previous topic, such as component VaR and marginal VaR. These tools provide insight on how the overall portfolio will be affected by individual position changes. This method can be used provided that all relevant risks have been identified within the risk management system.
In the risk management process, there is a problem with measuring the risk of some unique asset classes like real estate, hedge funds, and venture capital. Also, there may be limited information on investments in a certain class (e.g., emerging markets and initial public offerings).
There is a trend in the investment industry toward management choosing a global custodian for the firm. Such a choice means an investor aggregates the portfolios with a single custodian, which more easily allows a consolidated picture of the total exposures of the fund. The custodian can combine reports on changes in positions with market data to produce forward-looking risk measures. Thus, the global custodian is an easy choice in pursuing centralized risk management. Along with the trend toward global custodians,
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Topic 68 Cross Reference to GARP Assigned Reading – Jorion, Chapter 17
there has been a trend in the custodian industry toward fewer custodians that can provide more services. Large custodian banks such as Citibank, Deutsche Bank, and State Street are providing risk management products.
Those that choose not to use a global custodian have done so because they feel that they have a tighter control over risk measures and can better incorporate VaR systems into operations. There are often economies of scale for larger firms in that they can spread the cost of risk management systems over a large asset base. Also, they can require tighter control when their assets are partly managed internally.
Increasingly, clients are asking money managers about their risk management systems. The clients are no longer satisfied with quarterly performance reports. Many investment managers have already incorporated VaR systems into their investment management process. Widely used risk standards for institutional investors recommend measuring the risk of the overall portfolio and measuring the risk of each instrument. It may be the case that those who do not have comprehensive risk management systems will soon be at a significant disadvantage to those who do have such systems. There also seems to be some attempt by managers to differentiate themselves with respect to risk management.
Va R Appl ic a t io n s