To manage an effective risk management solution requires more than the calculation of VaR. Ultimately a successful risk management program requires the execution of an effective hedge. Technical analysis is a vital element of this strategy.
Recent market reversals brought about by the Sub-Prime mortgage melt down is clearly a significant market correcting event. No matter if you work in the risk department of a large bank with many employees or a small fund of funds as co-manager, you share the same basic concerns regarding the management of your portfolio(s)
1. how to maintain top quartile performance;
2. how to protect assets in times of economic uncertainty;
3. how to expand business reputation to attract new client assets;
It remains common in the financial industry to hear experienced Portfolio Managers state their risk management program consists of timing the market using their superior asset picking skills. When questioned a little further it becomes apparent that some confusion exists when it comes to hedging and the use of derivatives as a risk management tool.
Risk management analysis can certainly be an intensive process for institutions like banks or insurance companies who tend to have many diverse divisions each with differing mandates and ability to add to the profit center of the parent company. However, not all companies are this complex. While hedge funds and pension plans can have a large asset base, they tend to be straight forward in the determination of risk.
While Value-at-Risk commonly known as VaR goes back many years, it was not until 1994 when J.P. Morgan bank developed its RiskMetrics model that VaR became a staple for financial institutions to measure their risk exposure. In its simplest terms, VaR measures the potential loss of a portfolio over a given time horizon, usually 1 day or 1 week, and determines the likelihood and magnitude of an adverse market movement. Thus, if the VaR on an asset determines a loss of $10 million at a one-week, 95% confidence level, then there is a a 5% chance the value of the portfolio will drop more than $10 million over any given week in the year. The drawback of VaR is its inability to determine how much of a loss greater than $10 million will occur. This does not reduce its effectiveness as a critical risk measurement tool.
A sound risk management strategy must be integrated with the derivatives trading department. Now that the Portfolio Manager is aware of the risk he faces, he must implement some form of risk reducing strategy to reduce the likelihood of an unexpected market or economic event from reducing his portfolio value by $10 million or more. 3 options are available.
1. Do nothing - This will not look favourable to investors when their investment suffers a loss. Reputation suffers and a net draw down of assets will likely result;
2. Sell $10 million of the portfolio - Cash is dead money. Not good for returns in the event the market correcting event does not occur for several years. Being overly cautious keeps a good Portfolio Manger from achieving top quartile status;
3. Hedge - This is believed by all of the worlds largest and most sophisticated financial institutions to be the answer. Let's examine how it's done.
Recent market reversals brought about by the Sub-Prime mortgage melt down is clearly a significant market correcting event. No matter if you work in the risk department of a large bank with many employees or a small fund of funds as co-manager, you share the same basic concerns regarding the management of your portfolio(s)
1. how to maintain top quartile performance;
2. how to protect assets in times of economic uncertainty;
3. how to expand business reputation to attract new client assets;
It remains common in the financial industry to hear experienced Portfolio Managers state their risk management program consists of timing the market using their superior asset picking skills. When questioned a little further it becomes apparent that some confusion exists when it comes to hedging and the use of derivatives as a risk management tool.
Risk management analysis can certainly be an intensive process for institutions like banks or insurance companies who tend to have many diverse divisions each with differing mandates and ability to add to the profit center of the parent company. However, not all companies are this complex. While hedge funds and pension plans can have a large asset base, they tend to be straight forward in the determination of risk.
While Value-at-Risk commonly known as VaR goes back many years, it was not until 1994 when J.P. Morgan bank developed its RiskMetrics model that VaR became a staple for financial institutions to measure their risk exposure. In its simplest terms, VaR measures the potential loss of a portfolio over a given time horizon, usually 1 day or 1 week, and determines the likelihood and magnitude of an adverse market movement. Thus, if the VaR on an asset determines a loss of $10 million at a one-week, 95% confidence level, then there is a a 5% chance the value of the portfolio will drop more than $10 million over any given week in the year. The drawback of VaR is its inability to determine how much of a loss greater than $10 million will occur. This does not reduce its effectiveness as a critical risk measurement tool.
A sound risk management strategy must be integrated with the derivatives trading department. Now that the Portfolio Manager is aware of the risk he faces, he must implement some form of risk reducing strategy to reduce the likelihood of an unexpected market or economic event from reducing his portfolio value by $10 million or more. 3 options are available.
1. Do nothing - This will not look favourable to investors when their investment suffers a loss. Reputation suffers and a net draw down of assets will likely result;
2. Sell $10 million of the portfolio - Cash is dead money. Not good for returns in the event the market correcting event does not occur for several years. Being overly cautious keeps a good Portfolio Manger from achieving top quartile status;
3. Hedge - This is believed by all of the worlds largest and most sophisticated financial institutions to be the answer. Let's examine how it's done.
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