Business School

ACTL4303 AND ACTL5303

ASSET LIABILITY MANAGEMENT

Week 7
Risk Management
Greg Vaughan

What is Risk?
The probability of not meeting investment objectives
The investment objectives need to be explicit (eg a real return
above inflation of 3% over rolling five year periods, solvency
ratio above 110%)
For Accumulation members the probability of a negative return
is a standard definition
Superannuation funds are also increasingly concerned with
competitive returns relative to peers
Knightian uncertainty can we usefully estimate probabilities?

Standard Risk Measure Regime for

Superannuation Funds

Standard Risk Measure Regime for

Superannuation Funds

Calculations are before tax and administration fees

Best practice is to communicate more than one measure
(eg chance of positive real return over ten years)
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Risk Management

What are the exposures to various risks?

What are appropriate limits for financial exposures?
What is the measurement and monitoring framework?
What are the protocols for adjusting risk drifts?
What is the governance process for setting risk
management policies?
How independent is breach reporting and consequent
systems rectification?

Risk Identification (1)

Financial Risks
Market risk price volatility from stock market, interest
rates, exchange rates, commodities
Credit risk default and recovery, counterparty risks (eg
OTC derivatives)
Liquidity risk weighting in illiquid assets, currency hedges
Mandate specifications (eg tracking error limits, sector
weightings, stock specific active positions, cash restrictions,
derivative exposure limits ) control market risks

Risk Identification (2)

Nonfinancial risks
Operations risk front/back office separation, dealer
discretion
Model risk model selection and parameter estimation
Settlement risk sale of significant unlisted assets
Regulatory risk regulated assets, FIRB decisions
Legal risk stock borrowing collateral custody
Tax risk changes to tax regime
Accounting risk adequate corporate disclosure
Sovereign and political risks international equities
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Systemic Risk (Mike Barker 1999 and 2009)

Many transactions in financial markets are not price
sensitive and so price movements may not discourage
selling in some market conditions (eg dynamic hedging)
Leverage, including via derivatives, makes the financial
system more prone to instability
Capital adequacy standards for institutions may trigger
forced selling in weak markets decline in asset values
shrinks capital allowing less exposure to risky assets and
untimely selling
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Stability leads to instability (Hyman Minsky)

The financial system moves from stability to fragility,
followed by crisis (the Minsky moment)
The transition typically involves the accumulation of debt by
the non-government sector
Three types of debt
1. Hedge borrowwers: pay interest and pay down principal
2. Speculative borrowers: pay interest, rely on refinance
3. Ponzi borrowers : cant interest, rely on capital appreciation

A prevalence of Ponzi finance can eventually cause

systemic collapse
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Volatility-feedback hypothesis
Returns required by investors increase when volatility
increases due to risk aversion (CAPM)
If expected cash flows remain unchanged this will lead to a
fall in prices
Hence increases in volatility tend to coincide with negative
returns

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Market Crises and Contagion

The flow of information to markets explains a basic level of
day-to-day volatility
But market crises are driven by a collapse of liquidity
A crisis-induced demand for liquidity occurs as liquidity
suppliers pull back from the market
The result is significant price falls
The phenomenon spreads across markets when investors
hold diversified portfolios and expand their habitat

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Regime-switching models
Simple example is a regime-switching lognormal process
with two regimes
Rather than one pair of parameters (, ) to describe the
return distribution, we think of a different distribution for
each regime
Example
Regime 1 : Positive expected return, moderate volatility
Regime 2 : Negative expected return, high volatility
Markov switching between regimes probability of
changing regime depends only on the current regime, not
history
Use maximum likelihood to estimate (, ) for each regime
and the two probabilities of remaining in each
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Volatility is not risk

Popular criticism of volatility quantification
An expensive market with low volatility has latent risk
A steadily declining investment over a number of years,
incurring permanent loss of value, may not exhibit high
volatility (eg overpriced infrastructure)
A stock constantly buffeted by positive news will be volatile,
but may not be excessively risky (eg positive skew)
A bull market correction is not a bear market and will often
reverse
Return volatility ignores liabilities

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Volatility is serially correlated GARCH(1,1)

Large returns (of either sign) tend to be followed by more
large returns (of either sign)
Volatility for the current period is a function of a long term
reference level, volatility deviation in the prior period and
return disturbance in the prior period:

= + ( + ) (
2

2
t1

) + (z

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t1

t1

is the persistence of variation from the long term level

Is a standard normal (0,1) variable

t1

Projecting volatility using GARCH

The expectation of the last term is zero so volatility k
periods forward is simply

2 # =
!
Et " t+k $ + ( + ) (
k

Variance over time is the summation of sub-period variance

(assuming independence):

1 ( + ) )
(
( + )
k

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2
t+1:t+k

= k +

( )
2

1 ( + )

Projecting Volatility
In practice this type of model is only relevant over the shortterm
For example assume long-term equity market volatility is
20%pa
The persistence of volatility shocks is about 0.5 (+) on a
monthly basis
Volatility in past month is twice the historic average (40%pa)
That would imply volatility for the year ahead of 22.4%

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Human behavior and risk

Do fee incentives distort an investment managers risk
tolerance (eg hedge fund performance fees below high
water mark) ?
Is risk aversion stable or cyclical (ie greater at the troughs)?
If an investment committee capitulates in adverse
circumstances, an aggressive manager may be terminated
before their positions rebound.
Not much point being eventually right after the portfolio has
been withdrawn and reshaped
The risk appetite of an investment manager should not
exceed that of the client
Explicit and well considered risk parameters, expressed in
mandates, mitigate these problems
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Volatility attribution (1)

Volatility attribution analyses the variability of active return based on
assumptions about asset covariance and active risk

WP

Is the vector of portfolio asset class weights

WB

Is the vector of benchmark asset class weights

Is the covariance matrix of benchmark asset class returns

TV

Is a diagonal matrix of tracking variances for active

management within each asset class (square of tracking
errors)

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Volatility attribution (2)

On the assumption that active risk within asset classes is independent
of asset class market returns (alpha is independent of beta)

Var(RP ) = WP! WP + WP! TV WP

Var(RP RB ) = Var(AA)+Var(SS)
Var(AA) = (Wp WB )" (WP WB )
Var(SS) = WP! TV WP

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Volatility attribution (3)

A simple three asset class example

Asset
Equities
Volatility
17.0%
Tracking Error
2.5%
Correlations
Equities
1.00
Bonds
-0.20
Property
0.20

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Bonds
8.0%
1.5%

Property
5.0%
2.0%

1.00
-0.20

1.00

Volatility attribution (4)

Asset
Equities
Bonds
Property
Total
Portfolio Risk
Portfolio Var (%^2)
Portfolio Vol (%)
Active Risk
Var(AA) (%^2)
Var(SS) (%^2)
Total Active (%^2)
Total TE (%)

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Benchmark Portfolio A
60%
50%
30%
50%
10%
0%
100%
100%

101.8
10.1

Active A
-10%
20%
-10%
0%

76.8
8.8

Portfolio B
55%
40%
5%
100%

Active B
-5%
10%
-5%
0%

88.6
9.4

7.45
2.13
9.57
3.09

1.86
2.26
4.12
2.03

Volatility Attribution (5)

Active volatility should not to be confused with total portfolio volatility
Portfolio B has less active volatility but more total volatility
The proportion of active volatility due to tactical asset allocation varies
from 78% for portfolio A (7.45/9.57) to 45% for portfolio B (1.86/4.12)
If the portfolio asset allocation was the same as the benchmark asset
allocation all of the tracking variance would be due to security selection
Asset allocation is not necessarily the dominant driver of active volatility
and return
However total portfolio volatility is dominated by asset allocation
For Portfolio A only 2.8% of total volatility is due to security selection
(2.13/76.8), and for Portfolio B only 2.6% (2.26/88.6)

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Next Week

Heffernan Chapter 6 - Group J

BKM Chapter 26 - Group K

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