2005 Enterprise Risk Management Symposium The Society of Actuaries, the Casualty Actuarial Society and the Professional Risk Managers' International Association
Current Thinking on Risk Management May 2, 2005
Leslie Rahl President Phone: 212-404-6101 E-mail:
[email protected]
Capital Markets Risk Advisors (CMRA) does not warrant the truth, accuracy, timeliness or completeness of any information or data provided herein. This presentation does not constitute investment advice nor does it constitute a solicitation, recommendation, inducement or invitation by CMRA or any other person to buy, sell or hold any security, financial product or financial service or otherwise engage in investment activity. All copyrights, database rights and other intellectual property rights relating to this presentation belong solely to CMRA and no portion of these materials may be transferred, transmitted, extracted, duplicated, sold, resold or circulated in whole or in part without CMRA's prior written consent. © ALL RIGHTS RESERVED
Galaxy of Risks
(Partial listing)
Common Risk Measures Prepayment Sensitivity
Aging
Dollar Face
Alpha
Duration
Bank Tracking
DV01
Benchmark Equivalents
Effective Duration
Beta
Extension Risk
Bucketed Sensitivity
Factor Analysis
Concentration
Gamma
Convexity
Gap Analysis
Correlation
Likelihood of Default
Country Exposure
Loan to Valuation Ration
Coverage Ratios
Mark to Market
Credit Rating
Mark to Model
Current Risk Exposure
Option-Adjusted Spread
Delta
Position Reports
Devaluation Risk
Potential Risk Exposure
Relative Value Rho Risk Rating Scenario Analysis Sensitivity Sharpe/Treynor Measures Shortfall Probability Simulation Spread Analysis Standard Deviation Stress Testing Theta VaR Vega
(Partial listing)
CMRA’s Galaxy of Performance Measures
Absolute Return
Risk of Ruin
Appraisal Ratio
Semi-Variance
Cash Flow Adjusted Equity Market
Sharpe Ratio
Index Cash on Cash Returns
Sortino Ratio
Downside Deviation
Target Deviation Shortfall Probability
Downside Risk
Time-Weighted Rate of Return
Drawndown Risk
Treynor’s Measure
Information Ration
Value-at-Risk
Jensen’s Measure Modigliani Ratio
Vintage Year’s Comparison Benchmark Relative VaR Liquidity Adjusted VaR
Goals of Risk Control
Know Your Risks Define Your Tolerances Minimize Uncompensated Risks Minimize Unanticipated Risks
Policy Issues Where are you on this scale?
Formal
Informal
• Operate on trust “Do the right thing
• Rely on culture to control risk
• Often leaves room for “adverse innovation”
• “If it is not written here, don’t do it”
• Slows innovation and frustrates managers
• Often removes reward available at acceptable risk
Overview: Risk Management Framework Volatility Correlation VaR
Policy Limits Roles Authorities
Unbundling Products Measure All Risks
Stress Tests
Evaluate Portfolio Level & Mix
Limits Monitoring
Dialogue & Decisions
Daily Markto-Market
Capital
Performance Measurement & Research Allocation
Stress Testing Approaches
Quantative Evaluation of Tail Events
Testing Sensitivity Assumptions
Historical Events
Scenarios Based on History but Updated
InstitutionSpecific Scenarios
Extreme Standard Deviation Scenarios
How Often are Firm-Wide Stress Test Results Presented to Senior Management?
53.5%
% of Respondents
60% 50%
39.5%
40% 30%
23.3%
23.3%
20% Daily
Weekly
Source: Committee on the Global Financial System
Monthly
Quarterly
Do Any of Your Stress Tests Allow for the Interaction of Market Risk and Counterparty Default Credit Risk?
74.4%
% of Respondents
80%
60%
40% 25.6% 20% Yes
No
Source: Committee on the Global Financial System
Risk Management
Complexity of Valuation
Low
High
Liquid Transparent pricing
Illiquid Mark-to-model Optionality Uncertain cash flows Concentrated Leveraged
NAV/Fair Value Survey 51% of respondents indicated that they marked their long
positions to the midpoint of the market versus the more conservative approach of using the bid side. One participant marks to “last trade” and one used “last bid/offer”. Overall, practices varied significantly by fund type.
Fund of Funds Hedge Funds Mutual Funds Traditional Money Managers
% Marking to Midpoint 67 60 38 17
NAV/Fair Value Survey Reliance on a Single Quote
Traditional Money Managers Hedge Funds Mutual Funds
% Willing to Rely on One Quote 75.0 63.6 37.5
NAV/Fair Value Survey
Definitions of “illiquid” vary across participants and include: ♦ >10% ownership ♦ Zero or one market marker ♦ No price change for five consecutive business days ♦ Cannot sell position in one week at 1/3 daily volume ♦ Not able to be sold at the current value, within seven days
Asset Liquidity Affects Valuation Risk Time Series for Broker-Dealer Quotes on an MBS Derivative Quotes Received June 1999 to March 2001 for FNR 99-15 SB 102
100.5 100.4 96.4 92.6 92.5
97 92
Price
87 82 77
84.0 82.7 82.0 81.0 79.0
91.2 87.0 87.0 86.0
82.7 82.0 81.0 79.0 78.0
72
70.0 68.0 65.0
67 62
79.0 77.0 74.0 72.0 70.0
80.0 76.0 75.0 71.0 69.0
74.0 69.0 68.0 65.0 64.0
64.0
60.2 59.0
57 Jun 99
Sep 99
Dec 99
Mar 00
Jun 00
Sep 00
Dec 00
Mar 01
Quotes arranged from highest to lowest
Source: Hedge Fund Transparency, Quantifying Valuation Biased for Illiquid Assets, RISK, June 2002
Returns Vary Based on Methodology Used
Quarterly Returns - 12/99 to 3/00
Bid % Highest Lowest Average Drop high and low and average
12.9 18.6 15.3 15.1
Mid % Offer % 14.8 15.0 21.0 12.5 16.8 10.1 16.3 7.5
Returns Vary Based on Mid vs. Bid/Offer
Quarterly Returns - 12/99 to 3/00
Bid %
Mid %
Offer %
Highest Lowest
12.9 18.6
14.8 21.0
15.0 12.5
Average
15.3
16.8
10.1
Drop high and low and average
15.1
16.3
7.5
Importance of Valuation
Did the investor fairly pay/receive the correct amount for his or her investment/redemption? Are funds that employ similar strategies “comparable” or does
the investor need to make mental adjustments made for impact of different methodologies?
Valuation Due Diligence Questions Do you have written valuation policies and procedures? May I please see them? Who marks the book to market? In what percentage of your portfolio does the manager come up with
his/her own marks? Who reviews the marks? Who has authority to override? Who receives override reports? Since you trade in multiple time zones, how do you calculate your
NAV?
Valuation Due Diligence Questions (Cont’d)
What percentage of your portfolio is marked to model? Under what circumstances does the fund adjust a quoted price? How do you account for the lack of liquidity in your valuations? Do you haircut the price where the holding is large compared to
daily volumes? How do you deal with correlation assumptions? Do you mark longs to the bid and shorts to the offer? Everything at
midpoint? Other? How many data sources do you use? Do you vary volatility by maturity? By strike?
Valuation Due Diligence Questions (Cont’d) If the fund uses an average of multiple sources/quotes, what is
the general range between the minimum and the maximum? What is the largest spread you can remember? If the fund does not use an “average”, what is the method for
arriving at its marks? What controls does the fund have in place to avoid or mitigate
potential conflicts of interest relating to valuation? How does the fund use ex-post information to evaluate their
pricing? What assumptions does the firm use when market quotes are
not available? Who develops these assumptions?
Valuation Due Diligence Questions (Cont’d)
What process does the fund use to resolve disagreements between the traders and others with regard to pricing? Does the fund’s prime broker separately mark the portfolio? If so, how do the broker and firm reconcile differences, if any? Does the fund have a threshold at which it investigates offmarket transactions? If so, does the fund have a threshold at which it discloses to stakeholders off-market transactions? Does the fund have a valuation committee or designated people who perform the functions of a valuation committee?
Ten Valuation Principles
1) Valuations should be determined consistently and in good
faith 2) A firm should disclose its valuation policy and process to all
investors 3) Valuations should conform to the firm’s valuation policy and
process 4) Valuations should be verifiable 5) Unless a change is beneficial with regard to accuracy,
valuation methods should be applied consistently from period to period
Ten Valuation Principles (cont’d)
6) Material
changes in valuation methods communicated to appropriate stakeholders
should
be
7) A market price is the basic reference for building valuations,
and actual (traded) prices are the best indicators of the market price 8) Liquidity issues and transaction costs mitigate the law of one
price 9) Fair price is the amount at which two consenting parties agree
to transact at arm’s length 10) All prices are not created equally (e.g., large block vs. odd lot,
and two or more different dealers)
Aggregate Risk / Return Contribution of the FoF Portfolios by Strategy and Asset Allocation for the 3Q02-3Q03 Period Risk & Performance Contribution by Strategy for FoF Portfolio 2 (Size of Bubble = Asset Allocation)
Risk & Performance Contribution by Strategy for FoF Portfolio 1 (Size of Bubble = Asset Allocation) 40%
120%
G. Macro, 15.1%
Conv. Arb, 15.0%
25% F.I. Arb, 13.9%
20% Mkt Neutral, 10.5% F.I. Diversified, 7.8%
15% 10%
Distressed Sec, 17.8%
Contribution to Risk
100%
30%
L/S, 66.2%
80% 60% 40% 20%
5%
Conv. ArbFoF, 4.2% 3.3%
Em.Mkt, 2.1% 0%
0.0%
5.0%
Event Driven, 14.0%
0%
L/S, 3.0%
Mer.Arb, 2.1% 10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
Distr.Sec, 7.6% G. Macro, 2.7% 10.0% 20.0%
0.0%
30.0%
40.0%
50.0%
Contribution to Performance
Contribution to Performance
Risk & Performance Contribution by Strategy for FoF Portfolio 3 (Size of Bubble = Asset Allocation) 50%
Distr.Sec, 26.3%
40% Contribution to Risk
Contribution to Risk
35%
30%
20%
L/S, 14.9%
Conv. Arb, 10.7% E.Driven, 8.3%
Mkt Neut, 15.0%
10% G. Macro, 4.3% Merger. Arb, 6.1%
0%
Multi-S., 4.0%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
Contribution to Performance
Comparisons of Market Neutral Indices Across Different Sources
1997
1998
1999
2000
14.8 13.6 12.3
13.3 8.3 5.1
15.3 7.1 (0.8)
15.0 14.6 7.1
9.3 6.4 6.1
Tuna Maximum Difference
19.2
11.8
19.6
17.4
7.3
3.0
0.6
6.9
8.2
20.4
10.3
3.2
10.5
2.3
Average
15.0
9.6
10.3
13.5
7.3
8.1
1.2
CSFB/Tremont HFR Hennessee
Source: Tuna, HFR, CSFB/Tremont, Hennessee
2001
1997 to 2001 Sharpe Ratio Return 13.5 2.6 10.0 1.3 5.9 0.3
60.0%
CSFB/Tremont Market Neutral Index vs. Individual Managers 30
Return (%)
25 20 15 10
CSFB/Tremont Index
5 0 0
2
4
6
8
10
12
14
Standard Deviation (%) Source: CSFB/Tremont, Altvest, CMRA Analysis is based on 26 funds included in the CSFB/Tremont Index
Adding hedge funds to a 60/40 USD Portfolio
If we assume an 8.6% return, a 6% standard deviation*, and a 20% maximum constraint on a hedge fund allocation, a classical optimization would allocate 12% to hedge funds. If we used a 26.5% return (1999 actual) and the same other assumptions, the allocation would go to 20%. If we used a (5.1%) return (1998 actual) and the same other assumptions, the allocation would be 0%.
* 1995-2004 HFRI FoF Composite
16