2005 Enterprise Risk Management Symposium

2005 Enterprise Risk Management Symposium The Society of Actuaries, the Casualty Actuarial Society and the Professional Risk Managers' International A...
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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

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