Measurement and
Management of Market
Risk
VaR and Risk Budgeting in Investment Management
Zaur Nurtaza
Baruch College
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Agenda
Sell side vs Buy side
Buy side risks
Using VaR to measure and manage risk
Risk budgeting
Sell side vs Buy Side
Sell side
Sellers of financial services, such as banks
Wall Street is sell side
Buy side
Buyers, such as investors or funds
Investment management
Pension funds
Sell side has relied more on VaR measures
historically, but Buy side is increasingly
adopting the methods
Sell Side vs Buy Side
Characteristic
Sell Side
Buy Side
Horizon
Short-term (days)
Long-term (months or more)
Turnover
Fast
Slow
Leverage
High
Low
Risk measures
VaR
Stress tests
Asset allocation
Tracking error
Risk controls
Position limits
VaR limits
Stop-loss rules
Diversification
Benchmarking
Investment guidelines
Investment process
Large investors have a structured investment
process, as opposed to traders
First step: long term, strategic asset
allocation
Second step: choose managers
Active or passive
Evaluated with tracking error
VaR becoming more important
Globalization of available investments
Increased complexity of investments
Companies becoming more dynamic
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Hedge funds
Very heterogeneous class of assets
Includes a variety of trading strategies
Leverage and trade a lot
Similar to sell side
Liquidity risk more apparent
Loss from having to liquidate too quickly
Difficult to measure the exact value of the fund
Low liquidity underestimates volatility, thus risk
Low transparency
Definition of risk
Absolute vs Relative risk
Policy mix vs Active risk
Funding risk
Sponsor risk
Absolute vs Relative Risk
Absolute risk
Aka asset risk
Total possible loss over a horizon
Relative risk
Measured by excess return relative to a
benchmark
Policy Mix vs Active Risk
Policy mix risk
Associated with the target policy
More relevant for passive strategy
Active risk
Total PnL from across all managers
Diversification will reduce active risk
Brinson et al. (1986)
Funding risk
Aka Surplus risk
Risk of not being able to deliver fixed
liabilities
Assets vs liabilities of a pension fund
Defined benefit funds have the highest funding
risk
Defined contribution funds have lower
Surplus = Assets Liabilities
Surplus = Assets Liabilities
When assets and liabilities change by different
amounts, results in Surplus at Risk (SaR)
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Example: Surplus at Risk
The ABC Retirement Fund has $100 million in
assets and $90 million in liabilities. Expected
return on the surplus is 5% of assets ($5 million
over the first year). The volatility of the surplus,
scaled by assets, is 8%. Using a z-value of 2.33,
calculate the one year Surplus at Risk and the
resulting deficit
Expected value of the Surplus = $15 million
SaR = 2.33 x 8% x $100 million = $18.64
million
Deficit = $18.64 - $15 = $3.64 million
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Plan sponsor risk
Extension of surplus risk
Relates to those who ultimately bear
responsibility for pension fund
Economic risk
Variation in the total economic earnings of the
plan sponsor
Cash-flow risk
Variation of contributions to the fund
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Using VaR to monitor risk
Large firm vulnerable to different types of
risk
Monitor active managers risk
Manager taking on more risk (exceeding risk
budget)
Different managers taking similar bets
More volatile markets
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Using VaR to manage risks
VaR tools
Marginal VaR, component VaR
Global custodian
Centralization of performance, reporting, risk
management
Custodians track positions and have market data
Provide forward-looking risk measures
Custodian industry dominated by few large
players
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Risk budgeting
Top-down process that involves choosing
and managing exposures to risk
First establish a risk budget for the entire portfolio
Then allocate risk to individual positions
Differs from market value allocation since it
involves the allocation of risk
Evaluate an addition of a new manager
Use incremental VaR instead of individual VaR
Helps in monitoring risk on high level
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Conclusions
Buy side adopting VaR methods from Sell
side
VaR helps monitor and manage risks in
investment management process
Risk management systems are spreading
quickly in the industry
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