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VaR and Risk Budgeting in Investment Management

Sell side vs Buy side


Buy side risks
Using VaR to measure and manage risk
Risk budgeting

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

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

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

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

Absolute vs Relative risk


Policy mix vs Active risk
Funding risk
Sponsor risk

Absolute risk
Aka asset risk
Total possible loss over a horizon

Relative risk
Measured by excess return relative to a
benchmark

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)

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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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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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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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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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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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

15

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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