The Mathematics of Financial Modelingand Investment Management

23-RiskManagement Page 752 Wednesday, February 4, 2004 1:13 PM

752 The Mathematics of Financial Modeling and Investment Management

ing asset managers to accept market risk as they devise guaranteed-

return funds or convex strategies to protect the investor against down-

side risk. The type of quantitative methods used and the extent of risk

modeling is largely determined by the risk—relative or absolute—that

the asset management firm is exposed to; other important factors

include the prevailing culture and the competitive environment.

Some asset management firms are now defining their risk more

broadly as business risk. Market risk and the failure to deliver a mandate

are only two facets of business risk. Others include process flows and

fraud and come under the general heading of operational risk. Opera-

tional risk has been moved up on the agenda by management consultants

and, more recently, by the European Commission with proposals to

extend to the asset management subsidiaries of larger financial organiza-

tions the new Basel rules on capital charges to cover business risk.

Factors Driving Risk Management

One of the major contributions of quantitative methods to asset man-

agement is widely considered to be in the area of risk. For the more

quantitatively-oriented firms, ex ante risk measurement has enabled

risk-return optimization as prescribed by modern finance theory, the

dynamic management of risk, and the ability to handle structured prod-

ucts; for others, it means the ability to “look back” on risk.

Several factors are behind the focus on risk:

■ Regulatory and reporting frameworks have put risk on the agenda of

institutional investors.

■ Pension consultants are pressing for more measures of risk and tying

performance to risk.

■ Growing sophistication on the part of trustees and institutional inves-

tors is also a driver behind the demands for risk measures including

VaR.

■ The growing complexity of assets in portfolios (e.g., global assets,

structured products) is adding to risk and the need to monitor and con-

trol it.

■ The recent volatility in both asset classes and investment styles is

increasing the need to monitor tracking error in an effort to limit

downside risk.

■ The contribution risk modeling makes in defining mandates.

Risk Measurement in Practice

In practice, as noted previously, a whole battery of risk measures are

being used. A number of considerations can be made. The more complex