The risk systems should be able to create synthetic securities to represent these special
exogenous risks.
The ability of a risk system to correctly handle exotic securities has been crucial ever
since the advent of derivatives and complex mortgage securities in mainstream investor
portfolios. This is often an issue with securities subject to credit risk. Consider the US
college-saving plans that were invested infixed income mutual funds that lost over 90% of
their value in the recent Credit Crisis.This is often a big failing with risk systems.
Frequently, these more exotic securities just get skipped over and remain a ticking time
bomb. At worst, procedures should be in place such that if a security cannot be explicitly
modeled with reasonable effort, we proxy that security with something simple but
reasonable.We can no longer afford to leave government bonds, money market funds,
or other investments perceived as safe out of the process.
The quality of portfolio risk assessments is sensitive to the extent to which the risk
system natively recognizes the full nature of each particular security. If the system does
not recognize a security and, therefore, must evaluate risk based on the risks of
recognized proxies (or other forms of approximation) the risk assessment will be less
robust, even if completeness in security coverage was achieved. As such, all risk reports
should be footnoted with information as to what fraction of a portfolio was fully
recognized and on what portion of the portfolio it was necessary to resort to cruder
assessments.
The risk management system has to have good aggregation capabilities. Not only
should we be looking at individual portfolios, but aggregation at the product level, or by
regional office, or investment officer. Adherence to benchmarks and compliance con-
straints should be able to be checked regularly on an almost fully automated basis, with
exceptions brought to the attention of appropriate staff on a daily basis.
The reader has probably noticed by now that the subject of news analytics has not
been mentioned since the opening paragraphs. This intentional omission is meant to
convey that, while news analytics can be important building blocks, they cannot
contribute positively to an overall risk management process that is poorly conceived.
Prompt response to information flows is a necessary, but not sufficient condition for
success.
Managing firm-wide risk is all about deciding what you are trying to accomplish. We
need to consider three dimensions of risk for asset managers. The first aspect is the
distinction between client portfolio risk and asset manager business risk. The second
issue is the balance between long-term risks and short-term risks. Finally, we must
consider whether investment risks are perceived in absolute wealth terms, relative to
inflation or relative to market benchmarks. We also have to have a process that
accurately assesses the risks of all types of investment assets, related liabilities, and
potential exogenous economic influences on the investor.
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