Financial risk and the management of risk are at the core of investment success. The job of a Financial Risk Manager is to understand just how much money could be lost under various scenarios – and have a plan ready to deal with such events.
Importance of Managing Risk
The financial risk manager has a similar objective function to a portfolio manager. They both want to maximize the return on their capital. The financial risk manager may have an additional dimension to his problem, though. He must also condition his returns on the amount of risk he takes, whereas the portfolio manager may be more concerned with absolute returns.
A Portfolio Manager generally tries to maximize the return on a portfolio of financial assets subject to a mandate that imposes various constraints. In contrast, a Financial Risk Manager will be most concerned with the difference between the values of a portfolio of assets and a set of liabilities that are associated with those assets. For instance, the Financial Risk Manager at a properly governed pension fund will focus on the gap between the asset value and the present value of the commitment to pay benefits to beneficiaries of the pension plan.
“Risk” has many definitions. The conventional, business school definition is volatility, which is analyzed statistically with a panoply of Greek letters. This approach is seriously flawed since it relies on a small and highly auto-correlated data set analyzed by highly intelligent mathematicians who generally have limited experience in financial markets. One of the major problems that arose in the banking crisis was the extensive and mandated use of “Value at Risk” (VAR) models which purported to give banks the capability of managing the gaps between assets and liabilities.
Operationally, the flaw in the VAR approach is that it assumes that liquidity will always be sufficient to permit the Dynamic Hedging required to instantaneous adjust VAR. In practice, liquidity is never available when VAR managers need it.
Moving beyond these quantitative approaches to risk are qualitative concepts amenable only to market sceptics and historians – sometimes identifiable by battle scars and grey hair. A Liquidity Hole or a Vacuum is a condition that arises very occasionally when either buyers or sellers disappear – often in response to a “Black Swan” event. These “Risks” are dismissed by the Quants as falling into the five percent of their data sets that are statistically irrelevant. Of course, these are the times and events that really matter.
With this as background, we can now consider the role of Risk Manager in a typical institutional, and consider some of the governance implications that might be relevant.
Financial Risk Manager
A financial risk manager might be the individual tasked to run a portfolio of derivative instruments, maximizing the risk-adjusted return on capital (RAROC). Alternatively, the term risk manager might refer to what is typically called the “middle office.” If the trading desk is the “front office” and the operations area responsible for processing transactions and all other administrative functions (including accounting) is called the “back office,” the “middle office” is the independent bureau responsible for overseeing the trader.
The Front Office
There are different levels for a financial risk manager in the front office. At the micro-level, a risk manager may be a junior trader with responsibility for the derivatives books in one of the less active currency pairs (for a Forex operation or a fixed income portfolio). The junior risk manager’s responsibility is twofold. He will make prices to customers of the financial institution and he will take so-called proprietary positions. “Prop” positions involve taking positions in a specific set of financial instruments, using the institution’s capital, in order to maximize the portfolio’s return or to reduce the portfolio’s risk profile, or sometimes both.
At the more senior level, the risk manager is in charge of determining the macro positioning of the books, focusing on longer-term trends in the market.
The Middle Office
One of the biggest problems with the new financial products and the expanded interest in financial price risk is the rogue trader. A rogue trader is one whose behaviour is purposefully inconsistent with the stated aims of the shareholders and senior management of the institution for whom he works.
The purpose of the middle office is to enforce the policies set forth by the leaders of the institution in order to ensure that all traders act in the best interests of the firm.
The policies that embody this risk philosophy are known as the limits. Limits state what instruments are permitted to be traded, by whom, and in what amount.
When it comes to financial price risk, it is simply not enough to talk about notional amounts. It is more important to understand the amount of money that could be lost under various scenarios by having a particular position on the books. There are a number of different techniques that can be used to measure this exposure, none of which should be used exclusively. Together, they help the “middle office” risk manager keep senior and upper management informed of the financial price risks to which the firm is exposed. A good risk manager is one for whom there are no surprises. Every scenario is one that has been previously considered and for which the front office, the middle office, and the senior management have a plan in response. Contemporary financial markets move too quickly for ad hoc judgments.
Measuring Risk: Which return would you rather have?
A Canadian fixed income mutual fund portfolio manager makes a return of 28 percent for the year on his $100 million portfolio. A New York bank earns an absolute return of $15 million on its foreign exchange options portfolio. In trading, the desk used an average amount of capital of $10 million with two episodes during which they carried $25 million worth of capital at risk.
The Canadian mutual fund manager earned C$28 million on his portfolio. However, we do not know what kind of risk he took to earn this money. Perhaps he was conservative, investing only in government securities. Or maybe he engaged in large loans to Japanese financial institutions, earning a hefty credit spread over the interbank rate. We do not know from the data reported here.
We have a much better picture from the New York bank’s foreign exchange options desk. They have managed to carry very little risk, compared to the return that they have made. If the bank were to have another desk, say emerging markets, that used a similar amount of risk but only made $5 million, the bank could reallocate capital for the next fiscal period from the emerging markets desk to the foreign exchange options desk. This is the kind of management decision of a financial risk manager that maximizes profitability at the firm-wide level.