Developments in Risk Attribution

Singapore 2004 Developments in Risk Attribution Investment Managers Association of Singapore September 23, 2004 Alex Carmichael Director Risk Solutions & Operations RiskMetrics Group Asia Pacific Alex.carmichael@riskmetrics.com Singapore

Agenda 1. Introduction: VaR & TE 2. Recent trends in risk measurement and attribution 3. Measuring the risk of alternative investments 4. Ideas for combined risk analysis of traditional long-only portfolios with alternative investments slide 2

1. Relative VaR & Tracking Error Relative VaR measures the risk of under performing a Benchmark Portfolio Extends beyond PV, Duration and Gamma matching Tracking Error is a Special Case of Relative VaR» Confidence Level = 84.13%» Annualized Measure = 252 Trading Days VaR analysis brings standardization and flexibility to risk analysis slide 3

2. Risk Management for Asset Managers a spectrum of measures Risk Measures Market Exposure Absolute and Relative Weights Exposure Sensitivities Delta, Gamma, Duration Stress Testing Historical, What if Scenarios Risk Decomposition Tracking Error, Spread Risk Risk Attribution Allocation and Security Selection Requirements Portfolio and Benchmark Positions Multiple Classification Hierarchies + Security Modeling + Cross-Asset Class Aggregation + Market Data and Derived Data + Volatility and Correlation Generation + Full-Valuation Simulations + Data Granularity + Investment Process Modeling + Investment Process slide 4

A comprehensive approach: a single framework Portfolios and Benchmarks Security Modeling Classifications Simulation Aggregation Market Exposure Exposure Sensitivities Stress Testing Risk Decomposition Standard Market Data Standard Classifications Risk Attribution slide 5

Risk Attribution Equity Attribution:» Adjust by weights» Sector Allocation» Security Selection Fixed Income Attribution:» Adjust by weights or duration» Duration» Segment Allocation» Security Selection» Currency Allocation» Spread slide 6

Risk decomposition and issuer-specific credit risk Allocation Tracking Risk Decomposition Benchmark Portfolio Bet Risk F/X I/R Market Issuer Total 100.0 100.0 71.8 22.0 60.4 25.1 44.0 Governments 50.0 45.2-4.80 49.5 22.0 35.8 35.8 MBS 4.0 3.95 12.7 12.7 12.7 Corporates 50.0 50.8 0.85 44.2 44.2 4.3 44.0 Consumer, Cyclical 13.2 18.5 5.26 38.5 38.5 44.3 40.0 Consumer, Non-cyclical 11.8 6.9-4.90 35.1 35.1 36.7 9.7 MERCK & CO INC 0.5 0.0-0.51 7.3 7.3 7.5 0.9 COCA-COLA ENT. 0.4 1.1 0.60 7.6 7.6 7.3 4.3 ARCHER-DANIELS 0.6 0.0-0.60 7.2 7.2 7.2 0.9 ELI LILLY & CO 0.5 0.0-0.53 6.6 6.6 7.2 1.7 REVLON INC 0.3 0.1-0.26 6.9 6.9 1.1 7.2 Basic Materials 3.2 2.2-0.99 9.3 9.3 11.4 4.7 Technology 1.9 3.2 1.27 16.1 16.1 3.9 16.9 Portfolio Notes: 1) Majority of Corporate Tracking Risk is due to Issuer-Specific Volatility. 2) F/X Risk for International Bonds is mitigated by I/R correlations. slide 7

Marrying risk attribution with performance attribution Portfolio Benchmark Performance Risk Risk Bet Projection Attribution Attribution Index Total 7.50 127 285 0.45 Pharmaceuticals 4.13 11.50 17 43 0.39 Diversified Finan Serv 3.23 15.75 27 17 1.59 Electric -3.09 4.80 8 20 0.43 Telecommunications -1.35-5.00 17 13 1.29 Oil&Gas -1.68 6.50 2 30 0.06 Semiconductors 1.21 12.00 5 25 0.22 Banks -3.80 5.00 9 14 0.68 Computers -0.82 6.00 1 5 0.24 Retail 1.44 8.20 1 22 0.05.. Portfolio Notes: 1) Retail, Oil&Gas, Computers, and Semiconductors add risk without anticipated reward. 2) Phamaceuticals risk far exceeds anticipated reward. slide 8

3. Alternative Investments: Intelligence versus Information Position Transparency = Information» Managers providing investors with a list of positions can be useless for today s complex fund strategies.» Information Intelligence Analysis + Organization = Intelligence» Value is created when positions are independently priced (standardized), linked to models and risk factors (data), analyzed, organized and aggregated Intelligence = Better Decisions» Better decisions are possible when well organized, consistent reporting methods allow meaningful comparisons of valuations and risk results slide 9

Risk Types Market Risk potential loss due to market price volatility under normal and stressed conditions. Risk factors include equity time series, yield curves, volatilities, volatility surfaces, commodities, and currencies. Credit Risk potential loss due to issuer specific risk. CreditGrades uses a structural Merton model to calculate issuer specific spread risk. Valuation Risk potential loss due to hard to price, illiquid or mispriced securities. slide 10

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4. Combined Risk Analysis Options: 1. Describe alternative investment exposure as a beta to an index 2. Construct a NAV series for a fund or fund-of-fund 3. Combine portfolio using sensitivities 4. Describe alternative investment exposure as a sensitivity instrument within the regular VaR framework slide 14

Considering the Options No access to exposure level detail Hedge Funds do not adhere to benchmarks Portfolio churn and style drift may lessen the relevancy of past returns Standardized models and market data Sensitivities can be added:» Exposure to risk type» Exposure to scenario type» Exposure to risk factor Hedge fund exposures can be evaluated as a regular asset type with given sensitivities to standard risk factors slide 15

Adding Alternative Investments as an Asset Class in a VaR Framework Allocation Tracking Risk Contribution Benchmark Portfolio Bet Risk Total Asset Issuer Security Total 100.0 100.0 71 71 28 46-2 Corporates 50.0 50.8 0.85 46 42 2 40 Sun Microsystems Inc 0.4 1.7 1.29 18 11 9 Pep Boys 0.4 1.4 1.05 14 8 6 Ford Motor Co 0.3 1.2 0.90 12 8 6 Governments 50.0 45.2-4.80 23 21 9 6 6 United States Govt 12.2 10.1-2.15 13 8 1 3 Italy Govt 4.3 3.4-0.99 8 5 2 2 Italy 6.50% BTP Nov 27 0.2 0.1-0.19 2 1 1 Italy 4.25% BTP Nov 2009 0.3 0.0-0.22 1 1 Italy 4.50% BTP May 2009 0.3 0.1-0.21 1 1 Netherlands Govt 1.4 0.9-0.46 3 2 1 1 Alternative Investments 0.0 4.0 3.95 15 9 17-8 Oceanview Hedge Fund 0.0 3.1 3.06 12 6-7 Portfolio Notes: 1) Corporate issuer selection is adding most risk. 2) Only top 3 issuers and securities displayed. slide 16

Summary Detailed analysis and attribution of risk is available for traditional long-only portfolios Alternative Investments pose challenging problems but can be solved with:» Transparency» Standardization Including Alternative Investments as an asset class can be done with sensitivities to:» Standard risk factors» Standard stress scenarios slide 17