Risk measures differ among market participants mainly because of the following factors:
- The degree to which a participant is leveraged and their need to assess minimum capitalization or maximum leverage ratios.
- Risks to which different businesses are exposed.
- The regulatory and accounting requirements governing their reporting.
Financial institutions are exposed to three major risks. These risks are market risk, credit risk, and operational risk. Note that the risks are of interest to regulators.
The following are the significant risk measures applied by banks:
- VaR: VaR is used to determine the tail of the distribution of potential losses. VaR measures the market risk. In this context, market risk refers to changes in asset value.
- Leverage: Leverage ratios provide a weight for risk assets using various methods. The resulting weighted figure is then divided by equity. Riskier assets have a higher weighting, and so they require more equity to support them.
- Sensitivity measures: Banks use duration for held-for-sale, foreign exchange exposure, as well as equity exposures. All these exposure measures include the delta sensitivities of derivatives. These measures also monitor gamma and vega exposures of options.
- Economic capital: Economic risk measures are applied to the full balance sheet and involve estimation of the potential total loss of a company at a very high level of confidence, such as 99% to 99.99%. This is done by blending the market, credit, and operational risk measures.
- Scenario analysis: Scenario analysis examines the potential effect of different interest rates, inflation, and credit environments on the full balance sheet.
Asset managers are usually regulated for fair treatment of investors as opposed to regarding sufficient capital and liquidity. Disclosures are required to be full and accurate, show no favors to some clients at the expense of others. Most importantly asset managers should not employ misleading marketing strategies.
Risk management efforts primarily focus on volatility, the likelihood of losses, or the likelihood of underperforming a benchmark.
Traditional Asset Managers
Long-only asset managers prefer to express VaR in percentage. They also divide VaR and duration by the net assets of the portfolio under analysis.
The following are some of the risk measures that asset managers use:
- Sensitivities: Asset managers employ all sensitivity measures, including key duration, option-adjusted duration, and credit spread duration. The delta exposure of options is also included in these measures.
- Beta sensitivity: Beta is applied for the equity-only accounts.
- Liquidity: Liquidity features of an asset in a manager’s portfolio are of importance. The manager would want to know the number of days it would take to liquidate security.
- Scenario analysis: Traditional asset managers use scenario analysis to verify that the risks in the portfolio have not deviated from what was disclosed to investors. Besides, scenario analysis helps traditional asset managers to identify unusual behaviors that may arise in extremely stressed markets.
- VaR: Some traditional asset managers only use VaR for portfolios characterized as absolute return strategies. Note that such portfolios do not use market benchmarks as objectives.
Hedge funds using leverage should observe sources and uses of cash through time, just like banks. They should simulate the interplay among margin calls, market movements, and the redemption rights of investors to understand the worst-case needs for cash.
The following are the risk measures for hedge funds:
- VaR: Hedge funds that use VaR measures usually focus on high confidence levels of at least 90% and short holding periods.
- Scenarios: Hedge funds use scenarios that are the best fit for the specific risks of their strategy.
- Gross exposure: Gross exposure is an indicator of the total exposure to financial markets. A high gross exposure implies a more significant potential loss or gain.
- Leverage: Leverage measures are beneficial for hedge funds. There are different ways in which this measure treats derivatives since there are different ways of executing it.
- Drawdown: Drawback is used by hedge fund managers to measure the amount of time an investment takes to recover from a temporary fall of the net asset value.
A defined benefit pension plan makes payments to its pensioners in the future. These payments depend on the retiree’s final salary. Pension funds should be sufficiently funded to meet these future obligations.
The following are the key market risk measures for pension funds:
- Surplus at risk: Surplus at risk is an application of VaR. The assets in a portfolio are entered as long positions in a VaR model and the liabilities, as short fixed-income positions. It provides an estimate of the extent to which liabilities outperform assets.
- Glide path: A glide path is used to manage surplus at risk by charting multi-year stages to change a portfolio from a current state to a target state.
Insurers pass through significant regulation and accounting oversight about retaining reserves and reflecting their liabilities. Property and casualty insurance are not usually highly correlated with financial asset markets. Property and casualty insurance use significantly different risk metrics from those used for life insurance and annuities.
Property and Casualty Lines
The following are the risk measures used by the property and casualty lines of business:
- Scenario analysis: Scenario analysis is used in insurance the same way it is used by other market participants, such as banks, that have capital at risk.
- Sensitivities and exposures: Insurers try to monitor portfolio exposures arising from asset allocation to ensure that they remain within the target ranges.
- Economic capital and VaR: When payouts are more significant than expected, capital may be utilized. VaR is used to estimate the potential amount of loss at a given confidence level. Economic capital, on the other hand, is used as a measure of the market risks, insurance exposures as well as reinsurance coverage.
Life Insurance and Annuities
Life insurance and annuities have a strong correlation with the financial markets. Life insurers have an obligation of long-life liabilities and, therefore, have to maintain reserves that are highly dependent on discount rate assumptions as required by regulators.
The following are the market risk measures for life insurance portfolios:
- Sensitivities: This is how exposures of annuity liabilities and investment portfolios to market risk are measured and monitored.
- Asset and liability matching: The investment portfolio is more closely matched to liabilities in the case of life insurance and annuities than in property and casualty insurance.
- Scenario analysis: Stress and scenario testing is a primary tool that insurers use to define their risk appetite. Lifelines of insurance are focused on measures of potential stress losses. These losses arise from having more liabilities from insurance contracts than the investments of the insurance company.
Which of the following risk measures is most likely used by pension funds but not any other market participant?
B. Surplus at risk
The correct answer is B.
Defined benefit pension funds use surplus at risk as a measure of risk. It is the VaR for the assets, less liabilities. The assets in the portfolio are entered as long positions in a VaR model and the liabilities as short fixed-income positions. This measure provides an estimate of how much the liabilities outperform the assets.
A is incorrect. All the other market participants use sensitivity risk measures.
C is incorrect. All the other participants also use scenario analysis.
Reading 42: Measuring and Managing Market Risk
LOS 42 (l) Describe risk measures used by banks, asset managers, pension funds, and insurers.