Financial and Non-Financial Risk Exposures

Case Study: Analysis of Financial and Non-Financial Risk Exposures in the Portfolio Strategy of ABC Investments

Background:

ABC Investments is an institutional investor managing a diversified portfolio on behalf of its clients. The portfolio includes asset classes such as equities, fixed income, real estate, and alternative investments. ABC Investments aims to generate long-term capital growth while managing risk within acceptable levels. As a CFA Level 3 candidate, you have been asked to analyze and evaluate ABC Investments’ portfolio strategy’s financial and non-financial risk exposures.

ABC Investments has provided you with the following information:

1. Asset Allocation:
   • Equities: 50%
   • Fixed Income: 30%
   • Real Estate: 10%
   • Alternative Investments: 10%
2. Financial Risk Exposures:
   1. Market Risk:
      • ABC Investments’ portfolio is exposed to market risk due to fluctuations in equity and bond prices.
   2. Credit Risk:
      • The portfolio contains corporate bonds and loans, exposing ABC Investments to credit risk.
   3. Interest Rate Risk:
      • Fixed-income investments are susceptible to changes in interest rates, affecting the portfolio’s value.
   4. Liquidity Risk:
      • Some alternative investments in the portfolio may have limited liquidity, making it challenging to sell at desired prices.
3. Non-Financial Risk Exposures:
   1. Regulatory and Compliance Risk:
      • Changes in regulations or non-compliance could potentially impact the portfolio’s performance.
   2. Operational Risk:
      • Errors, system failures, or operation disruptions could adversely affect the portfolio’s returns.
   3. Environmental, Social, and Governance Risk (ESG):
      • The portfolio may expose ESG risks such as climate change, labor practices, or corporate governance issues.

Questions

1. Financial Risk Analysis:
   1. Identify and explain the key financial risks of ABC Investments’ portfolio strategy.
   2. Evaluate the impact of each financial risk on portfolio performance.
2. Non-Financial Risk Analysis:
   1. Identify and explain the critical non-financial risks associated with ABC Investments’ portfolio strategy.
   2. Evaluate the impact of each non-financial risk on portfolio performance.
3. Risk Management Strategies:
   1. Suggest risk management strategies to mitigate the identified financial risks. b. Suggest risk management strategies to mitigate the identified non-financial risks.
4. Portfolio Performance Evaluation:
   1. Assess the overall performance of ABC Investments’ portfolio given the identified financial and non-financial risks.
   2. Discuss potential limitations in evaluating portfolio performance in light of these risks.
5. Recommendations:
   1. Provide recommendations to ABC Investments on optimizing their portfolio strategy considering the identified risks.

Solutions

1. Financial Risk Analysis:
   1. 1. Market Risk: – Application of derivatives to hedge against market downturns.
      2. Credit Risk:– Diversifying fixed-income holdings by investing in different industries and credit rating bands.
   2. 1. Market Risk:– The portfolio may experience short-term volatility and potential long-term capital appreciation.
      2. Credit Risk:– Higher credit risk may lead to default or delayed interest payments, impacting portfolio income.
2. Non-Financial Risk Analysis:
   1. 1. Regulatory and Compliance Risk:– Regularly monitoring regulatory changes and adjustments to comply.
      2. Operational risk:– Implementing robust operational controls and system redundancies.
   2. 1. Regulatory and Compliance Risk:– Non-compliance may lead to legal actions or fines, affecting reputation and returns.
      2. Operational risk:– Operational failures may result in trading errors, loss of client confidence, and financial losses.
3. Risk Management Strategies:
   1. 1. Market Risk:– Utilize market index futures or exchange-traded funds (ETFs) for instant market exposure adjustments.
      2. Credit Risk:– Conduct thorough credit analysis and actively monitor credit.
   2. 1. Regulatory and Compliance Risk:– Maintain strong relationships with regulators and stay updated on new regulations.
      2. Operational risk:– Regularly review and improve operational processes and controls.
4. Portfolio Performance Evaluation:
   1. Assess portfolio returns against the benchmark, considering risk-adjusted metrics such as Sharpe or Information ratios.
   2. Recognize that certain risks may not be fully captured in performance evaluation metrics, requiring additional qualitative assessment.
5. Recommendations:
   1. Increase diversification across asset classes to reduce portfolio concentration risk.
      • Enhance ESG integration in investment decisions to mitigate environmental and social risks.
      • Implement stress-testing scenarios to assess the portfolio’s resilience to adverse market conditions.

Reading 16: Cases in Risk Management – Institutional

Los 16 (c) Analyze and evaluate the financial and non-financial risk exposures in the portfolio strategy of an institutional investor