### Risk Monitoring and Performance Measurement

A risk is a form of uncertainty that represents the ‘shadow price’ behind expected profits. The presence of the cost-benefit process is assured in the event that someone is willing to incur losses just to generate profits. For a return to be considered attractive, it should be able to cater for the incurred risks.

Usually, there are policy limits that force the willingness of an organization to assume risk to enable them to gain profits. Many organizations manage these risks through asset allocation policies and methods.

Therefore, there will be a mixture of assets that will give birth to a level of expected returns and risks that are in line with policy guidelines. The VaR is the most popular metric for risk in a financial institution.

VaR is the maximum dollar earnings or potential of loss linked to a specified statistical confidence level over a specified timeframe. It is also expressed as the number of standard deviations related to specified dollar earnings or loss potential over a specified timeframe. When the returns of an asset have a normal distribution, then the number of outcomes to be found within the average returns of the asset plus or minus one standard deviation is 67%.

Tracking error which is an idea analogous to VaR is applied by asset managers in gauging their profile of risk relative to a benchmark. For asset managers, a benchmark is usually assigned by clients including a projected risk-return target vis-a-vis the benchmark for all funds under the management of the asset manager. The risk budget is commonly known as tracking error which is the standard deviation for surplus returns.

VaR can be expressed as a dollar value by the multiplication of VaR by assets that are under management. It is now easy to project the dollar effect of losses to be suffered over a specified timeframe and confidence level. Capital owners looking forward to only suffer risks/gain returns from a specified asset class are able to assign capital in an index fund that is designed to precisely replicate a given index. Active management arises in the event of risks being taken away from the index.

Tracking error defines the extent to which the investment manager is given freedom to differ from the index. For the capital owner, the basis of the VaR linked to any specified asset class happens to be the summation of the risk linked to the said asset class and the risks related to asset management. A similar situation is witnessed when dealing with VaR related to any combination of asset classes and active management linked to the said asset classes.

The following is a formal definition of the return of a portfolio, $${ R }_{ p }$$, invested in a specified asset class:

$${ R }_{ p }=\left( { R }_{ p }-{ R }_{ a } \right) +{ R }_{ a }$$

Where the index’s or benchmarks return is denoted as $${ R }_{ a }$$, and the active or excess return is denoted by the terms in the parentheses. This expression shows that the portfolio variance’s return $$\left( { V }_{ p } \right)$$ can be reduced to:

$$\left( { V }_{ p } \right) =variance\quad \left( excess\quad return \right) +variance\quad \left( benchmark \right) +2\quad \left( Covariance\quad between\quad the\quad expected\quad return\quad and\quad benchmark\quad return \right)$$

In the event of risk being squandered, the profitability of the organization will be jeopardized. Furthermore, suppose that an organization takes excess risk relative to the budget allocation, then the organization risks unnecessarily large losses to gain returns that are neither expected nor desired. On the other hand, suppose that an organization takes too little risk relative to the budget allocation. Then, chances are that the expected returns will fall short of the budget.

With the above situation here are further concepts and methods behind monitoring risks and performance evaluation. It is in five themes:

1. Emphasis is on the fact that the monitoring of risks is an important process in the internal control environment. It guarantees that the firm undertakes properly scaled and authorized transactions.
2. There are three pillars behind risk management: planning, budgeting, and monitoring. These three aspects are strongly interconnected and to understand them we study their commonly applied counterparts based on financial accounting controls.
3. The definition of a Risk Management Unit (RMU) and its role within an organization are important and we will also define an independent RMU as a best practice for all investor categories.
4. The techniques applied by RMU for portfolio exposure monitoring include a provision of samples of reports likely to be used in the delivery of the information.
5. Commonly applied tools in performance measurement denote a marked duality between the monitoring of risks and performance evaluation (or performance measurement).

It has been noticed that there are many risk sources. Therefore, there should be a multidisciplinary approach to the management of risk in every modern organization. Some of the identified risk sources include market, credit and liquidity, and settlement, operational and legal risks.

## The Three Legs of Financial Accounting Control: Planning, Budgeting, and Variance Monitoring

The ideas of planning, budgeting, and variance monitoring are closely related in the financial accounting audit world. These ideas are all legs in the three-legged stool defining the control and structure of the organization. The success of the organization’s raison d’etre is determined by each of the legs.

### The Risk Plan

The most strategic plan is comprised of strengths, weakness, opportunities, and threats (SWOT) section where major organizational risks are talked over. The risk plan must be included as a different section of the organization’s strategic planning document. A plan must be vetted and discussed just like any other part of the planning document. At its final stage, the main themes assimilated in the plan should be capable of being coherently spoken to analysts, auditors, boards, actuaries, management teams, capital suppliers, and other concerned parties.

There are five guideposts that got to be included in a plan:

1. The relevant time period’s expected returns and volatility goals should be set by the risk plan. Furthermore, the established milestones should let oversight bodies recognize points of success or failure.
2. The risk plan must describe success and failure points. Risk capital can be described by using VaR methods for the purpose of the planning document.
3. The risk plan should predict how risk capital will be used to meet the goals of the organization. The plan should have a risk decomposition policy to direct how much of risk capital of the organization should be spent on a theme.
4. A risk plan is of help to an organization as it determines the bright line between events that are just disappointing and those that can cause serious damage. It does not matter if the event is a low-probability situation, strategic reactions and responses should be put in place to cater for any event that threatens the franchise. The risk plan should determine the severe losses that insurance coverage is needed to cover their downside.
5. The critical dependencies existing both inside and outside the organization should be identified by the risk plan. It should define the type of the solution to be followed if there are breakdowns in such dependencies. Critical dependencies include the dependency on some key employees plus some crucial sources of financing capacity. It should explore how key reliance behaves in all surroundings. In most cases, very good or very bad surroundings usually occur at the same time with other events.

The senior-most leadership in an organization should be actively involved to produce an effective risk plan. This will help create a way in which risk and return issues are handled to suppliers of capital, management, and oversight boards. It helps an organization in guaranteeing that allocations reflect organizational strengths and underpinnings.

The risk plan assists the organization in analyzing and comprehending the shadow price that must be accepted for generating returns. The presence of a risk plan creates an important statement concerning the management of business activities.

### The Risk Budget

The risk budget is usually referred to as asset allocation. Its role is to quantify the vision of the plan. Immediately when a plan is available, there should be a formal process of budgeting to express the allocation of risk capital in order to achieve the strategic plan of the organization. With a budget in place, the organization can respect its risk plan.

Financial budgets and risk budgets are similar in many ways. For financial budgets, net income is computed as the difference between revenue and expenditure. Returns on equity (ROE) are then estimated as net income divided by capital invested. For risk budgets, a risk charge can be related to each line item of revenue and expense projections. Returns on risk capital (RORC) can be related with all activities as well as the accumulation of all activities.

For ROE and RORC to be considered acceptable, they must surpass some minimum levels, for both risk and financial budgets. It is important to note that both RORC and ROE must be estimated over all relevant timeframes. The management must state the timeframes over which risk budget allocations are to be used up and over which returns on risk capital are to be measured.

Let us consider a hypothetical situation of an organization having an investment portfolio. The major concern of the organization is the effect on reported earnings and share price given the portfolio’s earnings volatility. When creating a risk budget for this portfolio, the organization might:

1. Identify acceptable levels of returns on risk capital and returns on equity over different intervals, from the risk plan and business plan.
2. Determine the suitable weights for each investment class applying the mean-variance optimization technique or other methods.
3. Simulate the performance of a portfolio constructed with these weights over different timeframes and test how sensitive this performance is to variations in return and covariance assumptions.
4. Guarantee that the levels of risks considered at the individual level of asset class and that of the portfolio taken wholly are at suitable levels against the business and risk plan.
5. Make sure that the expected variability around returns on risk capital is at acceptable levels.
6. Explore the downside scenarios that have an association with all the allocations, individually, over various horizons of time. Make sure that the owners of the plan and managers realize that such downsides are merely disappointing and not unnecessarily large, with the objectives of the plan in place.
7. For a logically analyzed response to be brought about, there should be a loop back to the process of planning in each significant downside scenario.

It is to note that risk budgeting includes elements of financial modeling and can be as a result specific factors within the organization.

### Risk Monitoring

Risk monitoring is a fundamental tool for controlling risk. Due to the scarcity of revenue and the costs incurred in the day-to-day operations of a business, monitoring teams are created to control material deviations from the target. As part of the process, there will be routine investigations of the unusual deviations from the target. For risk capital to be used in a consistent manner with the risk budget, monitoring controls should be put in place due to the scarcity of risk capital as a commodity.

Material variances from risk budget are a threat to the ability of the investment vehicle to meet its returns given risk capital targets. Using risk in excess may lead to loss levels that are not acceptable. On the other hand, spending too little risk it may result in unacceptable shortfalls in earnings. To detect and address material deviations in a timely manner, the monitoring of risks is of the utmost importance.

### Risk Monitoring-Rationale and Activities

The sense of risk knowledge is increasing among and within various organizations. The following are the sources this risk consciousness derives:

• Financial institutions that give loans to investors are increasingly careful of where assets are placed.
• Boards of investments clients, senior management, investors, and plan sponsors are more enlightened on matters to do with risk and are greatly conscious of their responsibilities as oversight bodies.
• Investors are required to have increased first-hand knowledge about their choices on investment. It is important that asset managers explain the sound reasoning behind their investments decisions during hard times. This disclosure is of benefit from two angles: it (1) raises the level of confidence in a client towards the manager and (2) reduces the risk of return litigation due to predictable events on an ex-ante basis.

This has led to many organizations and managers forming independent risk management units (RMU). These RMUs will oversee the portfolio risk exposures. These exposures should be authorized and aligned perfectly with the risk budgets. As a necessary part of the process, these RMUs are tasked with making sure that the company follows the best practices and consistent approaches.

### Objectives of an Independent Risk Management Unit

The following are the objectives of the RMU:

1. Gathering, monitoring, analyzing and distributing risk data to managers, clients, and senior management so as to understand and control the risk. The RMU is supposed to deliver the right information to the right constituency at the right time.
2. Assisting the organization in developing an organized process and framework to identify and address risk topics.
3. In addition to publishing periodic VaR information, the RMU must proactively pursue and have a topical vein. The implementation of the risk agenda and related initiatives is also the role of RMU.
4. The RMU observes trends in risk as they occur and recognizes unusual events to management at the appropriate time.
5. Catalyzing a comprehensive discussion on matters to do with risk including the not-easily measured matters.
6. As an element of the risk culture, the RMU should represent one of the nodes of the managerial convergence, thus promoting enhanced risk awareness including a common risk culture and vocabulary.
7. The RMU is part of the internal control environment. Therefore, it ensures that the authorization of the transactions is aligned with the management direction and the expectations of the clients.
8. The RMU, the portfolio managers, and the senior management identify and develop the measurement of risk and performance attribution analytical tools. Furthermore, the assessment of the used models’ quality in risk measurement is the role of the RMU.
9. Developing a risk data inventory to be applied in the evaluation of portfolio managers and market environments.
10. Explaining the tools used to both senior management and portfolio managers so as to better understand risks in individual portfolios and the source of their performance. With RMUs, there is transparency of the risk information.
11. Rather than managing risks, the RMU measures risk being used by those who are absolutely interested in the process.

### Examples of the Risk Management Unit in Action

For an internal control environment to be efficient, the flow of information should be timely, accurate, and meaningful between the senior management and the rest of the organization.

Risk monitoring is mainly about whether the investment activities of an organization are behaving in a manner that is expected by all parties. The portfolio should produce a return distribution satisfying the following standards:

1. Consistency with the expectations of the client;
2. Derived from the organizational or individual strengths;
3. High-quality and resulting from sound organizational and decisions executed accordingly;
4. It should be due to a process that is well-articulated and well-defined. Moreover, it should be as a result of major elements that are understood and embodied by the organization; and
5. Stability, consistency, and being controlled should be key features return distribution.

### Is the Forecasted Tracking Error Consistent with the Target?

As an estimate of the potential risk, the forecasted tracking error can be inferred from the positions held by the portfolio that are derived from the statistical approximation techniques that are forward-looking. A productive risk process demands that portfolio managers take a risk level that is appropriate and in accordance with the client’s expectations. The forecast should be run for each individual portfolio as well as for the total of portfolios owned by the customer.

Tracking error forecasts and tracking error budgets got to be comparable. The magnitude of the variance from the target should be determined by the policy standards for the easy identification of unusual deviations across accounts.

### Is the Risk Forecasting Model Behaving as Predicted?

For the risk forecasting model to produce an estimate of the tracking error that is forward-looking, it has to apply statistical models. It is the role of the risk forecasting model to produce a meaningful risk estimate.

Historical simulation is a technique used to examine the behavior of portfolios in times of stress. However, this method is not optimal in the sense that only one set of realized outcomes is produced by the observed data.

In this case, we apply the Monte Carlo simulation techniques to examine the various outcomes that are probabilistically implied by the one set of outcomes that took place.

## Quantifying Illiquidity Concerns

Due to the fact that the portfolio’s liquidity can change rapidly in difficult market surroundings, tools that evaluate portfolio liquidity are useful instruments of the stress analysis. The liquidity duration statistic is a tool used at GSAM (Generalized Sequential Access Method) to assess the possible implications of liquidity.

When computing this statistic, one should begin by giving an estimation of the average number of days required to liquidate a portfolio, under the assumption that the company doesn’t surpass a given percentage of the daily volume in any specified security. We wish to determine the time period it would take to liquidate portfolio holdings without material market impact.

In general, the liquidity duration for security $$i$$ can be expressed as follows:

$${ LD }_{ i }={ { Q }_{ i } }/{ \left( 15\times { V }_{ i } \right) }$$

Where $${ LD }_{ i }$$ is the liquidity duration statistic for security $$i$$, under the assumption that we are not exceeding 15% of the daily volume in that security, $${ Q }_{ i }$$ is the number of shares held in security $$i$$, and $${ V }_{ i }$$ is the daily volume of security $$i$$.

## Credit Risk Monitoring

In credit risk monitoring, the assumption is that the credit risk of each instrument is well researched and understood by the portfolio manager and that through factor models of other techniques, the RMU can approximate the VaR or tracking error consequences of credit exposures in the securities held in the portfolio. The RMU should understand potential outcomes in credit when dealing with brokers, custodians, execution counterparties, and others. Credit risk is usually the other side of the coin of market risk. It is the role of the RMU to ensure that credit policy criteria are met by all counterparties transacting and settling trades.

## Performance Measurement Tools and Theory

Performance measurement may be generally considered risk model validation.

The following are the objectives of performance measurement tools:

1. Determining whether the excess risk-adjusted performance given the benchmark chosen by the manager is consistent.
2. Determining whether the superior risk-adjusted performance according to the peer group generated by the manager is consistent.
3. Determining whether the returns attained are enough to compensate for the assumed risk in terms of cost/benefit.
4. Providing an argument for determining the managers whose processes produce high-quality excess risk-adjusted returns.

### Reasons That Support Using Multiple Performance Measurement Tools

The following are the items that need to be known when computing a risk-adjusted performance measure:

1. The returns over the relevant time period; and
2. The incurred risks to achieve the said returns.

### How to Improve the Meaningfulness of Performance Measurement Tools

Performance measurement tools allow one to measure to what extent the process is effective. The tools should confirm that the process is truly functioning according to the way it was designed.

An individual must be able to describe a normal behavior for a process to be present. Without this, then the process is likely to be vague.

For a behavior to be considered normal, it has to be predictable. It is important that performance measurement is supplemented with the following:

• A management philosophy that is articulate, from each portfolio manager; and
• A routine position and style monitoring process designed to identify deviations from philosophy or process.

There should a sufficient number of data points for a quantitative portfolio measurement tool to be considered effective. This is important if a conclusion is to be formed with a certain level of statistical confidence.

### Tool #1— The Green Zone

The following are the four elements in the green zone concept:

1. The portfolio’s normalized return should be computed for the prior week, month, and even the year. The portfolio’s normalized returns are defined as the difference between excess returns over the period and budgeted excess returns over the said period, divided by the target tracking error scaled for the time.
2. The ratio of the annualized tracking error to the targeted tracking error is computed for the prior twenty-day and sixty-day periods.
3. For the computations in i. and ii. denoted above, policy decisions on the type of expectations that is sufficiently large are formed, from a statistical point of view, to assert that it fails to fall in the green zone (zone of reasonable expectations).
4. Finally, we summarize the results of the green zone analysis in a document, followed by a brief description of the document.

Performance attribution is the most well-known tool to measure the quality of returns. This method is all about the source of returns to individual securities and the common factors. During the evaluation of the actual returns of a portfolio, our concern is that the returns were taken from those themes where the manager had planned to take the risk. Furthermore, there is consistency in the returns and the implied risks in the ex-ante analysis of risk.

### Tool #3—The Sharpe and Information Ratios

The Sharpe ratio divides a portfolio’s return in excess of the risk-free rate by the standard deviation of the portfolio. The information ratio, on the other hand, divides excess returns of a portfolio by the tracking error of the portfolio. Both tools are made in such a way that they generate estimates of risk-adjusted returns, where risk is described in standard deviation or tracking error.

The following are the strengths incorporated in the Sharpe and Information Ratios:

1. They can be used in measuring relative performance against the competition. This can be done by identifying managers who produce risk-adjusted excess returns that are superior to a pertinent peer group.
2. They confirm that the manager has produced enough excess returns to compensate for the assumed risk.
3. The statistics can be put into action at the portfolio level as well as for specific industrial sectors and countries.

The following are the disadvantages of the Sharpe and Information ratios:

1. They may need information that may be unavailable for the manager and their rivals.
2. In computing the statistics based on achieved risk as opposed to potential risk, then to some degree, the relevance of the statistics will rely on the friendliness of the environment to the manager.

### Tool #4 —Alpha versus the Benchmark

With this tool, the excess returns of the portfolio are regressed against the benchmark’s excess returns.

The following are the outputs of this regressions:

1. An intercept that is popularly known as ‘alpha’ or ‘skill’; and
2. A slope coefficient against the benchmark’s excess returns also called the beta.

We can also apply the standard confidence tests to the outputs of the regression. Furthermore, we can test the alpha term for statistical significance to check whether it is both positively and statistically different from zero.

The following strengths are incorporated in this performance tool:

1. It enables a manager to distinguish between surplus returns due to leverage and surplus return due to skill.
2. It is easy to compute the alpha and beta statistics and tests of significance.
3. The beta statistics show if an element of the manager’s returns is derived from being overweight and underweight the market.

However, this performance tool incorporates the following weakness:

1. It may be likely that there is an insufficient number of data points for a conclusion that is satisfactory concerning the alpha’s statistical significance.

### Tool #5—Alpha versus the Peer Group

With this tool, the manager’s excess returns are regressed against the excess returns of the peer group. It is a useful tool that determines whether the manager demonstrate his skills over and above what is present in the peer group.

The capital-weighted average return of all managers trading comparable strategies is the return of the peer group. The peer group is the basic competitor in the manager’s strategy.

This regression has the following outputs:

1. An intercept (alpha); and
2. A slope coefficient against the surplus returns of the peer group (beta).

The manager’s excess return against the peer group is represented by the alpha term. On the other hand, the extent to which the manager uses greater or lesser amounts as compared to their rivals is evaluated by the beta term.

#### Strengths:

1. The management’s opinion on whether the skill is absolutely present or excess returns are random outcomes is allowed.
2. It allows the management to differentiate between surplus returns due to leverage and excess returns as a result of skill.
3. It is easy to compute the alpha and beta statistics and tests of significance.

#### Weaknesses:

1. It may be likely that there is an insufficient number of data points for a conclusion that is satisfactory concerning the alpha’s statistical significance.
2. Returns of the peer group may be under/overestimated due to the presence of survivorship biases.
3. The presence of a wide divergence in the amount of money under management among the peer group is not accounted for.

## Practice questions

In which of the following measurement tools are we using the ratio of the annualized tracking error to the targeted tracking error for the prior twenty-day and sixty-day periods?

1. The Sharpe and Information Ratios