&
MUTUAL FUNDS
Report On
Risk Management Perspective with
respect to Emerging Markets
Submitted By
Moad Arsiwala
(08PMP00716)
Submitted To
Prof. Daveen B.S. Dhingra
IUD Evaluation
Date: - 11th December, 2009
The most vital decision regarding investing that an investor can make involves the
amount of risk he or she is willing to bear. Most investors will want to obtain the highest
return for the lowest amount of possible risk. However, there tends to be a trade-off
between risk and return, whereby larger returns are generally associated with larger risk.
Thus, the most important issue for a portfolio manager to determine is the client’s
tolerance to risk. This is not always easy to do as attitudes toward risk are personal and
sometimes difficult to articulate. The concept of risk can be difficult to define and to
measure. Nonetheless, portfolio managers must take into consideration the riskiness of
portfolios that are recommended or set up for clients.
RISK
An uncertainty that the actual outcome from an investment will differ from the expected
outcome can be defined as risk.
While evaluating a particular security or bunch of security i.e. portfolio investor’s give
priority to two main aspects which are as under:
➢ Expected Return
➢ Risk involved
Investor’s have a notion in their mind that a security should give maximum possible
return with same level of risk or minimize the risk with respect to expected return.
The risk that the value of on- or off-balance-sheet positions will be adversely affected by
movements in equity and interest rate markets, currency exchange rates and commodity
prices is called market risk. The main components of market risk are therefore equity,
interest rate, FX, and commodity risk.
At the top of the pyramid, we have total market risk, which is the aggregation of all
component risks.
In the middle of the pyramid, we see how financial instruments are driven by the
underlying component risks.
At the lowest level, market risk arises from fluctuating prices of financial instruments.
In addition to market risk, the price of financial instruments may be influenced by the
following residual risks: spread risk, basis risk, specific risk, and volatility risk.
Spread risk is the potential loss due to changes in spreads between two instruments. For
example, there is a credit spread risk between corporate and government bonds.
Basis risk is the potential loss due to pricing differences between equivalent instruments,
such as futures, bonds and swaps. Hedged portfolios are often exposed to basis risk.
Specific risk refers to issuer specific risk, e.g., the risk of holding Yahoo! stock vs. an
S&P 500 futures contract. How to best manage specific risk is a topic of debate. Note that
according to the Capital Asset Pricing Model (CAPM), specific risk is entirely
diversifiable.
Volatility risk is defined as potential loss due to fluctuations in implied option volatilities
and is often referred to as “vega risk.” Short option positions generally lose money when
volatility spikes upward.
Business risk is the risk of failing to achieve business targets due to inappropriate
strategies, inadequate resources or changes in the economic or competitive environment.
Credit risk, is the risk that a counterparty may not pay amounts owed when they fall due.
Sovereign risk is the credit risk associated with lending to the government itself or a party
guaranteed by the government.
Liquidity risk is the risk that amounts due for payment cannot be paid due to a lack of
available funds.
Accounting risk is the risk that financial records do not accurately reflect the financial
position of a company.
Country risk is the risk that a foreign currency will not be available to allow payments
due to be paid, because of a lack of foreign currency or the government rationing what is
available.
Political risk is the risk that there will be a change in the political framework of the
country.
Environmental risk, the risk that a company may suffer loss as a result of environmental
damage caused by themselves or others which impacts on their business.
Systemic risk is the risk that a small event will produce unexpected consequences in local,
regional or global systems not obviously connected with the source of the disturbance.
Reputational risk is the risk that the reputation of a company will be adversely affected.
As there is a saying that ‘we should not put all eggs in one basket’, same goes with
investment don’t block or invest all the funds available in one particular security but to
diversify among different avenues. This gives rise to designing of portfolio of securities
which contains bunch of potential stocks which ensure the best possible return at a
manageable risk level.
Beta measure is used to analyze to ensure sensitivity of security return with respect to
fluctuations in overall market.
Within a portfolio it is advised not to have exposure in one particular sector but to
diversify among various sectors in order to eliminate the diversifiable or the unsystematic
risk which is related to one particular company or one particular sector.
Through diversification, adding of sufficient stocks in portfolio the unsystematic risk can
be eliminated. But systematic risk can’t be removed as it is related with the whole
economy.
There are numerous ways of diversification:
The investor should also keep in mind the perils associated with over diversification.
There should not be too many securities in the portfolio that it creates difficulty in
handling them. The question is how to determine the number of securities to be
maintained within the portfolio. Generally portfolio should have a mix of ten to fifteen
securities. It can be inferred that the number of securities should be limited to the extent
that the investor is able to earn handsome amount of return with manageable risk.
PORTFOLIO SELECTION
Efficient Frontier
Investor’s select a portfolio which fall on the Efficient Frontier. Efficient Frontier is a
group of securities within a portfolio where:
Generally risk level observed in emerging markets is far higher compared to developed
markets. The situation prevailing in emerging markets are highly volatile which demands
constant monitoring of the portfolio and up gradation in portfolio from time to time.
This model is used while selecting a portfolio comprising of potential securities. There
are steps involved in this particular model.
➢ Utility models
➢ Geometric Mean model
➢ Safety First model
➢ Stochastic Dominance Model
PORTFOLIO REVISION
There are many factors which affect the investor’s which make portfolio revision and up
gradation necessary. This step not only ensures investor’s wealth maximization but at
times helps him to minimize the losses due to high volatility observed in the market
➢ Change in wealth
➢ Change in time horizon
➢ Changes in liquidity needs
➢ Changes in taxes
➢ Bull and Bear markets
➢ Inflation rate changes
➢ Changing return prospects
Generally risk level observed in emerging markets is far higher compared to developed
markets. The situation prevailing in emerging markets are highly volatile which demands
constant monitoring of the portfolio and up gradation in portfolio from time to time.
EMERGING MARKET v/s DEVELOPED MARKETS
There is vast difference between the emerging markets and developed markets. Emerging
are the growing markets which are new and has the potential to perform well. Naturally
while designing portfolio it needs to be considered the market in which the portfolio is
designed. The risk level would be far higher in emerging markets compared to the
developed markets.
The portfolio selection and revision techniques which are followed become more
prominent with respect to emerging markets than the developed markets. Also, such
techniques are to be followed on the continual basis when the investor’s portfolio is
designed with respect to emerging markets.
Emerging market tend to exhibit cyclical market behaviour due to interest rate
differentials with foreign currencies. They often appreciate steadily during normal market
conditions but depreciate violently in times of crisis as investors retreat to the safe haven
of low-yielding currencies. High volatility and the unfavourable interest rate differential
means currency risk hedging can be costly. Given the poor average performance of such
hedges, many corporates question their long-term benefit.
The emerging markets possess high level of risk due to volatility observed so such
techniques are to be used on continual basis to minimize losses, maintain profitability and
growth of capital.
Until the last few years, the conventional view towards investing in emerging markets
was that sustainability considerations too often appeared subordinate to the quest for
economic growth. Emerging markets are now seen by many in the investment community
as a place where good rewards can be earned.
EIRIS had just completed a review of the opportunities for responsible investment in
emerging markets, which reveals the possibilities for diversification and risk management
for investors as well as wider potential gains for sustainability.
The report identifies factors hindering Socially Responsible Investment in emerging
markets:
➢ Perceived lack of consistent and widespread good corporate governance.
➢ Continuing government ownership and control such as with many large listed
Asian companies that can be a critically important variable in Environmental and
Social Governance performance.
➢ The retention of large controlling interests by families in many emerging market
companies that limit the rights and influences of minority shareholders.
➢ Even where governance, environmental or labour regulations are strong in some
countries, enforcement is sometimes weak.
➢ Doubts about the honesty of some disclosed information or its credibility. For
instance, in relation to ISO14001, the reputation of those providing the
certification is crucial for trusting the information disclosed.
As the risk level is higher in emerging market, due to heavy fluctuations in prices of
securities there is a need to have various risk management techniques to minimize the
risk and at the same time maintain profitability.
things?
Treat the risks What are we going to do about
them?
Monitor and review How do we keep them under
control?
Communicate and consult Who should be involved in the
process?
Establish Context:
Establishing the context is concerned with developing a structure for the risk
identification and assessment tasks to follow. This step:
➢ Establishes the company and project environment in which the risk assessment is
taking place;
➢ Specifies the main objectives and outcomes required; identifies a set of success
criteria against which the consequences of identified risks can be measured; and
➢ Defines a set of key elements for structuring the risk identification and assessment
process.
Identify risks:
Each corporate need to identify the possible sources of risks and the kinds of risks faced
by it. This requires an intimate knowledge of the company, the market in which it
operates, the legal, social, political and cultural environment in which it exists, as well as
the development of a sound understanding of its strategic and operational objectives,
including factors critical to its success and the threats and opportunities related to the
achievement of these objectives.
The risk identification process must be comprehensive, as risks that have not been
identified cannot be assessed, and their emergence at a later time may threaten the
success of the company and cause unpleasant surprises. Risk identification should be
approached in a methodical way to ensure that all significant activities within the
company have been identified and all the risks flowing from these activities defined.
Information used in the risk identification process may include historical data, theoretical
analysis, empirical data and analysis, informed opinions, and the concerns of
stakeholders. Various possible risks are already discussed earlier.
Analyze risks:
During the Risk Analysis step the company transforms risk data into decision making
information. The company has to evaluate impact, probability and timeframe. This means
that they have to classify and prioritize risks.
Risk analysis is the systematic use of available information to determine how often
specified events may occur and the magnitude of their consequences. The analysis stage
assigns each risk a priority rating, taking into account existing activities, processes or
plans that operate to reduce or control the risk.
A matrix, like Table 2, can be structured according to the kinds of risks involved in the
company’s objectives, criteria and attitudes to risk. For example, the specific Table 2 is
not symmetric, indicating that the company is concerned about most catastrophic events,
even if they are rare. This might be appropriate where human safety is threatened and the
company needs to ensure the associated risks are being managed whatever the likelihood
of their occurrence.
Where the impacts of potential risks are purely economic, and particularly where there
may be limit to the potential exposure, catastrophic but rare events may be viewed as
moderate risks and not treated in such detail.
To implement a structure like this, it is important that clear and consistent definitions of
the consequence and likelihood scales are used.
Risk evaluation is the process of comparing the estimated risk against given risk criteria
to determine the significance of the risk. When the risk analysis process has been
completed, it is necessary to compare the estimated risks against risk criteria which the
company has established. The risk criteria may include associated costs and benefits,
legal requirements, socioeconomic and environmental factors, concerns of stakeholders,
etc. Any risks that have been accorded too high or too low a rating are adjusted, with a
record of the adjustment being retained for tracking purposes. The outcome is a list of
risks with agreed priority ratings. Adjustments to the initial priorities may be made for
several reasons.
➢ Risks may be moved down. Typically these will be routine, well-anticipated risks
that are highly likely to occur, but with few adverse consequences, and for which
standard responses exist.
➢ Risks may be moved up. Typically there will be two categories of risks like this:
those risks that are more important than the initial classification indicates; and
those risks that are similar to other high-priority risks and hence should be
considered jointly with them.
➢ Some risks may be moved up to provide additional visibility if the project team
feels they should be dealt with explicitly.
Risk evaluation therefore, is used to make decisions about the significance of risks to the
company and whether each specific risk should be accepted or treated. For the purpose of
risk management, risks need to be classified as primary risks and secondary risks.
Primary risks are those that are an essential part of the business undertaken. Secondary
risks are those that arise out of the business activities, but are not integrally related to
them. For example, the risks arising out of the industry structure are primary in nature,
foreign currency exposure arising due to exports are secondary in nature. To a large
extent, primary risks have to be borne in order to generate cash flows. They can be
covered only partly. Unlike primary risks, secondary risks can be covered to a large
extent, and only a part of them are unavoidable. This distinction becomes very important
while deciding on the risks to be covered.
Further, it is generally observed that when a firm faces a high degree of primary risk, it
can bear less of secondary risk. A firm having a low degree of primary risk may be able
to bear higher secondary risk, depending on the management’s risk bearing capacity.
Treat risks:
The purpose of risk treatment is to determine what will be done in response to the risks
that have been identified, in order to reduce the overall risk exposure. Unless action is
taken, the risk identification and assessment process has been wasted.
Risk treatment converts the earlier analyses into substantive actions to reduce risks. Any
controls and plans in place before the risk management process began are augmented
with risk action plans to deal with risks before they arise and contingency plans with
which to recover if a risk comes to pass.
At the end of successful risk treatment planning, detailed ideas will have been developed
and documented about the best ways of dealing with each major risk, and risk action
plans will have been formulated for putting the responses into effect.
Risk treatment might also include alteration of the base plans of the business.
Occasionally the best way to treat a risk might be to adopt an alternative strategy, to
avoid a risk or make the company less vulnerable to its consequences.
During the response identification and assessment process, it is often helpful to think
about responses in terms of broad risk management strategies. The following are the
different approaches:
Risk Avoidance:
An extreme way of managing risk is to avoid it altogether. This can be done by not
undertaking the activity that entails risk. Though this approach is relevant under certain
circumstances, it is more of an exception rather than a rule.
It is neither prudent, nor possible to use it for managing all kinds of risks. The use of risk
avoidance for managing all risks would result in no activity taking place, as all activities
involve risk, while the level may vary.
Loss Control:
Loss control refers to the attempt to reduce either the possibility of a loss or the quantum
of loss. This is done by making adjustments in the day-to-day business activities.
Combination:
Combination refers to the technique of combining more than one business activities in
order to reduce the overall risk of the firm. It is also referred to as aggregation or
diversification. It entails entering into more than one business, with the different
businesses having the least possible correlation with each other.
Separation:
Separation is the technique of reducing risk through separating parts of businesses or
assets or liabilities. A firm having two highly risky businesses with a positive correlation
may spin-off one of them as a separate entity in order to reduce its exposure to risk.
Risk Transfer:
Risk is transferred when the firm originally exposed to a risk transfers it to another party
which is willing to bear the risk. This may be done in three ways. The first is to transfer
the asset itself. There is a subtle difference between risk avoidance and risk transfer
through transfer of the title of the asset. The former is about not making the investment in
the first place, while the latter is about disinvesting an existing investment. The second
way is to transfer the risk without transferring the title of the asset or liability. This may
be done by hedging through various derivative instruments like forwards, futures, swaps
and options. The third way is through arranging for a third party to pay for losses if they
occur, without transferring the risk itself. This is referred to as risk financing. This may
be achieved by buying insurance. A firm may insure itself against certain risks like risk
of loss due to fire or earthquake, risk of loss due to theft, etc.
Risk Retention:
Risk is retained when nothing is done to avoid, reduce, or transfer it. Risk may be
retained consciously because the other techniques of managing risk are too costly or
because it is not possible to employ other techniques. Risk may even be retained\
unconsciously when the presence of risk is not recognized. It is very important to
distinguish between the risks that a firm is ready to retain and the ones it wants to offload
using risk management techniques. This decision is essentially dependent upon the firm’s
capacity to bear the loss.
Risk Sharing:
This technique is a combination of risk retention and risk transfer. Under this technique, a
particular risk is managed by retaining a part of it and transferring the rest to a party
willing to bear it.
Effective risk management requires a reporting and review structure to ensure that risks
are effectively identified and assessed and that appropriate controls and responses are in
place.
Regular audits of policy and standards compliance should be carried out and standards
performance reviewed to identify opportunities for improvement. It should be
remembered that companies are dynamic and operate in dynamic environments. Changes
in the company and the environment in which it operates must be identified and
appropriate modifications made to systems.
Continuous monitoring and review of risks ensures new risks are detected and managed,
and that action plans are implemented and progressed effectively. The monitoring
process should provide assurance that there are appropriate controls in place for the
company’s activities and that the procedures are understood and followed. Any
monitoring and review process should also determine whether:
Review processes are often implemented as part of the regular management meeting
cycle, supplemented by major reviews at significant project phases and milestones.
Monitoring and review activities link risk management to other management processes.
They also facilitate better risk management and continuous improvement.
The main input to this step is the risk watch list of the major risks that have been
identified for risk treatment action. The outcomes are in the form of revisions to the risk
register, and a list of new action items for risk treatment. Risk monitor and review
involves:
The risk manager reports periodically to the senior managers on the effectiveness of the
plan, any unanticipated effects, and any correction that the company must take to mitigate
the risk.
The risk register and the supporting action plans provide the basis for most risk reporting.
Reports provide a summary of risks, the status of treatment actions and an indication of
trends in the incidence of risks. They are usually submitted on a regular basis or as
required, as part of standard management reporting.
These traditional risk management techniques are used but it has its own limitations.
➢ Looks at the downside of Risk (losses)
➢ Doesn’t exploit the benefits of technology advancements
➢ Fails to address & adjust to meet emerging requirements
➢ Focus is on tactical aspect and doesn’t look at the big picture (inward-looking)
➢ Allows division of risk management in departments
➢ Doesn’t force alignment with business strategy
➢ Allows selective risk management without oversight.
EXTERNAL PRESSURES-
There are numerous external pressures on the companies which require portfolio
managers to devise sound risk management techniques. Some of the notable pressures
are:
➢ Regulatory environment is changing due to global financial crisis.
➢ The rating agencies, such as S&P, evaluate companies on Risk Management.
➢ There is an increased expectation by shareholders for effective risk management.
➢ Building on confidence in investment community and stakeholders.
➢ An increased expectation for improved corporate governance of risk.
➢ Organizations such as RIMS &PMI are promoting risk management at multiple
levels.
➢ SEC requires companies to describe risks that may have a material impact on
future financial performance.
INTERNAL REQUIREMENTS
In order to meet both the external as well as internal requirements there is a need to have
full proof risk management system which the traditional risk management technique fail
to offer on account of many irregularities mentioned earlier.
This calls for a need of a management technique to manage risk on all fronts i.e.
Enterprise Risk Management.
ERM is not one event or circumstance, but a series of actions that permeate an entity's
activities.
Environment Scanning
Tracking of current and previous issues.
Strategic Alignment
Align risk management with firm’s strategic direction
Risk Assessment
Prioritize and report organization’s risk events
To prepare a well planned response to Risk Events when and if theyRisk Response Planning
occur.
Market risk models are designed to measure potential losses due to adverse changes in
the prices of financial instruments. There are several approaches to forecasting market
risk, and no single method is best for every situation.
Over the last decade, Value-at-Risk (VaR) models have been implemented throughout
the financial industry and by non-financial corporations, as well. Inspired by modern
portfolio theory, VaR models forecast risk by analyzing historical movements of market
variables.
To calculate VaR, one can choose from three main methods: parametric, historical
simulation, and Monte Carlo simulation. Each method has its strengths and
weaknesses, and together they give a more comprehensive perspective of risk.
To account for the discontinuous payoff of nonlinear instruments like options, risk
simulations should use full valuation formulas (e.g., Black- Scholes) rather than first
order sensitivities (e.g., delta).
The following table describes the three main methodologies for calculating VaR.
From an end-user perspective, the important point to remember is that if you have
significant nonlinear exposures in your portfolio, a simulation approach with full position
re-pricing will generally be more accurate than a parametric approximation for estimating
VaR—however, at the cost of greater complexity.
CONCLUSION
The focus of good risk management is the identification and treatment of these risks. Its
objective is to add maximum sustainable value to all the activities of the company.
However considering the situation prevailing in emerging market which is far more
different and highly volatile compared to the developed markets. So, it should be borne in
mind of investors as well as portfolio managers that the techniques used for managing
risk should be used on continual basis as far as emerging markets are considered.
The portfolio revision, up gradation techniques and ERM would give desirable results
only when used with proper strategy and direction to ensure that the high risk prevailing
in having exposure in portfolio of emerging markets is minimized to a manageable
extent. It is clear that all risks can be minimized to the level of systematic risks which
can’t be minimized or reduced as it is related to whole economy.