Risk Budgeting.

Slides:



Advertisements
Similar presentations
Asset Pricing. Pricing Determining a fair value (price) for an investment is an important task. At the beginning of the semester, we dealt with the pricing.
Advertisements

Mean-variance portfolio theory
Chapter 1 Managing Investment Portfolios.  integrated set of steps undertaken in a consistent manner to create and maintain an appropriate portfolio.
Optimal Decentralized ALM Jules H. van Binsbergen, Stanford University Michael W. Brandt, Duke University and NBER Ralph S.J. Koijen, University of Chicago.
Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edition by Frank K. Reilly & Keith C. Brown Chapter.
Empirical Financial Economics 5. Current Approaches to Performance Measurement Stephen Brown NYU Stern School of Business UNSW PhD Seminar, June
Chapter 6 An Introduction to Portfolio Management.
1 ASSET ALLOCATION. 2 With Riskless Asset 3 Mean Variance Relative to a Benchmark.
Evaluation of portfolio performance
Long/Short Trading Strategy Cam’s Crazies Global Asset Allocation February 2005.
18 September 2003 Joeri van Alphen Lodewijk van Pol Modelling Active Management AFIR 2003, Maastricht.
Portfolio Management Grenoble Ecole de Management.
Dynamic Portfolio Management Process-Observations from the Crisis Ivan Marcotte Bank of America Global Portfolio Strategies Executive February 28, 2013.
Chapter 12 Global Performance Evaluation Introduction In this chapter we look at: –The principles and objectives of global performance evaluation.
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 21-1 Chapter 21.
Portfolio Management-Learning Objective
Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edition by Frank K. Reilly & Keith C. Brown Chapter 7.
Some Background Assumptions Markowitz Portfolio Theory
Asset Management: Education Investment Policy Statements.
The Montgomery Institute Investment Proposal December 2013.
Portfolio Management Unit – 1 Session No.4 Topic: Investment Objectives Unit – 1 Session No.4 Topic: Investment Objectives.
McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Performance Evaluation and Active Portfolio Management CHAPTER 18.
Active versus Passive Management September 13 th, LAPERS Darren Fournerat, CFA, CAIA Laney Sanders, CFA.
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 24-1 Portfolio Performance Evaluation.
Asset Pricing Models Chapter 9
PORTFOLIO OPTIMISATION. AGENDA Introduction Theoretical contribution Perceived role of Real estate in the Mixed-asset Portfolio Methodology Results Sensitivity.
All Rights Reserved to Kardan University 2014 Kardan University Kardan.edu.af.
Private Wealth Management The Portfolio Management Process Jakub Karnowski, CFA Portfolio Management for Financial Advisers.
The Asset Allocation Process. Strategic and Tactical Asset Allocation. Jakub Karnowski, CFA Portfolio Management for Financial Advisers.
Unit – III Session No. 26 Topic: Optimization
McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Performance Evaluation and Active Portfolio Management CHAPTER 17.
Chapter 7 An Introduction to Portfolio Management.
Framework. Notation r=vector of excess returns –Bold signifies vectors and matrices. We denote individual stock excess returns as r n. –Excess above risk.
Portfolio Management Unit – III Session No. 27 Topic: Implementing the Strategic Asset Allocation Unit – III Session No. 27 Topic: Implementing the Strategic.
Risk Management Basics
Central Bank of Egypt Performance Measurement Tools.
March 2014 Abdelhamid Mortagy Central Bank of Egypt I. Portfolio Management Choices Prepared & Presented By: Abdelhamid Mortagy.
March-14 Central Bank of Egypt 1 Strategic Asset Allocation.
March-14 Central Bank of Egypt 1 Risk Measurement.
EQUITY-PORTFOLIO MANAGEMENT
Capital Allocation to Risky Assets
A Primer on WARF’s Hedge Fund Portfolio:
Portfolio Performance Evaluation
Capital Market Theory: An Overview
abcd Active Management or the Equity Risk Premium: Place Your Bets
Market-Risk Measurement
Topic 4: Portfolio Concepts
Markowitz Risk - Return Optimization
INVESTMENTS: Analysis and Management Second Canadian Edition
The Theory of Active Portfolio Management
Risk Management Basics
Portfolio Performance Evaluation
Portfolio Selection (chapter 8)
6 Efficient Diversification Bodie, Kane and Marcus
Capital Asset Pricing Model
Chapter 19 Jones, Investments: Analysis and Management
Evaluation of Investment Performance
Portfolio Management Chapter 21
Portfolio Performance Evaluation
Capital Market Charts 2005 Series (Modern Portfolio Theory Review) IFS-A Charts 1-3 Reminder: You must include the Modern Portfolio Theory Disclosure.
Capital Market Charts 2004 Series (Modern Portfolio Theory Review) IFS-A Charts 1-9 Reminder: You must include the Modern Portfolio Theory Disclosure.
TOPIC 3.1 CAPITAL MARKET THEORY
Investments: Analysis and Management
Saif Ullah Lecture Presentation Software to accompany Investment Analysis and.
Economic Capital and RAROC
Portfolio Management: Course Introduction
The Theory of Active Portfolio Management
Chapter 21 Jones, Investments: Analysis and Management
The swing of risk/return
Figure 6.1 Risk as Function of Number of Stocks in Portfolio
Presentation transcript:

Risk Budgeting

Index Risk Management Framework What is Risk Budgeting? Rationale for Risk Budgeting SAA Determines Benchmark and Active Management Parameters Portfolio risk Strategic v. Active Decisions Key Inputs for Risk Budgeting Eight Steps to Risk Budgeting IX. Risk budgeting example X. Allocating risk optimally XI. Conclusion

I- Risk Management Framework Risk Management is an ongoing process of: 1. Risk Measurement What is our risk? How do we measure our risk? 2. Risk Attribution Where does our risk come from? Which decisions contributed to risk? 3. Risk Allocation How do we utilize/manage risk going forward? How do we want to allocate risk? When risk is allocated, we go back to step1 Stage I & II are the foundations to Risk Budgeting

II- What is Risk Budgeting? Budgeting risk is not different than budgeting time or money What is budgeted is the total risk we are willing to incur to generate returns (i.e. our risk tolerance) The way we “spend” this resource is by taking exposure to asset classes and active risk

III- Rationale for Risk Budgeting Risk constraints are specified by the Board in the Investment Policy Need to make optimum use of this available risk in order to maximize return Some portfolio management strategies use risk more efficiently than others How do you decide how much risk to allocate to each portfolio strategy/manager?

IV- SAA Determines Benchmark and Active Management Parameters Board Prepares Investment Policy Input Input Board/ Investment Committee Middle Office Input Strategic Asset Allocation Prepares Approves + TE Guidelines (Active Limits) Benchmark

V- Portfolio risk can be deployed in one of two ways: Move along the efficient frontier Try and move ahead of the frontier New SAA Existing SAA Active Risk Expected Return Risk (Volatility) Source: World Bank

VI- Strategic vs. Active Decisions Strategic Decisions Main decision Measurement Active Decisions Implementation Costs Importance How much market or systematic risk (a.k.a. beta) versus liabilities? How much active risk (a.k.a. alpha) versus the policy benchmark? Investing (long-only) in the benchmark portfolio Outperform (long/short versus) the benchmark portfolio Cheap (low fees) and does not require much skill Expensive (fees and cost of infrastructure) and skill is critical Historically, this has been the dominant source of risk in most institutional portfolios Historically, this has been a small part in most institutional portfolios Measurement: excess return over benchmark Measurement: total return of the benchmark Source: World Bank

VI- Strategic vs. Active Decisions Strategic Decisions Active Decisions Total return of the benchmark portfolio Excess return over the benchmark portfolio, Alpha Return Measure Volatility of absolute returns, Volatility of excess return, Tracking Error (TE), Risk Measure Sharpe Ratio (SR), ratio of returns over the risk free rate to volatility of return Efficiency Measure Information Ratio (IR), ratio of excess returns (alpha) to tracking error (TE) Source: World Bank

VI- Allocating Risk Between Strategic and Active Decisions: Theory Institutional investment objective is to maximize wealth of the portfolio subject to overall risk tolerance under certain expectations of Sharpe Ratio for strategic (benchmark) decision and Information Ratio of active management Given the overall risk budget, the optimal split between strategic and active risks for expected Sharpe Ratio (SR) and Information Ratio (IR) and assuming no correlation between the two is determined by:

VI- Allocating Risk Between Strategic and Active Decisions: Reality Given this framework, if the SR = IR the optimal allocation between strategic and active risks is equal!!! Then why do most institutions allocate only a small proportion of the total risk to active management? This implies that most institutions are not very confident of achieving consistent IR, net of fees In reality, due to various constraints, IR decreases when tracking error increases Therefore, it is important to efficiently allocate risk across different strategies/ managers

Strategic Asset Allocation Risk Budgeting Example =300 bps Total Risk Budget Overall/total risk budget set by Board TE=157 bps Active Management IR=0.40 Strategic Asset Allocation =255 bps SR=0.65 =0.2 Director of investments delegates risk to portfolio managers TE=30 bps Treasury Active IR=0.3 TE=76 bps Currency Active IR=0.7 TE=63 bps MBS Active IR=0.5 This example uses tracking error as measure of risk. In allocating risk to traders stop-loss limits might be more common and TE figures need to be translated into e.g. value-at-risk or drawdown risk figures. Portfolio managers allocate their risk budget to strategies and styles (directional bets, relative value bets, etc), or external managers Source: World Bank

VII- Key Inputs for Risk Budgeting What are we budgeting for? Active Risk, Total Risk, Surplus Risk… Time Horizon: one month is too short, 10 years is too long… A Measure of Risk: Tracking Error, Value at Risk, Drawdowns, Surplus at Risk… A Measure of Opportunities Information Ratio, Sharpe Ratio, … Correlation Assumptions

VIII- Eight Steps To Risk Budgeting: Step 1: Determine benchmark. The benchmark determines the neutral point for risks in portfolio. Active views are taken relative to the benchmark Step 2: Determine investment constraints. Establish explicit limits on portfolio exposures, of the kind “maximum 30% of corporate bonds,” or “the duration deviation from the benchmark should not exceed one year” Source: World Bank

VIII- Eight Steps To Risk Budgeting: Step 3: Determine permissible active investment strategies. Once constraints are known, determine what strategies can be utilized (e.g. currency exposures) Step 4: Determine maximum amount of tracking error for each strategy. Maximum tracking error (TE) is determined by multiplying average deviation of the particular risk times the estimated volatility of that risk Source: World Bank

VIII- Eight Steps To Risk Budgeting: Step 5: Estimate excess return per unit of risk for each strategy & correlation of excess returns between strategies. The estimation of return per basis point of TE measures how strategy will be going forward Step 6: Determine target excess return or target TE. Allocation of risk should maximize excess return given target level of risk Source: World Bank

VIII- Eight Steps To Risk Budgeting: Step 7: Determine optimal amount of risk to each strategy. Use mean-variance optimization technique to allocate tracking error to each investment strategy Step 8: Carefully monitor realized risk characteristics of total portfolio and individual strategies. Correct potential problems by comparing ex ante assumptions with ex post behavior Source: World Bank

Strategic Asset Allocation IX- Risk Budgeting Example =300 bps Total Risk Budget Overall/total risk budget set by Board TE=157 bps Active Management IR=0.40 Strategic Asset Allocation =255 bps SR=0.65 =0.2 Director of investments delegates risk to portfolio managers TE=30 bps Treasury Active IR=0.3 TE=76 bps Currency Active IR=0.7 TE=63 bps MBS Active IR=0.5 This example uses tracking error as measure of risk. In allocating risk to traders stop-loss limits might be more common and TE figures need to be translated into e.g. value-at-risk or drawdown risk figures. Portfolio managers allocate their risk budget to strategies and styles (directional bets, relative value bets, etc), or external managers Source: World Bank

X- Allocating Risk Optimally… The maximization problem can be formulated as: Where w is the vector of (net) portfolio weights, w·α equals the expected (excess) return of the portfolio, and TEmax is the overall risk budget

X- Allocating Risk Optimally… Optimal risk allocation: maximize expected return subject to a constraint on risk Inputs: Overall risk budget set by oversight committee Expected (target) information ratios Correlation assumptions

XI- Conclusion Active management can produce high risk-adjusted returns while maintaining, or even reducing, total portfolio risk To allocate or distribute total risk more efficiently, a risk budgeting framework is needed Practical issues should be considered carefully: Beware of hidden beta: don’t pay alpha-fees for beta-products Consider removing constraints on active managers

XI-Conclusion Separate allocation to alpha sources from beta allocation Consider sourcing alpha from markets that are not in your policy benchmark

Case Study & Thank you