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Subject Risk Analysis and Management

Code BEO410

Assignment Session , 00

Student David Johnston

ID 665

Due Date 500pm Friday Oct. 1

Tute Thurs 00pm

Tutor Syd Lambrick

Article 1

'Managing Risk in the Funds Management Sector' is as the title would suggest, an article providing a comprehensive analysis of risk management in the active funds management industry. Morony has broken up his article into two main sections; Fiduciary risk or client risk, and firm risk. Throughout Morony's analysis, practical examples and solutions employed by Bankers Trust Fund Management (BTFM) to mange and control these risks are provided. Morony writes about identifying ways to combat risk in the funds management sector. His article is well written for its applicability to the funds management sector.

Morony, throughout his analysis, looks at ways of managing risk for fund managers in a very practical way. He starts by cementing that if risk is ignored or not controlled properly then it will damage both the business and its clients, 'if a fund manager cannot control risk then there is no way to survive in the long run'.

Morony identifies the importance of setting benchmarks for managers to match and teaching clients about these benchmarks. Negative portfolio returns in a weak market but with above-benchmark performances can yield dissatisfaction among its clients whereas positive portfolio returns in a strong market but with below-benchmark performances can result in client satisfaction. Morony identifies this dilemma among fund managers and intelligently suggests 'to resolve the tension between absolute returns and relative returns, fund mangers must provide considerable client education and explanation'. To ensure client satisfaction a key to any successful business BTFM ensure that all its clients agree to the terms of the mandate before it is signed and the fund accepted.

Market risk refers to 'the to the possibility of loss on a portfolio as a result of adverse movements in interest rates, foreign exchange rates and other market prices'. Despite all the advancements in risk management procedures, there is no one ideal to forecast portfolio performance. Morony questions the extensive use of historical data and that portfolio returns are distributed normally, moreover suggesting they exhibit leptokurtosis or 'fat tails'. The existence of these fat tails is due to extreme movements among markets being more common than normal distribution suggests. He gives us an example by sighting correlation differences during market crises 'for example, during the 18 Russian bond crises the correlation between equities and bonds moved from 0.1 to -0.56'. Correlation is used in formulating overall portfolio risk, so you could imaging the miscalculations as a result of using historical data during these volatile times. To combat this problem, BTFM 'combines the historic reaction of different markets in particularly volatile periods… to test unusual correlation patterns against current portfolio positioning'.

The concept of risk budgets is a new concept in managing risk. A risk budget is a 'mixture of simple portfolio construction limits' set out to ensure risk isn't being underestimated or overlooked. If a risk budget limit is broken then managers must explain why the portfolio should continue. Morony emphasises managers should take risks but believes in ensuring the risks are 'intentional and reflect the strength of the views of the portfolio manager'.

Firm risk is extremely important for a stable company. It is the risk to the firms revenue and reputation. Morony identifies firm risk as being either governance risk or operating risk.

To ensure the controlling of governance risk, BTFM require all staff to be trained in key business policies and procedures and sign a code of ethics. Stringent controls on employee trading are also implemented by BTFM along with security on insider trading and daily checks on portfolio restrictions. All this is to protect the firms reputation which can, if unmonitored, result in 'negative publicity and/or a decline in market confidence, and consequent business loss'.

Morony cleverly suggest that operating risk can be managed by 'identifying key individuals in the firm' and certifying their knowledge is passed on to others in the company in-case of their departure. Disaster recovery plans are also a must. Back-up computer systems and safe storage of computer data regularly downloaded. With real time information a must in such businesses, Morony concludes 'it is imperative that resources are committed to the establishment and maintenance of such a (back-up) site'.

Article

Miccolis's article 'Enterprise Risk Management in the Financial Services Industry From Concept to Management Process' is a five step process focusing on 'developing best strategies' the first stage of enterprise risk management (ERM). The financial service industry widely believes in the use of ERM in addressing major business challenges, however only a small number of companies have fully implemented ERM, especially in the insurance sector. Miccolis's article shows financial service companies, in particular insurers, a process that will help them both shape risk exploit risk for their enterprises.

Miccolis believes a firms first step to developing best strategies is to 'assess all risks in the current environment'. From here the risks are then classified into 'manageable' or 'strategic' risk factors. Strategic risk factors, unlike manageable risk factors, are addressed with a change in strategic direction.

Miccolis's article states that secondly, a company needs to 'develop a financial model that will be used in later steps to evaluate.. (these) strategies'. One problem Miccolis identifies is that some decisions may grow earnings but at the expense however, of capital return. Therefore strategies must be co-ordinated to minimise these trade-offs. In order to accomplish this, a firm must evaluate strategies in contrast to the identified risk environment. To accomplish this, a 'stochastic financial model is constructed'. This model is constructed by allocating each item on the financial statement to its operational and financial component. By doing this, all strategic risks modelled in the first stage, and their correlation are reflected in this stochastic model.

Miccolis goes on by separating the needs of both the policyholders (step ) and the owners/shareholders (step 4). Policyholders needs are focused on the 'determination of economic capital' where as the owners needs are focused on financial gains, stability, and growth. Miccolis believes these areas need different risk evaluations to maximise a firm's desired output. He also advises how insurance companies can calculate these risks to best effect.

The stochastic modelled in step could give thousands of possible combinations of strategies to evaluate, therefore, Miccolis suggests the use of 'mathematical optimisation technology'. This would speed up the process of strategy evaluation. In any case, 'the final evaluation and selection of the best combinations of strategies is accomplished through discussion by management… armed with the insight into the risks and values of each strategy'.

Refining the strategies is the last step for a business to implement the first stage of ERM. Mercolli says this is done by decomposing the prior analysis into root causes, which 'is done by turning uncertainty associated with a variable in the financial model 'on' or 'off''. By constantly applying this process and isolating the impact of each strategy, the firm can both refine its strategies and select the best ones.

Miccolis's analysis of ERM is well written for the use of financial service companies. After reviewing the article and putting it into practise, insurance managers can be confident of developing the best set of strategies to managing risk at the enterprise level and therefore increasing the enterprises value

Bibliography

Article 1

Morony, A. (18) Managing Risk in the Funds Management Sector. Web http//www.apra.gov.au/RePEc/RePEcDocs/Archive/conference_papers1/risk_funds_management_sector.pdf

Article

Miccolis, J. (Nov. 000) Enterprise Risk Management in the Financial Services Industry From Concept to Management Process. Web http//www.irmi.com/expert/articles/miccolis00.asp

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