Risk Management: Foundations for a Changing Financial World

CHAPTER 13

HOW RISK MANAGEMENT CAN BENEFIT PORTFOLIO MANAGERS^m

Michelle McCarthy

Using value at risk to analyze portfolio risk may appear to be inaccurate and to present yet another constraint on portfolio managers. But VAR, which measures an investment’s potential loss exposure over a specified time period at a given confidence level, can help senior managers in investment firms practice unified and disciplined risk management, giving investors more-reliable results and permitting portfolio managers to use a less restricted range of investment instruments.

Risk measurements help senior managers at investment firms supervise portfolio managers and help clients monitor the mix and concentration of risks in their portfolios. Although individual portfolio managers may not see the benefits of risk management, it does provide genuine benefits to this group as well. Part of the “disconnect” perhaps lies in different notions of what constitutes risk itself and thus how risk can, or should, be managed. This presentation defines risk and risk management for an investment firm, reviews the background of value at risk and describes the process of adopting VAR for investment portfolios, and discusses the benefits, criticisms, and limitations of VAR in a portfolio management context.

DEFINING RISK

Risk for an investment management firm can be viewed from three perspectives: absolute versus relative risk, fund-specific risk versus risk among a group of funds, and surprise losses.

Absolute ...