Risk Management: Foundations for a Changing Financial World

CHAPTER 14

MERGING THE RISK MANAGEMENT OBJECTIVES OF THE CLIENT AND INVESTMENT MANAGERⁿ

Bennett W. Golub

Ex ante tracking-error models are the next step in the logical progression of risk measurement and risk management techniques. Proper use of these models can offer managers an opportunity to base their judgments on precise sets of statistics so that managers know when—and when not—to take various risks. With any kind of probability-based model, however, the absence of some method for understanding the potential impact of extreme events can result in extremely unfortunate circumstances because tracking-error models tend to overly discount some of the extreme events that can and do occur. Thus, stress testing is a critical component of any risk management regime.

Investment managers must communicate with clients and accurately identify their true portfolio objectives. Uncertain objectives can lead to client dissatisfaction with the performance delivered, particularly if the outcome is negative but sometimes even when it is good. Once the objectives are defined, the manager’s challenge is to ensure that the portfolio is managed within the client’s risk tolerances.

Fortunately, there are a variety of approaches to assist managers in accomplishing this task. Parametric risk analysis provides an effective tool for monitoring a portfolio’s exposures. Ex ante tracking-error forecasts permit managers to combine parametric risk measures into a single probability-weighted measure. In ...