Risk Management Selected ConceptsAgenda Definitions Basic Concepts of Modern Portfolio Theory Selected Risk Management Metrics Investment Policy and ConclusionsDefinitionsQuite often risk is perceived only with negative connotationsoDictionary.com defines risk as:1. The possibility of suffering harm or loss; danger. 2. A factor, thing, element, or course involving uncertain danger; 3.a. The danger or probability of loss to an insurer. b. The amount that an insurance company stands to lose. 4. a. The variability of returns from an investment. b. The chance of nonpayment of a debt. 5. One considered with respect to the possibility of loss: a poor risk. However, risk may also contain another element oThe Chinese use two symbols to define risk:1. The first symbol is for “danger” 2. The second is for “opportunity” What is Risk?1.From our previous definition, Risk Management (RM) would entail administering a mix of danger and opportunity.2.A more classic approach defines RM as a process (an attempt, really) to identify, measure, monitor and control uncertainty in an orderly and methodical manner (often using mathematical models).Both approaches to RM are correct.However, RM is more of avoiding dangers than seeking the opportunities. RM in a modern acception entails following a pre-established management process and performing mathematical models (Greek letters and other sophisticated financial metrics). RM is about understanding human behavior and finding a “comfortable” trade-off between expected reward and potential loss.What is Risk Management ?RM entails managing exposure and uncertainty.Risk Topology in the Investment Management contextInvestment RisksLiquidityOperationalRegulatoryHuman FactorMarket RiskCredit Portfolio ConcentrationIssuer Counterparty RiskEquity/commodity (price)Interest RatesCurrencyLegalSystemic1.Market risk is the uncertainty of changes in the assets returns relative to changes in the market.2.Derives from market-wide factors which affect issuers and investors. Such factors will include (but will not limited to):a)Interest rates;b)Inflation rates;c)Currency exchange rates;d)Demographics (remember Michael Cichons comments about demographic implications!);e)Unemployment rates;f)General legislation;g)Risk of natural disasters (Katrina, Rita, earthquakes, floods, fire, etc.).Market Risk- Credit risk is the uncertainty in a counterpartys (or obligors) ability to meet payment of its obligations. Associated concepts:Default probability is the likelihood that the obligor will default on its obligation either over the life of the transaction or at an specific timeframe.Credit exposure is the amount of outstanding at the time of a potential default.Recovery rate is the fraction of the exposure that might be recovered. Credit quality is the perceived ability (usually by a credit rating agency) of an issuer or counterparty to meet its obligation. Credit rating is assigned by credit analysts to the counterparty (or specific obligation) and can be used for making credit decisions.Credit RiskStandard Standard deviation of expected returns;Correlations of the pairs of instruments in the portfolio.4.A portfolio is a basket or set instruments that presents, in a comprehensive and accumulated manner, a risk return profile that responds to the goals and risk tolerance of the investor.Conclusions5.James Tobin showed that it is possible to combine the efficient portfolios with the risk free asset, thus creating a set of portfolios with superior characteristics (super efficient frontier).6.William Sharpes idealized model* proposed Tobins tangent portfolio must be the market portfolio.7.Investors use asset classes to determine Strategic Asset Allocation (for which the number of correlations is small and more of less stable and easier to determine).8.Practical Lessons:Volatility worsens as the time horizon shrinks ( there are benefits to long term investing, remember Sudhir Rajkumars presentation on 20 yr. volatility of US stocks! );Diversification reduces volatility efficiently;Conclusions8.Practical Lessons:A practical way to invest in a diversified portfolio is through representative market indices or index funds;Dont go for Alpha until investment and risk management process is mature (remember Lesson 8 of Jay Collins presentation! );Modern Portfolio Theories provide simple, intuitive solutions to investing, but have their limitations and should be one of many elements to be considered;Strong governance and prudence! should be prerequisites for safe and efficient investment of Social Security Funds;Sound Risk Management starts with an adequate policy statement.Thank you.Conclusions