Risk assessments of retail investment products in hong kong and mainland china

Risk assessments of retail investment products in hong kong and mainland china
1 RZ130 Risk assessments of retail investment products in Hong Kong and mainland China 3 IFPHK CE credits 3 SFC CPT hours 3 MPFA non-core CPD hours Speaker: Dr. LAM Yat Fai (林日辉博士) Doctor of Business Administration (Finance) CFA CAIA FRM PRM MCSE MCNE 6:30pm to 9:30pm Friday 19th July 2013
2 Outline  Suitability of investment products  Major investment products  Qualitative risk assessment  Quantitative risk assessment  Practical issues  Private banking and corporate banking
3 What is this investment product?  Excellent investment product  High return  Low risk  Huge growth potential  Very stable income  As reliable as deposits
4 What is this investment product?  Very popular investment product  Mr. LAM acquired HK$ 100,000 yesterday  Mrs. LEE further brought HK$ 500,000 this morning  Subscription to be closed by this end of today  Limited offer to very few VIPs like you
5 What is this investment product?  Today the market is going up  The price will be more expensive tomorrow
6 What is this investment product?  Today the market is going down  The price is very attractive today
7 Sure win selling strategy  HK$ 100 Parknshop gift coupon for every HK$ 100,000 subscription
8 Very familiar conversions
9 Whom are you talking to?
10 Whom are you talking to?
11 Lehman Brothers minibonds
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13 Supervisory framework  Zoning  No gift  Audio recording  Code of conducts  Investor education  Key fact sheet  Suitability assessment  and many more
14 Suitability assessment Suitability assessment Investor profiling Product assessment Product risk level Product features Risk tolerance level Know your client
16 Common investment products in Hong Kong  Retail  Investment funds  Hedge funds  Bonds  Structured notes  Principal protected notes  Currency linked deposits  Equity linked deposits  Insurance linked investment schemes
17 Common investment products in Hong Kong  Private banking and corporate banking  Accumulator  Decumulator  Target redemption  Pivot  Currency linked notes with multiple underlying and fixing
18 Investment products in China  Private placement lending  Asset backed securities
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20 Risk rating of RMB bonds
21 Risk rating of common products Products Level Deposits 1 Government bonds 1 to 2 Corporate bonds 2 to 3 Currency linked deposits 3 to 4 Equity linked notes 4 to 5 Credit linked notes 5
23 Product risk assessment Qualitative  Expert judgment  Subjective  Time consuming  Less consistent  Very flexible Quantitative  Model based  Objective  Automated  Consistent  Less flexible
24 Regulatory risk factors  SFC’s key facts statement  http://www.sfc.hk/web/EN/regulatory- functions/products/product- authorization/products-key-facts- statements.html  HKMA’s important facts statement  http://www.hkma.gov.hk/media/eng/doc/key- information/guidelines-and- circular/2011/20110418e1.pdf
25 Descriptive report  Many lengthy paragraphs  broken down by risk type  to conclude a risk rating  Several pages to several lines  Very similar reports among similar investment products
26 Score card  Each risk factor is classified into one of several risk types  5 to 10 risk types  Each risk type is assigned a score “1” to “5”  3 to 6 risk factors per type  All scores are combined into a risk rating according to some rules
27 Qualitative assessment  Experience oriented  Subjective  Less consistency  Subject to manipulation  Argument among various departments  Time consuming  Regular update on annual basis
29 Basel III framework  Market risk  Currency rate  Interest rate  Equity price  Commodity price  Credit risk  Operational risk  Liquidity risk  Reputation risk  Legal risk  Strategic risk
30 Assumptions  Investment products,  without maturity, to be held until maturity  with maturity less than one year, to be held until maturity  with maturity longer than one year, to be reviewed and re-balanced on annual basis  What would be the percentage of potential loss of the principal after one year under an extreme condition (e.g. once every hundred years)?
31 Currency risk  For investment product not transacted in HKD  VaR at 99th percentile 1-year horizon   Currency rate this week Drift = - 1 × 100% Currency rate last week Volatility = Standard deviation Most recent 52 drifts 52 Extreme loss = 2.3264 × Volatility      
32 Annualized drift at 99th percentile -2.3264 volatility 99%
33 Equity price risk  For investment products linked to performance of specific equity  VaR at 99th percentile 1-year horizon   Equity price this week Drift = - 1 × 100% Equity price last week Volatility = Standard deviation Most recent 52 drifts 52 Extreme loss = 2.3264 × Volatility      
34 Commodity price risk  For investment products linked to performance of specific commodity  VaR at 99th percentile 1-year horizon   Commodity price this week Drift = - 1 × 100% Commodity price last week Volatility = Standard deviation Most recent 52 drifts 52 Extreme loss = 2.3264 × Volatility      
35 Fund price risk  For investment funds  VaR at 99th percentile 1-year horizon   Fund price this week Drift = - 1 × 100% Fund price last week Volatility = Standard deviation Most recent 52 drifts 52 Extreme loss = 2.3264 × Volatility      
36 Interest rate risk  For investment with principal to be locked in until maturity  VaR at 99th percentile 1-year horizon   Drift = Interest rate this week - Interest rate last week Volatility = Standard deviation Most recent 52 drifts 52 Extreme loss = 2.3264 × Volatility × Maturity
37 Credit risk Rating Corp (%) Bank (%) Gov’t (%) AAA, AA 1.6 1.6 0 A 4 4 1.6 BBB 4 4 4 BB 8 8 8 B 12 8 8 CCC to C 12 12 12 Unrated 12 12 12
38 Operational risk  To capture the extreme loss as a result of investment product complexity  Based on standardized approach, Basel III  Low 12%  Medium 15%  High 18%
39 Liquidity risk  To capture the extreme loss as a result of immediate liquidation  Based on collateral haircut table, Basel III  Exposure – government vs corporate  Credit rating – BB or above  Residual maturity
40 Collateral haircut table
41 Integrated extreme loss             Integrated loss = 1 - 1 - Currency risk loss × 1 - Equity/Comodity/Fund price risk loss × 1 - Interest rate risk loss × 1 - Credit risk loss × 1 - Operational risk loss × 1 - Liquidity risk loss
42 Calibration products  1 – US treasury fund  2 – Fixed income fund  3 – Blue chip equity fund  4 – Commodity fund  5 – Statistically sufficiently above “4”
43 Minimum risk level  To capture  Factors not incorporated in the model  Qualitative factors  Industry consents  Regulatory expectations
44 Minimum risk level  Fixed income fund 2  Corporate bond 2  Developed market equity fund 3  Currency linked deposits 3  Emerging market equity fund 4  Hedge fund 4  Equity linked notes 4  Credit linked notes 5
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49 Practical issues  Peer group comparison  Sensitivity vs stability  Product decomposition  2-dimensional rating  New product  New product category  Marketing vs risk management  Data  Transition gap
50 Peer comparison  HSBC  Hang Seng Bank  DBS(HK)  Wing Lung Bank  Wing Hang Bank  Bank of Communications  ICBC(Asia)  ANZI(HK)
51 Point-in-time vs through-the-cycle
52 Product decomposition  Different decomposition may result different product rating  CLD = Deposits – Put option  Product rating = 4  CLD = Worse of two short term bonds in different currencies  Product rating = Max(1, 2) = 2
53 2-dimensional rating  Risk rating of insurance policy  “A”, “B”, “C”, “D”, “E”  Risk rating of investments  “1”, “2”, “3”, “4”, “5”  Risk rating of ILAS product  Insurance policy ~ Investments  A1, B2, A3, C4, B5
54 New product  New fund  Proxy by similar fund with sufficient history  New equity  Proxy by similar equity with sufficient history  No proxy  The highest historical rating in the category
55 New product category  New products  RMB bond  iBond  ILAS  CLDs with multiple underlying  Product committee to design the rating methodology
56 Contradiction  Marketing  Product rating as low as possible  Product information as little as possible  Less change on product rating  Risk management  Product rating as high as possible  Product rating “5” with insufficient information  More frequent update on product rating
57 Data  Manageable and easily accessible  Reuters and Bloomberg  Lipper and MorningStar  Product data  From marketing department  Financial market data  From ???
58 Transition gap  New risk ratings materially deviating from existing ratings  Lower new ratings – Good  Higher new ratings – What to do?  Should the sold products with mis- matches be liquidated?  Should I inform the mis-match to customers
60 Private banking  Customers with HK$ 8 mn liquid cash  Portfolio with diversified investment product components  Investment risk assessed on portfolio basis  How to quantify investment portfolio risk?  Dilution  Diversification
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62 Corporate banking  Corporate customers with higher risk in their financial profile essentially demand correspondingly higher risk hedging strategies in offsetting direction so as to bring their financial profile back to affordable risk levels  Only corporate customers with sufficient knowledge in financial instruments, who know clearly the costs and benefits of different types of hedging instruments, may choose to adopt more complex hedging instruments, in order to reduce the risk of their financial profile more efficiently at a minimum cost
63 Level of sophistication  Level 1  Vanilla currency and interest rate derivatives without optionality  Level 2  Vanilla currency options and interest rate derivatives with optionality  Level 3  Currency options and interest rate derivatives with exotic payoffs  Level 4  Any hedging instruments falling outside Levels 1, 2, 3 and 5  Level 5  Hedging instruments which are only allowed to be acquired by professional investors under the regulatory guidelines from the HKMA and/or SFC, e.g. accumulators
64 Further complication  Asset class  Short selling  Credit line  Collateral
65 Q & A
66 Thank You
67 Upcoming IFPHK Continuing Education Programs: http://www.ifphk.org/CEP/ce-calendar Institute of Financial Planners of Hong Kong 13/F, Causeway Bay Plaza 2, 463 - 483 Lockhart Road, Hong Kong Tel: 2982 7888 Fax: 2982 7777 Email: education@ifphk.org Website: www.ifphk.org

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