NORTHFIELD<br />Using a Structural Model for Enterprise Risk<br />April 12th 2011<br />Presented by Nick Wade<br />Directo...
Talking Points for Today<br /><ul><li>Fund managers need detailed risk attribution for risk budgeting, performance attribu...
CRO/Board/Trustees/Investment Committee need high-level risk across the firm
Client needs vary - Who is the asset owner?
Returns for illiquid assets e.g. direct property contain “appraisal smoothing” effects and do not reflect underlying risk ...
Risk Models typically used for fund management are not consistent across asset classes and markets, and usually ignore “di...
We need to provide an integrated platform that can provide different levels of detail to different audiences, and include ...
E.g. what will happen if oil prices go up? Does my portfolio reflect my belief that Toyota will perform twice as well as BHP?
Bad: Typically single-asset class models; delivered in stand-alone software</li></ul>Enterprise Risk <br /><ul><li>Good: t...
Good: typically an integrated platform
Bad:one dimensional, return-based; problematic for Illiquid instruments
Solution: Find an integrated Platform that can do both</li></ul>Offer a customizable reporting tool on top of a set of sma...
Why VaR and return-based models may not be enough<br /><ul><li>Many “enterprise” risk systems assume:</li></ul>Horizon: th...
difficult assets can be “proxied” with equity securities</li></ul>Credit Ratings, Accounting data are reliable<br />
Why do we have this split?<br /><ul><li>Bank/Hedge Fund/Trading Desk</li></ul>Risk management is about maintaining solvenc...
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Nick Wade Using A Structural Model For Enterprise Risk, Dst Conference 2011 04 12

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On why a multi-factor or structural model of risk might be a good idea at the enterprise level, rather than the more common VaR models based simply on historical returns

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  • Nick Wade Using A Structural Model For Enterprise Risk, Dst Conference 2011 04 12

    1. 1. NORTHFIELD<br />Using a Structural Model for Enterprise Risk<br />April 12th 2011<br />Presented by Nick Wade<br />Director, Asia Marketing<br />Northfield Information Services Inc.<br />nick@northinfo.com<br />+81(0)3 5403-4655<br />+61(0)2 9238-4284<br />
    2. 2. Talking Points for Today<br /><ul><li>Fund managers need detailed risk attribution for risk budgeting, performance attribution, scenario analysis and portfolio construction
    3. 3. CRO/Board/Trustees/Investment Committee need high-level risk across the firm
    4. 4. Client needs vary - Who is the asset owner?
    5. 5. Returns for illiquid assets e.g. direct property contain “appraisal smoothing” effects and do not reflect underlying risk i.e. it’s not a real price.
    6. 6. Risk Models typically used for fund management are not consistent across asset classes and markets, and usually ignore “difficult” asset classes like property, infrastructure, private equity.
    7. 7. We need to provide an integrated platform that can provide different levels of detail to different audiences, and include the “difficult” asset classes</li></li></ul><li>More about that split…<br />A split in the world:<br />Portfolio Management and Asset Management Firms<br /><ul><li>Good:Risk analysis and portfolio management done using multi-factor models, contributions to risk aligned with contributions to return
    8. 8. E.g. what will happen if oil prices go up? Does my portfolio reflect my belief that Toyota will perform twice as well as BHP?
    9. 9. Bad: Typically single-asset class models; delivered in stand-alone software</li></ul>Enterprise Risk <br /><ul><li>Good: the typical VaR measures are intuitive
    10. 10. Good: typically an integrated platform
    11. 11. Bad:one dimensional, return-based; problematic for Illiquid instruments
    12. 12. Solution: Find an integrated Platform that can do both</li></ul>Offer a customizable reporting tool on top of a set of smart components that can deliver both “VaR” and also multi-factor risk decomposition consistently and comparably across asset classes and markets satisfying both fund management and enterprise risk requirements<br />
    13. 13. Why VaR and return-based models may not be enough<br /><ul><li>Many “enterprise” risk systems assume:</li></ul>Horizon: that the “enterprise” runs a risk of not surviving past the weekend e.g. 10 day VaR<br />Returns-based: that the “enterprise” only invests in liquidly exchange traded instruments, and that therefore the observed returns tell you all you need to know about risk<br /><ul><li>no direct property, infrastructure, private equity, timber and so forth
    14. 14. difficult assets can be “proxied” with equity securities</li></ul>Credit Ratings, Accounting data are reliable<br />
    15. 15. Why do we have this split?<br /><ul><li>Bank/Hedge Fund/Trading Desk</li></ul>Risk management is about maintaining solvency in the event the value of the assets declines i.e. Survival<br />Some measures of drawdown risk such as parametric VaR, are just the standard deviation times a scaling factor.   This is what the RiskMetrics system was created for at JP Morgan.<br /><ul><li>Asset Manager/Pension Fund/Sovereign Wealth</li></ul>Risk is about how the variability of return from period to period reduces compounding of returns over time.  The geometric mean return of a portfolio is equal to the arithmetic mean of the returns minus one half the variance of the returns<br />Investor wealth depends on the compounding of returns over time, so the variance of the returns (not the standard deviation) is the predominant issue in controlling investor risk.  As such, the most relevant measure of risk to decompose is the variance, not the tracking error or VaR.<br />
    16. 16. A Third Choice?<br /><ul><li>Create a multi-asset class risk model based on familiar approaches in asset management
    17. 17. Cover unlisted assets using a structural model, not historical returns
    18. 18. Use market-implied credit measures, not agency ratings
    19. 19. Embed into a firm-wide integrated platform
    20. 20. Offer reporting at different levels of granularity from enterprise VaR down to single-security contributions to (sub)portfolio risk, satisfying different constituencies</li></li></ul><li>7<br />Northfield Products and Services<br />Delivered as stand-alone applications or smart components within a partner integrated platform:<br /><ul><li>Portfolio Construction Tools (Optimizer, MARS)
    21. 21. Risk Management (Risk Model Family)
    22. 22. Asset Allocation Tools (ART)
    23. 23. Performance Attribution</li></li></ul><li>What Northfield EE Can Do<br /> a multi-factor model of risk across asset classes<br /><ul><li>Analyze risk consistently across a broad range of asset classes
    24. 24. Structural Model for unlisted/illiquid asset classes – avoid issues with appraisal smoothing
    25. 25. Structural Model for Credit Risk – avoid agency credit ratings
    26. 26. Over 5 million individual instruments plus client defined terms:</li></ul>Global equity securities: developed and emerging, including externally managed funds<br />Global fixed interest: developed and emerging government, corporate, convertible, CMO, MBS, ABS, muni, and agency bonds, and private placements, including externally managed funds<br />Global REIT securities<br />Direct investment in property down to tenant level<br />Direct investment in infrastructure projects down to cashflow level<br />Derivative securities such as swaps, futures, options<br />Hedge Funds with undisclosed constituents<br />
    27. 27. How Does Northfield EE do this?<br /><ul><li>NOT an unstable unclear roll-up of a dozen or more individual models
    28. 28. Atomic Approach to Risk
    29. 29. One set of factors for all asset classes
    30. 30. Market Risk
    31. 31. As a function of macro- and micro-economic effects</li></ul>Interest rate risk<br /><ul><li>The effect on the price of securities of yield curve shape changes
    32. 32. Credit risk
    33. 33. As a function of macro- and micro-economic effects</li></ul>Currency risk<br />Effect of embedded optionality<br />Effect of prepayments<br />Exposure of cashflows to macro- and micro-economic drivers of risk<br /><ul><li>Dynamic capture of new factors & transient effects via an adaptive hybrid risk model factor structure</li></li></ul><li>Northfield Innovation – The Hybrid Model<br /><ul><li>Combine macro, micro, and statistical factors
    34. 34. Gain the advantages of each, whilst mitigating the limitations of each</li></ul>Intuitive, explainable, justifiable observable factors<br />Minimal dependence on accounting information<br />Rapid inclusion of new or transient factors<br /><ul><li>Estimate using time-series approach</li></ul>Diversify away estimation error<br />best for markets with moderate to low dispersion<br />best for portfolios with moderate/high diversification<br />
    35. 35. Equity in the EE framework<br /><ul><li>Macro factors</li></ul>Market, sector, oil, interest rates, market development, currency<br /><ul><li>Micro factors</li></ul>Size, value, growth, momentum<br /><ul><li>Temporary factors</li></ul>Statistical factor analysis acting on the residual return to ensure full capture of pervasive effects at all times<br /><ul><li>Adjustments for non-stationarity</li></ul>Exponential weighting, conditional variances, Parkinson range measures, cross-sectional dispersion adjustment<br />
    36. 36. Fixed Income in the EE framework<br /><ul><li>Interest rate risk</li></ul>All bonds are priced relative to their local curves and their sensitivity to yield curve shape changes is captured<br /><ul><li>Credit risk</li></ul>market-derived measures independent of credit ratings<br />We expose the drivers of credit risk: macro, micro and issuer specific<br /><ul><li>Currency risk</li></ul>Global currencies are explicitly included in the model<br /><ul><li>Optionality, Prepayment, Convertibles</li></ul>Binomial tree pricing enables us to capture the effect of put, call, sinking fund, and prepayment risk at each node on the tree<br />Quadrinomial (3D tree) allows accurate pricing of converts without Black-Scholes assumptions<br /><ul><li>Issuer-specific risk</li></ul>Individual bond risk also includes issuer-specific risk<br />12<br />
    37. 37. Additional Coverage:<br />Hedge Funds, undisclosed constituents:<br /><ul><li>Return series and details provided by client or Northfield to our EENIAC tool
    38. 38. Sharpe style-analysis to get index weightings
    39. 39. Constituents optimized to reduce number of names to provide appropriate specific risk</li></ul>Derivative Securities<br /><ul><li>Terms and conditions are provided by the client to our EENIAC tool
    40. 40. A set of exposures and all other necessary files is returned to the client (for example composite assets reflecting underlying basket) </li></ul>Unlisted e.g. Direct Property<br /><ul><li>Provide cashflow (lease-level) terms and conditions in prefabricated templates to EENIAC
    41. 41. Risk exposures and all necessary supporting files are returned (for example, composite assets reflecting underlying holdings)</li></li></ul><li>Northfield EE Summary<br />EE provides:<br /><ul><li>a consistent framework for enterprise risk and performance attribution
    42. 42. 60,000 equity and 500,000 fixed interest instruments as standard
    43. 43. structural model for credit risk that is independent of credit ratings
    44. 44. structural model for illiquid assets avoiding appraisal smoothing
    45. 45. On-demand access to a further universe of over 5 million CMO, MBS, ABS, muni, and agency securities
    46. 46. On-demand analysis of client-supplied instruments</li></ul>Northfield EE is<br /><ul><li>Available as a stand-alone application or via industry leading partners
    47. 47. Integrated within DST Anova</li></li></ul><li>Northfield risk analysis offers…<br /><ul><li>Appropriate Models for Each Market
    48. 48. Investment sense,broad acceptance & academic approval
    49. 49. Intuitive factors used to describe risks
    50. 50. Analysis that is comparable across markets
    51. 51. Systematic risks detected & understood
    52. 52. “Glass box” – open, clear models & systems</li>

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