Active Portfolio Management - GARP
Transcript of Active Portfolio Management - GARP
Active Portfolio Management: Balancing Risk & Opportunity
Ludger Overbeck University of Giessen, Germany [email protected]
GARP 13th Annual Risk Management Convention, New York, February 2012
INTEGRATED APPROACH TO VALUE-BASED MANAGEMENT
Intertwine risk, capital, risk-adjusted performance and business strategy
Risk Of Business
Capital Allocation
Risk-Adjusted Performance
Strategic Planning
Future Risk Taking
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Relationships to single customers
Business divisions/
Business areas
Group
Products
Decision- levels
Capital market- oriented
target
Allocation of
Resources
Strategic Planing/
Evaluation
Economic Capital
RAROC
Expected Return by Investor
% Increase of Return
Growth
Capital market (Expectations of shareholders )
Company value oriented Steering Concept
Value- oriented Steering
Economic Profit
• Economic profit puts a focus on both: growth and profitability.
• Like RAROC it can be applied on all decision levels.
THE VALUE ORIENTED STEERING CONCEPT STRIVES - BY MEANS OF RAROC - ON THE INCREASE OF ECONOMIC PROFIT
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Agenda
We will consider the following questions: What is economic capital and RAROC? Benefits of the RAROC-calculations? Tools and Application. Measurement of EC
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Objectives of Economic Capital Measurement
Objectives of credit portfolio modeling in Financial Institutions
l Computing the portfolio loss distribution Measures: Unexpected Loss, Credit VaR, Economic Capital Capital buffer to protect the institutions against unexpected losses
l Allocation of Economic Capital Distribution of capital to business units to measure performance Distribution to individual transactions to optimize risk/return ratios
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Why risk measurement / management?
Success Successful firms attract
more capital
Risks
Most businesses go along
with risk taking
Capital Risks has to be cushioned
by capital
Capital and Success can be quantified also risks have to be quanitified!
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Objectives of Economic Capital Measurement
• Efficient deployment of capital • Compare performance of business divisions • Risk vs. Return for business areas, customer groups products etc.
• Risk Appetite of bank • Regulatory requirements • Target Rating
• Value creation at origination • Avoid non-profitable transactions (including risk) • Identification of Hedging needs
Efficient allocation of resources to
maximize return
Protection of organization
Risk-adjusted Pricing
Which strategic business areas should
be expanded?
What are the capital requirements
How to determine risk-adjusted prices
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What is economic capital?
EC is the capital needed as a cushion against large losses. l In mathterms:
– Usually: Quantile of a loss distribution minus its expected loss, Quantile (99%)(L) -EL
– Alternative: Expected Shortfall: E[L|L>”Large”], possibly “Large”=Quantile.
l Can be viewed as a insurance or risk premium, that conceputually should be invested in riskless and liquid assets!
l Quantile or “Large” indicated the risk appetite of the institution and depends also on the desired own default probability.
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Loss Distribution
Set Time Horizon Obtain Loss
Distribution Set Level of
Confidence, e.g. 99%-Quantile
Read off Economic Capital
0 0.005 0.01 0.015 0.02 0.025 0.03
0
50
100
150
200
250
Expected Loss Economic Capital
Unexpected Loss
Loss
Probability Density or Frequency of Losses
99%-Quantile Mean
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0
5
10
15
20
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Year
Cred
it Lo
ss
Objectives of Economic Capital
Expected Loss
Unexpected Loss
95% Quantile
Economic Capital
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Business Concepts for ACPM
Basic Concepts for ACPM
l Credit should be consistently priced l Credit should be transferred to a central portfolio management
unit l Credit should be managed in a portfolio context
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Business Concepts
Separation of Origination and Portfolio Management Origination is responsible for Client Relation PM is responsible for
l Aggregation l Re-distribution l Securisation l Hedging, Investment l Optimisation
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Three stages of Portfolio Management
Risk Controlling/Management l Measurement, Limit setting, ex post
Risk advisory l Measurement, “pricing”, RAROC-approach
Active Risk Management l Measurement and Market pricing l Risk/Return analysis and modeling l Hedging, investing l Strict separation of origination and risk managemt l Transfer pricing
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Stage 1
Risk Controlling, centralized function l First credit portfolio models l Marginal risk contribution drives internal pricing of credits l RAROC-pricing tool l Hurdle rate l Prices are bank specific l Institutional risk aversion is important l Ignores market perception of risk through credit spreads l Different incentives between front, middle and back offices
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Stage 2
Advisory l Centralized function decides about hedges and investments from
a top-down perspective l Often ignores still market pricing l Problem of cost and revenue allocation
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Stage 3
Origination transfers all risk to a portfolio management function against a “transfer fee”
Transfer fee should capture all returns, “opportunities” and the risk costs ( sometimes called “Mark-to-hedge”)
All risk management including capital management is with the portfolio management function
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Sales Capital market ACPM
(Active credit port-
folio management)
Sale at
market price
Buys
&
sells
generates
lending business with
customers
is ”owner of the risk”
– manages credit portfolio
– structures risks
– optimizes RWA application
– improves risk-return ratio
risks on the market
ACPM is the defined interface between sales and credit capital markets
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ACPM What are the targets?
Strengthening pricing sensitivity through transparent credit risk costs Improvement of risk profile Reduction of concentration risks Generation of add-on revenues through active positioning
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ACPM What are the challenges?
Transferring relatively illiquid products into capital markets Integration of market and credit risk and pricing Portfolio modeling Optimization of risk/return profile
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Improvement of Risk Profile
Possible stylized example “Black” =Starting Portfolio “Yellow”= Peak single exposures
hedged l little effect, i.e. no single name
concentration “Blue”=Numerical Optimization
l Major improvement l Basically yielding optimal
industry/regional allocation “Green”= additional qualitative
adjustments based on views towards industries/regions
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Improvement of Risk Profile
Possible stylized example Total improvement of Expected
Loss by 10% Decrease probability of loosing
more than 10% is reduced to a third (from of 7.2% to 2.4%)
Economic Capital reduced by 20% from 5% to 4%.
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- illustrative -
Contributory Economic Capital as a function of industry
EDF: 30 bp R²: 30 %
LGD: 50 %
CTY: Germany
CEC in % Exposure
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
Chemicals FinanceCompanies
Semi-conductors
Application of RAROC
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EC and RAROC example
As in the EL example: PD=30BP, LGD=50%, EAD=1,500,000, EL=2,250 EC=5% (i.e. Chemical) of exposure=75,000 Assume return (after non-risk cost) of 10,000=0.66% net margin RAROC=(Return-EL)/75,000=7,750/75,000=10.33%
If we could made the same loan in “semi-conductor” industry, EC=2.5%, the
RAROC would double to 20.33% A “RAROC-hurdle”-rate of 20 % would only be reached by the second
transaction. The transaction with the “chemical”, could perhaps sold in the market,
swapped or syndicated. Bank has to much concentration in “chemical”
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Portfolio report
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Active Credit Portfolio Management
In addition to the loan book, ACPM units shouls also have more trading like books l Investments for diversification and yields l Hegde book for single names l Macro Hedges l Rebalancing
l Trading opportunities
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Some quotations
Early as from 1998 (OWC in ERISK)
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Some quotations
Moodys KMV: early mover in ACPM: Kealhofer McQuown Vasicek founded KMV which provided
l EDF-measure: Expected Portfolio l Cited from: A brief History of Active Credit Portfolio Management
– Three principles – Hold credit only if compensated for the marginal risk – Reduce concentration and correlation – Reward liquid products, i.e. consider how liquid a product is.
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Some citations (KMV)
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Citation KMV
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Summary
Active Portfolio Management is a l Holistic approach to risk/return optimization l Considers all transactions in a portfolio level l Wants to avoid concentration in the portfolio
– Since Concentration leads to large „unexpected losses“ – Diversification strategies reduce concentration
l Portfolio view enables to define target portfolio l Might inprove risk opportunity profile by
– Hedging – Investing – Avoiding/limiting transactions with a high concentration risk
– or large risk with respect to return
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Summary
Active Portfolio Management requires
l Consistent and sensible risk adn return measurements l Joint analysis of market and credit risk l Consistent and rigorous pricing of transactions l Identification of hedging, trading and investment opportunities l Positioning in the secondary market l Portfolio view