Institutional Investor's Alpha Magazine - May 2008 - (Page 62)

Risk Management financial engineering pioneer, Rahl ran the derivatives business at Citibank in the 1980s before establishing her consulting ﬁrm in 1991. She preaches the importance of rigorous risk analysis and testing to cope with the impact of the types of investments she peddled in her earlier role. Rahl recommends applying stress tests to see how a portfolio would react to sharp drops, market shifts, unusual situations or changes in underlying assumptions. Stress-testing models, which are included in risk systems, can reveal weaknesses that a simple VaR test misses. But Rahl says too many ﬁnancial ﬁrms continue to rely mostly on VaR. Back in April 2000, Rahl’s ﬁrm conducted a survey of risk practices and found that 45 percent of ﬁnancial ﬁrms, including hedge funds, were not using stress tests at all. Although she hasn’t updated the survey, she says she has noticed only a slight improvement since then. As a concept, Value at Risk has been around at least since the 1950s. It got its ﬁrst major boost in the 1980s, when broker-dealers began using it to help determine market exposure. VaR revolves around a formula to calculate the maximum potential loss in a portfolio at a high probability (usually set at 95 to 99 percent) over a ﬁ xed time period. VaR’s big move to the buy side came in 1994 when J.P. Morgan & Co. built a system around a VaR calculator to measure portfolio risk for an end-of-day report to senior management. That was the genesis of the RiskMetrics system that J.P. Morgan began offering to institutional — STEVEN HARRISON, clients in 1996, then PRESIDENT, IMAGINE SOFTWARE spun out in a stand-alone company in 1998. RiskMetrics Group, which went public in January of this year, remains a leading risk systems provider in what has become an increasingly crowded ﬁeld of vendors selling to hedge funds, banks and other asset managers. Today risk systems boast considerably more computing power and ﬂexibility than in the early days. They include several kinds of VaR calculators, a Monte Carlo simulator for historical testing, stress-testing models and various other models for running projections. Most systems allow users to create customized tests and produce a wide range of reports, charts, graphs and spreadsheets. Vendors increasingly offer hosted systems, in which the servers and technology are owned and maintained by the provider, with users logging in to run their tests and create reports. The hosted approach eliminates the need for costly software installations and hardware purchases and upgrades to keep the system running. By all accounts, these new-generation risk management systems can digest and analyze massive quantities of historical and market data faster and more accurately than ever before and are capable of churning out reports in a matter of minutes. Risk systems providers compete not only on speed and functionality but also on supplying historical market data that users can load into calculators to test against their own portfolios. Yet with all that computing power and sophistication at hand, some risk managers still fall back on the simplest VaR calculators as their primary tools. Old habits are hard to break. “We have been trying to get people to not do that for ten years,” says Gregg Berman, co-head of the risk business group at RiskMetrics. “Risk management is a lot more than VaR. It has to do with scenario analysis, stress testing, a whole suite of things.” Berman joined RiskMetrics in 1998 after serving as the co-manager of several multiasset hedge funds run by British hedge fund manager ED&F Man Group (now Man Group). Like many in the risk management ﬁeld, he has a background in science rather than business. Berman has a Ph.D. in physics from Princeton University. Satyajit Das, a Sydney, Australia–based risk consultant to banks and fund managers and author of Traders, Guns and Money, believes the limits of VaR make it less and less useful for hedge funds that deal in increasingly complex, multiasset strategies. “If I am a hedge fund manager, I would rely entirely on stress tests,” Das says. Berman says the idea that hedge fund risk managers should simply turn off the VaR calculators in their risk management software is the wrong response to recent market disruptions. Depending on the portfolio, some type of VaR analysis might provide useful information. The task of the risk manager is ﬁ rst to understand the particular nature of the portfolio to be analyzed, then to determine what sorts of questions to ask and ﬁ nally to decide on the correct tools to do the job. “The ﬁrst question is, How do I put all this information together?” Berman says. “The second is, Am I measuring the right things?” VaR is often misunderstood as a concept. It can be a simple calculation for evaluating listed securities. But it can also be molded into a more powerful and complex analytical tool by adding different data and modeling techniques, including stress tests. Oleg Movchan, chief risk ofﬁcer at Alexandra Investment Management, a New York–based hedge fund firm with $1 billion under management, says knowing which tools to use and how to employ them is a big part of his job. “This whole discussion about the usefulness of VaR makes very little sense,” Movchan says. “Is a screwdriver a good tool or not? That is a meaningless question. Is a screwdriver good for screwing? Yes. Is it good for hammering nails? No. The question that should be asked is whether VaR is the right tool for a speciﬁc problem. “For some complex products, where assumptions about stability of volatility and correlations and perfect “If you are making a billion-dollar bet, you are supposed to be analyzing what is really in this basket that somebody sold you.” 62 • INSTITUTIONAL INVESTOR’S ALPHA • MAY 2008

Table of Contents Feed for the Digital Edition of Institutional Investor's Alpha Magazine - May 2008

Institutional Investor's Alpha Magazine - May 2008 Contents Letter from the Editor Longs & Shorts Pension Corner: Send in the Clones The Good Guys: Outside the Box Cover Story: Welcome to Oz Interview: The Tipping Point Regulation: When Sentinels Go Astray Strategies: Taking Credit Research Center: The Hedge Fund 100 Book Excerpt: Shoot the Messenger Alpha Bytes: VaR Enough? Unhedged: Commentary: Not Your Father's Activist

Institutional Investor's Alpha Magazine - May 2008

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