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Dr Lance Smith, chief executive of Imagine Software

Best practice in post-crisis risk management

By Lance Smith - The market turbulence of the past three years has exposed a number of flaws and limitations in traditional approaches to risk management. In the aftermath of the crisis, investors are increasingly pressuring alternative investment managers to ensure the most advanced and appropriate tools and methodologies are being used to deliver the most robust risk management process possible.


In assessing risk management methods, timeliness requirements may be divided into three categories: real time, intra-day and end-of-day. Real-time risk measurement is vital, for instance, for option traders who need tick-by-tick deltas, but less essential to long/short equity traders, although real-time P&L can tell you a lot. Intra-day means on-demand, such as a stress test or scenario analysis to see the effect of trades on the portfolio’s risk profile, while end-of-day means static risk reports compiled after trading is finished.
There has been much discussion over the past couple of years about the deficiencies of the best-known risk measurement, value at risk. VaR is based on various mathematical assumptions that may not hold true in the real world, particularly regarding correlations. Under extreme market conditions, these assumptions can break down and result in unexpectedly high losses. The premise of VaR is that experiencing losses due to a three-standard-deviation event is just bad luck, the result of an unhappy chain of coincidences. But in fact it is usually due to an event that the manager did not anticipate.
That’s not to deny VaR’s usefulness. Because it is calculated in the same way every day, any significant change in its value is an indication of something in the portfolio that warrants investigation. A sudden increase in daily VaR can provide an early warning that something has changed, or that the manager may has unknowingly taken on some directional exposure, although it will still be necessary to work out what it is.
Effective risk management, therefore, is proactive, and it should not rely on a single metric. It’s critical to complement VaR with many other ways of looking at risk. One way is to carry out stress tests – as long as their design is effective in capturing what actually happens in the marketplace. For example, a standard risk slide for an options portfolio that moves stock prices and implied volatilities up and down will yield surprisingly little information of real value, and can obscure the data that are actually relevant to the manager’s strategy.
Even well-designed stress tests may fail to capture the effect of market changes on liquidity. At times of extreme turbulence the liquidity of certain types of instrument can all but dry up, creating huge bid-ask spreads. While liquidity may eventually return, in the meantime portfolio managers facing margin calls may have to unwind more liquid positions at unfavourable prices. It’s therefore important for managers to analyse positions by liquidity buckets to ensure they have a sufficiently large position in the most liquid bucket to be able to meet potential margin calls.
What can one conclude? Risk managers should be sceptical, proactive and interactive; they need constantly to slice and dice their portfolios looking for fault lines and combinations of events with consequences that traditional risk methods may not capture. It’s a dynamic profession, as anyone sitting back to wait for their daily risk reports will sooner or later find out the hard way.
Dr Lance Smith is chief executive of Imagine Software
Please click here to download a copy of the Hedgeweek Special Report - Hedge Fund Risk Winter 2010


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