Investment Risk and Uncertainty: Advanced Risk Awareness Techniques for the Intelligent Investor

CHAPTER 18

Northfield’s Integration of Risk Assessments across Multiple Asset Classes

Dan diBartolomeo, PRM, and Joseph J. Importico, CFA, FRM

Risk management for investment portfolios is in strong contrast to the concepts of risk management that are common for banks and other financial intermediaries who operate with at-call liabilities (i.e., borrowed money where the lender such as a bank’s depositors can demand repayment at any time). For a bank or highly leveraged hedge fund, solvency is the key aspect of risk management. If the risk of the asset portfolio is high, the entity must reduce gearing by either increasing capital or decreasing assets. Rather than being concerned about the probability distribution of cumulative returns over long periods, the emphasis here is controlling risks on a day-to-day basis so as to ensure that the entity has a positive net accounting worth at all times and remains viable under the applicable regulatory scheme. For financial intermediaries, risk measures such as value at risk (VaR) and expected shortfall are denominated in wealth units (e.g., dollars) so as to highlight the need for the entity to maintain a positive net worth in the face of the potential range of immediate losses in asset values.

To manage risk, we first must assess the magnitude of the risk and then must decompose the risks into a set of cause-and-effect relationships that we call factors. Just as a chef knows how changing the amount of an ingredient changes the taste of ...