Risk Management: Foundations for a Changing Financial World

CHAPTER 4

REPORTING AND MONITORING RISK EXPOSURE^d

Robert W. Kopprasch, CFA

A simple risk-management system involves identification of the risk, its quantification, and modification or nullification of that risk. Many different methods of modifying risk exist, but even using the same methodology, obtaining reasonable results across different financial instruments is impossible. Instead of defining risk as volatility of returns, perhaps it should be defined as mean shortfall, or downside semivariance. Prospective losses can be controlled by setting limits on positions and by limiting exposures without collateral.

Investment firms must take risks in order to outperform the market. Managers cannot simply buy the “market” and hope to achieve relative outperformance. How firms incorporate risk into the investment process depends on the organization, the systems it uses, and the quantitative skills of the people involved.

THE RISK-MANAGEMENT SYSTEM

Different types of risks, such as those shown in Figure 4.1, are interrelated and cannot be isolated and handled separately. Market risks associated with the illiquidity, volatility, and correlation structure of the market cannot always be separated from either operational risks, such as model risk, audit failure, and human error, or credit risks, such as default, custodian failure, downgrades, and collateral problems. For example, the purchase of an option to eliminate market risk creates a risk associated with the credit of the counterparty ...