To manage an effective risk management solution requires more than the calculation of VaR. Ultimately a successful risk management program requires the execution of an effective hedge. Technical analysis is a vital element of this strategy.
Recent market reversals brought about by the Sub-Prime mortgage melt down is clearly a significant
market correcting event. No matter if you work in the risk department of a large bank with many
employees or a small fund of funds as co-manager, you share the same basic concerns regarding the
management of your portfolio(s)
It remains common in the financial industry to hear experienced Portfolio Managers state their risk
management program consists of timing the market using their superior asset picking skills. When
questioned a little further it becomes apparent that some confusion exists when it comes to hedging and
the use of derivatives as a risk management tool.
Risk management analysis can certainly be an intensive process for institutions like banks or insurance
companies who tend to have many diverse divisions each with differing mandates and ability to add to the
profit center of the parent company. However, not all companies are this complex. While hedge funds
and pension plans can have a large asset base, they tend to be straight forward in the determination of risk.
While Value-at-Risk commonly known as VaR goes back many years, it was not until 1994 when J.P.
Morgan bank developed its RiskMetrics model that VaR became a staple for financial institutions to
measure their risk exposure. In its simplest terms, VaR measures the potential loss of a portfolio over a
given time horizon, usually 1 day or 1 week, and determines the likelihood and magnitude of an adverse
market movement. Thus, if the VaR on an asset determines a loss of $10 million at a one-week, 95%
confidence level, then there is a 5% chance the value of the portfolio will drop more than $10 million over
any given week in the year. The drawback of VaR is its inability to determine how much of a loss greater
than $10 million will occur. This does not reduce its effectiveness as a critical risk measurement tool.
A sound risk management strategy must be integrated with the derivatives trading department. Now that
the Portfolio Manager is aware of the risk he faces, he must implement some form of risk reducing
strategy to reduce the likelihood of an unexpected market or economic event from reducing his portfolio
value by $10 million or more. 3 options are available.
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