UCITS IV Risk Requirements: The VaR Approach
Executive Summary
ƒƒ The European Union recently
approved new regulation on
mutual funds called UCITS IV
(Undertakings for Collective In-
vestment in Transferable Secu-
rities, fourth edition). UCITS IV,
which is patterned on regulato-
ry risk requirements for banks,
provides two approaches to
regulatory risk management of
a fund’s portfolio: the Commit-
ment Approach and the Value-
at-Risk (VaR) Approach.
ƒƒ Funds that use derivatives more
extensively often opt for the
VaR approach. The VaR fund
must establish, implement
and maintain a documented
system of internal limits for the
measures used to satisfy the
regulatory requirements.
ƒƒ Western Asset establishes
warning levels that are lower
than the regulatory maximum
limit, as well as escalation pro-
cedures, to better manage the
risks of the portfolios.
ƒƒ Western Asset performs stress
tests for portfolios on at least
a monthly basis, including ev-
ery time the VaR exceeds the
orange warning level for more
than two consecutive days and
when the daily loss is higher
than the estimated VaR.
© Western Asset Management Company 2011. This publication is the property of Western Asset Management Company and is intended for the sole use of its clients,
consultants, and other intended recipients. It should not be forwarded to any other person. Contents herein should be treated as confidential and proprietary information.
This material may not be reproduced or used in any form or medium without express written permission.
The European Union recently approved new regulation on mutual funds called UCITS IV (Un-
dertakings for Collective Investment in Transferable Securities, fourth edition). UCITS IV, which
is patterned on regulatory risk requirements for banks, provides two approaches to regulatory
risk management of a fund’s portfolio: the Commitment Approach and the VaR (Value-at-Risk)
Approach. A UCITS IV fund, through its board of directors, has to select the approach that best
fits the investment activities of the portfolio.
In the Commitment Approach, the net exposure of derivatives cannot exceed 100% of the fund’s
net asset value (NAV). There are complex rules to translate the derivatives held by the portfolio
into equivalent amounts of underlying assets. Other rules concern the process of netting offset-
ting exposures to come up with a final exposure of derivatives, also called “global exposure” or
leverage.
Funds that use derivatives more extensively often opt for the VaR approach. They can choose
between relative and absolute VaR limits. The relative approach uses a ratio of up to 200% be-
tween the VaR of the portfolio and the VaR of a reference portfolio. The absolute approach is
generally used when there is no reference portfolio or benchmark; it allows the one-month VaR
to be up to 20% of the NAV. UCITS IV establishes strict rules for the computation of VaR and
requires regular stress- and back-testing to complement VaR estimation.
UCITS IV requires VaR to be computed on at least a daily frequency. Depending on the strat-
egy being pursued, intraday calculations may also be necessary. The VaR fund must establish,
implement and maintain a documented system of internal limits for the measures used to satisfy
the regulatory requirements. UCITS IV indicates that the VaR process must meet the following
parameters and standards:
• One-tailed confidence interval of 99%.
• Horizon equivalent to one month.
• Effective observation period (history) of risk factors of at least one year.
• Must take into account idiosyncratic and default risks.
• Must include all positions and derivatives.
• Must take into account basis risks, and second-order and nonlinear risks.
Western Asset currently uses the Barclays Point® Tail-Risk Model as its UCITS IV VaR calculator.
Point is a well-established, well-documented and widely used tool within the asset management
industry.
The Point risk model has the ability to display systematic, idiosyncratic and default risks both at
the portfolio and at the security level. Idiosyncratic risks are risks that affect one specific posi-
tion of the portfolio, while systematic risks affect the whole market or an entire market segment.
The combination of the three risk components forms the overall portfolio risk. Systematic risks
covered by Point include interest rate curve (term structure), currency, credit spread, volatility
and basis risks.
 UCITS IV Risk Requirements: The VaR Approach

Point associates a bundle of risk factors to each financial instrument used in the portfolio. Over
600 risk factors are modeled by the system, including the systematic risks noted above. Interest
rate positions are mapped to key rate durations to better capture term structure risk. The model
also uses second-order parameters such as gamma and convexity to better represent the nonlin-
earity of instruments at the total-portfolio level.

A common assumption in financial settings is that returns are lognormally distributed—that is,
the logarithms of (1+returns) form a normal (Gaussian) distribution, a pattern that looks like a
bell-shaped curve. The Point Tail-Risk Model does not assume that factor returns are lognormally
distributed. Fat-tailed distributions are calibrated to historical returns, assigning a higher prob-
ability to large losses (tail events) than the normal distribution would; this is empirically closer
to the reality of financial markets.

The model uses special techniques to model the co-dependence of risk factors. A Monte Carlo
simulation is used to calculate VaR numbers at a portfolio level: The system simulates thousands
of scenarios based on the assessed behaviours of the risk factors and their relationships, and
estimates the possible future behaviour and risk of the portfolio as a whole.

Central risk scenarios are evaluated using recent market information, while tail risks—the rarer
events—are modeled using the full historical dataset. We believe that given the high confidence
level required by regulation, shorter observation periods that focus only on recent events are
not appropriate.

Western Asset establishes warning levels that are lower than the regulatory maximum limit, as
well as escalation procedures, to better manage the risks of the portfolios.

Yellow Level
• Around 70% of the maximum regulatory limit, depending on the product.
• Discussion takes place among Portfolio Management (PM), Risk Management (RM), and
Portfolio & Quantitative Analysis departments of Western Asset.

Orange Level
• Around 80% of the maximum regulatory limit, depending on the product.
• Discussion takes place between Chief Risk Officer (CRO) and the Market and Credit Risk
Committee (MCRC).

Red Level
• Around 90% of the maximum regulatory limit, depending on the product.
• Discussion takes place between CRO and MCRC.
• Bias to reduce systematic risk.

Exhibit 1 is an example of the VaR history of a UCITS fund managed by Western Asset:

Western Asset 2 August 2011

 UCITS IV Risk Requirements: The VaR Approach

Exhibit 1
99% Monthly VaR in bps (Barclays Point®)
99% monthly VaR in bps (Barclays Point)
Legal Limit Inform Regulator
2000
MCRC
1750
CRO + CIO
1500
RM + PM
1250

1000

750

500

250

0
24 May 02 Jul 11 Aug 21 Sep 29 Oct 08 Dec 20 Jan 01 Mar 08 Apr 22 May
2010 2010 2010 2010 2010 2010 2011 2011 2011 2011
Source: Western Asset
The backtesting requirements of the regulation are also strict. The intent is to closely monitor
the accuracy and performance of the VaR model used. Backtesting of the VaR model should be
performed at least once a month, using daily data. By definition, a 99% confidence level daily
VaR is a loss that the fund is not expected to exceed on more than 1% of days. A common way
to backtest a VaR model is to observe the realized returns of the fund and check the frequency
at which they exceed the VaR number calculated by the model. For UCITS backtesting, if a loss
exceeding the calculated VaR (called an exceedance) occurs much more often than once every
100 days (1% of the time), it means that the model underestimates the real risk of the fund. It is
expected that two to three exceedances occur per year (1% of 250 business days is 2.5). Western
Asset considers that up to four annual exceedances are acceptable, in accordance with UCITS
rules.

Exhibit 2 shows an example of the backtest performed to check the accuracy of the VaR model
used to monitor UCITS funds.
Exhibit 2
Backtesting—Daily Returns Backtesting—Daily
and VaR Range Returns and VaR Range
Number of Days=273 Exceedings=0=> 0% (Expected 1.0%, Regulatory Limit 1.6%)
500

400

300

200

100 Daily Returns

0
-100

-200

-300
VaR
-400

-500
24 May 02 Jul 11 Aug 21 Sep 29 Oct 08 Dec 20 Jan 01 Mar 08 Apr 24 May
2010 2010 2010 2010 2010 2010 2011 2011 2011 2011
Source: Western Asset

Western Asset 3 August 2011

 UCITS IV Risk Requirements: The VaR Approach

Western Asset performs stress tests for portfolios on at least a monthly basis, including every
time the VaR exceeds the orange warning level for more than two consecutive days and when
the daily loss is higher than the estimated VaR.

Interest rates, credit spreads and currencies are submitted to shocks created by Western Asset’s
risk management group, which is independent from the investment team. Scenarios are designed
to account for situations not encompassed by the VaR model, such as unexpected changes in cor-
relations or changes in risk factors that are more severe than projected. Western Asset attempts
to keep scenarios plausible, relevant to the developments in financial markets, and adapted to
the evolution of the economic/financial environment.

Exhibit 3 is an example of a stress test run for a fund that uses the absolute VaR approach:

Exhibit 3
Scenario Analysis

Factor Representative Historic 1-Standard Isolated Scenario

Risk Factors / Asset Classes Current Value Deviation Tracking Error Stress Shock
Sensitivities Data Series Volatility (18m) Impact
Shock

0–4yr Nominal Rates -0.29 USGG2YR 0.47 89% 40 -12 -25 -7

US

4–30yr Nominal Rates 0.27 USGG10YR 3.06 31% 90 26 -75 20

Europe

0–4yr Nominal Rates -0.04 GDBR2 1.61 69% 110 -5 -50 -2

Rates

4–30yr Nominal Rates 0.69 GDBR10 3.02 25% 70 52 -50 35

0–4yr Nominal Rates GJGB2 0.18 49% 10
Asia

4–30yr Nominal Rates GJGB10 1.17 30% 30

Agencies / Supras
Sr / LT2 Financials ML EB3A 136 26% 40 150
T1 / UT2 Financials ML ET10 522 51% 270 700
Industrials / Utilities -0.82 ML EJ00 / EK00 118 22% 30 -21 75 61
High-Yield ML H0A0 509 26% 130 500
Spreads

ABS Agency MBS

Non-Agency MBS
Main ITRAXX-EUROPE 102 51% 50 100
Xover -0.08 ITRAXX-XOVER 370 45% 160 -13 500 38
FINSEN ITRX EUR SNR FIN 157 68% 110 100
CDX IG CDX-IG 89 45% 40 100
SOVX ITRX SOVX WE 197 70% 140 100

EUR -9% USD / EUR 1.44 11% 16% -143 -5% 44

GBP
Currencies

JPY
CAD
AUD -9% USD / AUD 1.07 14% 14% -136 -10% 94

Main CDS ITRAXX-EUROPE 102 51% 53 100

Options

XOVER CDS ITRAXX-XOVER 370 45% 165 500

FINSEN ITRAXX-FINSEN 157 68% 107 100
CDX IG CDX-IG 89 45% 40 100
ITRX SOVX WE 0.72 ITRX SOVX WE 197 70% 137 98 100 -209

Perfect Correlated Tracking Error 518 Carry / Yield Advantage -1

CDS Factor Sensitivities must be calculated manually
Zero Correlation Tracking Error 230

Total Return Under Scenario 74

Source: Western Asset

Western Asset 4 August 2011

 UCITS IV Risk Requirements: The VaR Approach

In summary, UCITS IV regulation contains many requirements for European funds that are
patterned on bank regulation. In this white paper, we have described Western Asset’s approach
to satisfying these regulations, in particular VaR monitoring, which is generally used for the
most sophisticated funds.

Past results are not indicative of future investment results. This publication is for informational purposes only and reflects the current opinions of Western Asset
Management. Information contained herein is believed to be accurate, but cannot be guaranteed. Opinions represented are not intended as an offer or solicitation
with respect to the purchase or sale of any security and are subject to change without notice. Statements in this material should not be considered investment advice.
Employees and/or clients of Western Asset Management may have a position in the securities mentioned. This publication has been prepared without taking into
account your objectives, financial situation or needs. Before acting on this information, you should consider its appropriateness having regard to your objectives,
financial situation or needs. It is your responsibility to be aware of and observe the applicable laws and regulations of your country of residence.
Western Asset Management Company Distribuidora de Títulos e Valores Limitada is authorized and regulated by Comissão de Valores Mobiliários and Banco Central do
Brasil. Western Asset Management Company Pty Ltd ABN 41 117 767 923 is the holder of the Australian Financial Services Licence 303160. Western Asset Management
Company Pte. Ltd. Co. Reg. No. 200007692R is a holder of a Capital Markets Services Licence for fund management and regulated by the Monetary Authority of Singapore.
Western Asset Management Company Ltd is a registered financial instruments dealer whose business is investment advisory or agency business, investment management,
and Type II Financial Instruments Dealing business with the registration number KLFB (FID) No. 427, and a member of JSIAA (membership number 011-01319). Western
Asset Management Company Limited (“WAMCL”) is authorized and regulated by the Financial Services Authority (“FSA”). In the UK this communication is a financial
promotion solely intended for professional clients as defined in the FSA Handbook and has been approved by WAMCL.

Western Asset 5 August 2011