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Portfolio Management and Risk Management Process
This section deals with the internalization of the internalization of the on-going capability to make and implement portfolio management and risk management decisions in a consistent and disciplined manner.
Overview
Over the past 20 years, we have been engaged by and have worked with over 300 institutional clients in evaluating, developing, implementing, and managing a variety of portfolio management and risk management programs.
The types of institutional clients include financial intermediaries, energy companies, agricultural concerns, government entities, consumer finance corporations, and regulatory agencies.
The management activities involved in these engagements include asset/liability management, interest rate risk management, portfolio management, currency risk management, and commodity price risk management.
The primary focus of these engagements has been the internalization of the on-going capability to make and implement portfolio management and risk management decisions in a consistent and disciplined manner. This focus is driven by a commitment to a sound personal and portfolio management and risk management philosophy. This philosophy is maintained within a framework of proven principles that is constantly being adapted to ensure suitability in contemporary applications.
The following comments on developing and implementing a portfolio management and risk management process are a direct result of the experiences gained from these engagements. The comments are organized in the following sections:
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Performance Profile - The driving force of any effort to develop and implement an internalized portfolio management and risk management process.
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Basic Elements of Portfolio & Risk Management Process - There are five basic elements every portfolio management and risk management program needs to include.
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Summary
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Performance Profile
The driving force of any effort to develop and implement an internalized portfolio management and risk management process is the conscious decision, by management, to proactively manage the performance profile created by the underlying business and/or portfolio.
Performance profile, simply defined, is a graph depicting how the value, gain/loss, income, or cost of a business activity or portfolio changes as a result of changes in the associated price, interest rate, or exchange rate. This is usually done with the size of the business activity or portfolio remaining constant.
The techniques employed to create performance profile graphs are very similar regardless of the underlying business or portfolio. However, each type of business or portfolio tend to have a unique set of values for three main variables:
1. Size of business activity or portfolio balances.
2. Price, interest rate, or exchange rate associated with the business activity or portfolio.
3. Resulting value, gain/loss, income, or expense created by relating Item 1 with Item 2.
(JDH Note: I am in the process of modifying a series of performance profile charts related to businesses in each of the main global economic drivers. These performance profile charts will include; interest rates; fixed income portfolios; equity portfolios; energy related production, marketing, and consumption profiles; currency; and, various commodity profiles. Modifications to these profiles will be completed within the next few weeks. In the interim, I would appreciate your comments regarding the profiles in which you have the most interest.)
Creating a graph of the "as is" performance profile can be as simple as creating a graph of a single security portfolio, or as complex as executing a series of sophisticated balance sheet, cash flow, income statement, and econometric models representing the relationships of a myriad of interrelated business activities or portfolio holdings. Regardless of how simple or complex the effort, an "as is" profile can, and must, be produced before developing and implementing strategies to alter the profile. The reasons for this are fairly straightforward:
• Without an understanding of the "as is" profile, it is difficult, if not impossible, to evaluate the effectiveness of any strategy implemented to alter the "as is" profile.
• Regardless of how well intentioned management's risk management efforts might be, without an understanding of the "as is" profile, many risk management strategies actually end up exacerbating risk exposure as opposed to managing it towards the desired profile.
From any given point in time, there are three basic alternative shapes the "as is" performance profile can be managed toward:
1. Increased risk.
2. Decreased risk.
3. Unchanged risk.
Regardless of the desired shape, and regardless of why that shape is desired, the key objective is to develop an explicit expression of the potential consequences our actions will have on the risks inherent in the resulting performance profile.
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Basic Elements of Portfolio & Risk Management Process
There are five basic elements every portfolio management and risk management program needs to include. Furthermore, all of these issues will need to be addressed rather intensely in the initial development stages, and then to varying degrees on an on-going basis. These five main elements are:
1. Start-up, Documentation, and Approval.
2. Risk Analysis and Quantification.
3. Strategy Development.
4. Strategy Implementation and Management.
5. Accounting, Recordkeeping, and Reporting.
The primary challenge in virtually every portfolio management and risk management engagement has been to clearly identify how management is currently managing risk. Once this step is accomplished, a project plan can be developed to facilitate the integration of these five elements into the dynamics of the existing portfolio management and risk management process (regardless of management's sophistication level).
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Start-up, Documentation, and Approval
The focus of this element is to educate staff, management and board, along with enhancing internal policies and procedures to a level, wherein, portfolio management and risk management decisions can be made and implemented on a consistent and disciplined basis. The important subsets of this element include:
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Current Management Practices
Identify portfolio management and risk management practices currently employed. The three main categories include:
1. Policy decisions.
2. Cash market transactions.
3. Forwards, futures, options, and other derivatives.
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Internal Training
Conduct internal training for staff, management and board. Given that most staff, management, and board members are well up the experience curve on the effect policy decisions and cash market transactions have on their performance profile, the focus of this training tends to evolve around the application of important derivatives instruments, concepts, and techniques to the portfolio management and risk management practices already being employed. In addition to defining what derivatives are, the important derivatives concepts that usually need to be covered include (refer to Glossary):
• Underlying instrument.
• Exchange traded instruments vs. over-the-counter (OTC) instruments.
• Future/forward pricing structure.
• Volatility.
• Time decay.
• Convergence (as it applies to both price and volatility).
• Exercise (strike) price vs. current price:
• Out of the money (OTM).
• At the money (ATM).
• In the money (ITM).
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Policies and Procedures
Develop written portfolio management and risk management policies and procedures that are consistent with the existing management policies and procedures framework. In addition to being integrated with existing policies and procedures, explicit provisions should be made for:
• Assignment of functional responsibilities for management and staff.
• Evaluation and selection of firms through, and with, whom portfolio management and risk management strategies will be implemented.
• Securing management and board approval of both the overall process and the implementation of the process.
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Risk Analysis And Quantification
The focus of this element is to establish a quantitatively based performance profile analysis methodology, the foundation of which is the measurement of the risk inherent in the basic business or portfolio being managed. This enables management to make conscious decisions and take deliberate actions to alter or maintain the "as is" performance profile. The important subsets of this issue include:
Type of Risk Exposure
Once the "as is" performance profile has been created and verified as accurately representing the underlying business activity or portfolio, it is fairly easy to identify the inherent type of risk exposure. Once the inherent risk exposure has been identified, three critical management events are enabled:
1. Management can objectively evaluate and express the acceptability of the inherent risk exposure.
2. Management can explicitly state their intent regarding the continued acceptance of, or alterations to, the inherent risk exposure relative to a commonly understood reference point.
3. Management can immediately separate the suitability of instruments, positions, strategies, and tactics into two main action groups:
• Pursue those alternatives that have performance profiles that, when added to the "as is" profile, produces the desired profile.
• Eliminate those alternatives that have performance profiles that, when added to the "as is" profile, would tend to exacerbate undesirable changes to the "as is" profile.
Performance Profile Objectives
Conscious and explicit statement of management's objectives regarding the "as is" performance profile. Generally speaking, management can choose to maintain, increase, or decrease the risk inherent in the "as is" profile through a variety of portfolio management and risk management strategies and tactics.
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Strategy Development
The focus of this element is to ensure the suitability of portfolio management and risk management strategies and tactics to management's performance profile objectives and, in some cases, expected market conditions. Therefore it is assumed that steps have already been taken to properly analyze, quantify, and present the risks inherent in the "as is" performance profile. The important subsets of this element include:
Idealized Price, Interest rate, or Exchange Rate Movement Cycle
Identify the four basic phase of the idealized price, interest rate, or exchange rate movement cycle:
• Bottom.
• Rising.
• Top.
• Declining.
Alternative Risk Profile Management Methods
Review the three main alternative methods for managing the risk profile:
1. Policy decisions.
2. Cash market transactions.
3. Futures, options and other derivatives.
Strategy Matrix
Construct a 3D strategy matrix of the ideal strategies for each phase of the price, interest rate, or exchange rate movement cycle for each of the main alternative performance profile management methods.
(JDH Note: I am in the process of modifying a series of ideal strategy matrices related to businesses in each of the main global economic drivers. Modifications to these matrices will be completed within the next few weeks. In the interim, I would appreciate your comments regarding the matrices in which you have the most interest.)
Identify Current Cycle Phase
Identify the current phase of the price, interest rate, or exchange rate movement cycle and select the equivalent strategies from strategy matrix that are suitable to both the current cycle phase and management's performance profile objectives.
Performance Profile Modeling
Model the performance profiles of the equivalent strategies. Regardless of the degree of conviction we might have regarding the current price, interest rate, or exchange rate cycle phase, a serious effort should be made to evaluate the possible performance profile of each strategy in scenarios that are neutral, favorable and adverse to the underlying position. The main issues considered in this modeling effort include (email your comments to me if you think there is a need to develop the following points in greater detail):
• Time frame dynamics (static, collapsing or expanding);
• Beginning point.
• Ending point.
• Duration.
• Underlying risk position;
• Quantity.
• Pricing index.
• Price, interest rate, or exchange rate movement scenarios driven by volatility;
• Up.
• Down.
• Flat.
• Basis relationship between the pricing index influencing the underlying risk position and the pricing of the performance profile management position.
• Performance profile management position;
• Ratios.
• Contract month placement;
• Nearby stack and roll.
• Strip.
• Deferred stack and peel.
• Combination.
• Entry/exit method;
• All at once.
• Scale-in/out.
• Cash flow requirements.
• P&L impact.
• Presentation of modeling results;
• Tabular.
• Graphic.
Equivalent Strategy Comparison
Evaluate the suitability of the equivalent strategies by comparing the performance profiles and related reward/risk ratios of each strategy:
• Relative to each other.
• Relative to the desired changes in the underlying performance profile.
• Relative to the "as is" performance profile.
Suitable Strategy Selection
Select the most suitable strategy for implementation. This step is facilitated by seeking a balance between:
• Strategy costs;
• The imbedded costs of each strategy if prices, interest rates, or exchange rates go flat.
• The out-of-pocket loss that would be suffered on the underlying position if adverse price, interest rate, or exchange rate movement occurs, and the recovery potential afforded by implementing each strategy.
• The opportunity gain that would be realized on the underlying position if favorable price, interest rate, or exchange rate movement occurs, and the foregone opportunity caused by implementing each strategy.
• The consequences of maintaining the "as is" performance profile in favorable, adverse and flat price, interest rate, or exchange rate scenarios.
• The probabilities associated with each of the scenarios. An important aspect of this step includes an attempt to quantify and prepare for the risk of being wrong in the cycle phase assessment. This, in turn, includes the effort to identifying the appropriate measures to;
• Minimize the risk of foregoing opportunity gains from favorable movements on the underlying position.
• Maximize the opportunity to recover out-of-pocket losses from adverse price movements on the underlying position.
No Acceptable Alternative
Occasionally, management will be left with no alternative but to continue accepting the "as is" performance profile. This occurs when the performance profiles of all the alternative strategies have unacceptable reward/risk ratios.
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Strategy Implementation and Management
The focus of this element is prompt implementation of strategies selected, and timely tactical adaptations to maintain the suitability of the strategies to management's performance profile objectives and current market conditions. The important subsets of this element include:
Position Entry
Range entry methodology:
• Percent of position.
• Timing.
Periodic Position Adjustments
Events necessitating periodic adjustments:
• Basis relationship changes.
• Time decay management.
Position Exit
Range exit methodology:
• Planned.
• Early.
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Accounting, Recordkeeping and Reporting
The focus of this element is to ensure accurate accounting, recordkeeping and reporting of the results of all strategies and tactical adjustments. This will enable the objective evaluation of the results of the portfolio and risk management efforts. The important subsets of this element include:
GAAP and taxes
Ensure proper accounting treatment for GAAP and taxes.
Reconciliation
Systematically reconcile internal transaction records with brokerage firm records.
Reporting
Periodically report strategy performance to management and board.
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Summary
Regardless of management's performance profile objectives, the foregoing five basic elements and related subsets need to be addressed on an on-going basis in order to develop, implement and maintain a disciplined portfolio management and risk management program.
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