Nick Wade Using A Structural Model For Enterprise Risk, Dst Conference 2011 04 12

D R A F T – W O R K I N P R O G R E S S

April 12th 2011Presented by Nick WadeDirector, Asia Marketing

Northfield Information Services [email protected]

+81(0)3 5403-4655+61(0)2 9238-4284

NORTHFIELDUsing a Structural Model for Enterprise Risk

mailto:[email protected]


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Talking Points for Today

Fund managers need detailed risk attribution for risk budgeting, performance attribution, scenario analysis and portfolio construction

CRO/Board/Trustees/Investment Committee need high-level risk across the firm

Client needs vary - Who is the asset owner?

Returns for illiquid assets e.g. direct property contain “appraisal smoothing” effects and do not reflect underlying risk i.e. it’s not a real price.

Risk Models typically used for fund management are not consistent across asset classes and markets, and usually ignore “difficult” asset classes like property, infrastructure, private equity.

We need to provide an integrated platform that can provide different levels of detail to different audiences, and include the “difficult” asset classes


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More about that split…

A split in the world:

– Portfolio Management and Asset Management Firms

Good: Risk analysis and portfolio management done using multi-factor models, contributions to risk aligned with contributions to return

E.g. what will happen if oil prices go up? Does my portfolio reflect my belief that Toyota will perform twice as well as BHP?

Bad: Typically single-asset class models; delivered in stand-alone software– Enterprise Risk

Good: the typical VaR measures are intuitive Good: typically an integrated platform Bad: one dimensional, return-based; problematic for Illiquid instruments

Solution: Find an integrated Platform that can do both

– Offer a customizable reporting tool on top of a set of smart components that can deliver both “VaR” and also multi-factor risk decomposition consistently and comparably across asset classes and markets satisfying both fund management and enterprise risk requirements

INVESTMENT MANAGEMENT SOLUTIONS | Optimising Your Investment Business

Why VaR and return-based models may not be enough Many “enterprise” risk systems assume:

– Horizon: that the “enterprise” runs a risk of not surviving past the weekend e.g. 10 day VaR

– Returns-based: that the “enterprise” only invests in liquidly exchange traded instruments, and that therefore the observed returns tell you all you need to know about risk

no direct property, infrastructure, private equity, timber and so forth difficult assets can be “proxied” with equity securities

– Credit Ratings, Accounting data are reliable


Why do we have this split?

Bank/Hedge Fund/Trading Desk– Risk management is about maintaining solvency in the event the value of

the assets declines i.e. Survival– Some measures of drawdown risk such as parametric VaR, are just the

standard deviation times a scaling factor. This is what the RiskMetrics system was created for at JP Morgan.

Asset Manager/Pension Fund/Sovereign Wealth– Risk is about how the variability of return from period to period reduces

compounding of returns over time. The geometric mean return of a portfolio is equal to the arithmetic mean of the returns minus one half the variance of the returns

– Investor wealth depends on the compounding of returns over time, so the variance of the returns (not the standard deviation) is the predominant issue in controlling investor risk. As such, the most relevant measure of risk to decompose is the variance, not the tracking error or VaR.


A Third Choice?

Create a multi-asset class risk model based on familiar approaches in asset management

Cover unlisted assets using a structural model, not historical returns

Use market-implied credit measures, not agency ratings

Embed into a firm-wide integrated platform

Offer reporting at different levels of granularity from enterprise VaR down to single-security contributions to (sub)portfolio risk, satisfying different constituencies


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Northfield Products and Services

Delivered as stand-alone applications or smart components within a partner integrated platform:

Portfolio Construction Tools (Optimizer, MARS)

Risk Management (Risk Model Family)

Asset Allocation Tools (ART)

Performance Attribution


What Northfield EE Can Doa multi-factor model of risk across asset classes

Analyze risk consistently across a broad range of asset classes Structural Model for unlisted/illiquid asset classes – avoid issues

with appraisal smoothing Structural Model for Credit Risk – avoid agency credit ratings Over 5 million individual instruments plus client defined terms:

– Global equity securities: developed and emerging, including externally managed funds

– Global fixed interest: developed and emerging government, corporate, convertible, CMO, MBS, ABS, muni, and agency bonds, and private placements, including externally managed funds

– Global REIT securities– Direct investment in property down to tenant level– Direct investment in infrastructure projects down to cashflow level– Derivative securities such as swaps, futures, options– Hedge Funds with undisclosed constituents


How Does Northfield EE do this?

NOT an unstable unclear roll-up of a dozen or more individual models

Atomic Approach to Risk One set of factors for all asset classes

– Market Risk As a function of macro- and micro-economic effects

– Interest rate risk The effect on the price of securities of yield curve shape changes

– Credit risk As a function of macro- and micro-economic effects

– Currency risk– Effect of embedded optionality– Effect of prepayments– Exposure of cashflows to macro- and micro-economic drivers of risk

Dynamic capture of new factors & transient effects via an adaptive hybrid risk model factor structure


Combine macro, micro, and statistical factors

Gain the advantages of each, whilst mitigating the limitations of each

– Intuitive, explainable, justifiable observable factors– Minimal dependence on accounting information– Rapid inclusion of new or transient factors

Estimate using time-series approach– Diversify away estimation error– best for markets with moderate to low dispersion– best for portfolios with moderate/high diversification

Northfield Innovation – The Hybrid Model


Equity in the EE framework

Macro factors– Market, sector, oil, interest rates, market development, currency

Micro factors– Size, value, growth, momentum

Temporary factors– Statistical factor analysis acting on the residual return to ensure full capture of

pervasive effects at all times

Adjustments for non-stationarity– Exponential weighting, conditional variances, Parkinson range measures, cross-

sectional dispersion adjustment

INVESTMENT MANAGEMENT SOLUTIONS | Optimising Your Investment Business 12

Fixed Income in the EE framework

Interest rate risk– All bonds are priced relative to their local curves and their sensitivity to yield

curve shape changes is captured

Credit risk– market-derived measures independent of credit ratings– We expose the drivers of credit risk: macro, micro and issuer specific

Currency risk– Global currencies are explicitly included in the model

Optionality, Prepayment, Convertibles– Binomial tree pricing enables us to capture the effect of put, call, sinking fund,

and prepayment risk at each node on the tree– Quadrinomial (3D tree) allows accurate pricing of converts without Black-

Scholes assumptions

Issuer-specific risk– Individual bond risk also includes issuer-specific risk


Additional Coverage:

Hedge Funds, undisclosed constituents: Return series and details provided by client or Northfield to our EENIAC tool Sharpe style-analysis to get index weightings Constituents optimized to reduce number of names to provide appropriate

specific risk

Derivative Securities Terms and conditions are provided by the client to our EENIAC tool A set of exposures and all other necessary files is returned to the client (for

example composite assets reflecting underlying basket)

Unlisted e.g. Direct Property Provide cashflow (lease-level) terms and conditions in prefabricated templates to

EENIAC Risk exposures and all necessary supporting files are returned (for example,

composite assets reflecting underlying holdings)


Northfield EE Summary

EE provides: a consistent framework for enterprise risk and performance attribution 60,000 equity and 500,000 fixed interest instruments as standard structural model for credit risk that is independent of credit ratings structural model for illiquid assets avoiding appraisal smoothing On-demand access to a further universe of over 5 million CMO, MBS,

ABS, muni, and agency securities On-demand analysis of client-supplied instruments

Northfield EE is Available as a stand-alone application or via industry leading partners Integrated within DST Anova


Appropriate Models for Each Market

Investment sense, broad acceptance & academic approval

Intuitive factors used to describe risks

Analysis that is comparable across markets

Systematic risks detected & understood

“Glass box” – open, clear models & systems

Northfield risk analysis offers…

Documents

Nick Wade Using A Structural Model For Enterprise Risk, Dst Conference 2011 04 12