THE RISK MANAGER

Many of the readers of this web site are familiar with the concept of the portfolio manager, an individual whose primary function is to maximize investment returns under a prescribed set of conditions. A good portfolio manager is judged by the consistency of his/her track record in outperforming the designated benchmark. For a portfolio manager of an American equity portfolio, one logical benchmark to choose may be the performance of the Standard & Poor's 500 index. This article will introduce the concept of a risk manager. In modern financial institutions and sophisticated corporate Treasuries, the term has two different meanings.

A risk manager might be the individual tasked to run a portfolio of derivative instruments, maximizing the risk-adjusted return on capital (RAROC). RAROC is a subject that we will discuss in an ancillary piece later on. Or, the term risk manager might refer to what is typically called the "middle office." If the trading desk is the "front office" and the operations area responsible for processing transactions and all other administrative functions (including accounting) is called the "back office," the "middle office" is the independent bureau responsible for overseeing the traders.

THE FRONT OFFICE

There are different levels of risk manager in the front office. At the micro level, a risk manager may be a junior trader with responsibility for the derivatives books in one of the less active currency pairs (for a foreign exchange operation or a fixed income portfolio). The junior risk manager's responsibility is twofold. He will make prices to customers of the financial institution and he will take so-called proprietary positions. "Prop" positions involve taking positions in a specific set of financial instruments, using the institution's capital, in order to maximize the portfolio's return or to reduce the portfolio's risk profile or both.

At the more senior level, the risk manager is in charge of determining the macro positioning of the books, focusing on longer-term trends in the market. For example, a fixed income senior risk manager may determine that he wants his entire trading unit to focus on curve-steepening strategies. He will direct the micro-risk managers in charge of the different parts of the yield curve to position their books accordingly. He may instruct the long-bond trader to clear out his inventory, while taking on fixed income derivatives positions that will profit from a curve-steepening scenario. The actual mechanics of how the junior risk manager effects this in the marketplace is his local responsibility.

THE MIDDLE OFFICE

One of the biggest problems with the new financial products and the expanded interest in financial price risk is the rogue trader. A rogue trader is one whose behaviour is purposefully inconsistent with the stated aims of the shareholders and senior management of the institution for whom he works.

The purpose of the middle office is to enforce the policies set forth by the leaders of the institution in order to ensure that all traders act in the best interests of the firm.

The policies that embody this risk philosophy are known as the limits. Limits state what instruments are permitted to be traded and by whom and in what amount.

When it comes to financial price risk, it is simply not sufficient to talk to notional amounts. It is more important to understand the amount of money that could be lost under various scenarios by having a particular position on the books. There are a number of different techniques that can be used to measure this exposure, none of which should be used on its own exclusively. Together, they help the "middle office" risk manager keep senior and upper management informed of the financial price risks to which the firm is exposed. A good risk manager is one for whom there are no surprises. Every scenario is one that has been previously considered and for which the front office, the middle office and the senior management have a plan in response. Contemporary financial markets move too quickly for ad hoc judgments.

We will discuss the techniques for measuring financial price risk in the future. These include the following:

OBJECTIVES

The risk manager has a similar objective function to the portfolio manager. They both want to maximize the return on their capital. The risk manager may have an additional dimension to his problem, though. He must also condition his returns on the amount of risk he takes whereas the portfolio manager may be more concerned with absolute returns.

Which return would you rather have?

A Canadian fixed income mutual fund portfolio manager makes a return of 28% for the year on his 100 million-dollar portfolio. A New York bank earns an absolute return of 15 million dollars on its foreign exchange options portfolio. In trading, the desk used an average amount of capital of 10 million dollars with two episodes during which they carried 25 million dollars worth of capital at risk.

The Canadian mutual fund manager earned 28 million Canadian dollars on his portfolio. However, we do not know what kind of risk he took to earn this money. Perhaps he was conservative, investing only in government securities. Or maybe he engaged in large loans to Japanese financial institutions, earning a hefty credit spread over the interbank rate. We do not know from the data reported here.

We have a much better picture from the New York bank's foreign exchange options desk. They have managed to carry very little risk, compared to the return that they have made. If the bank were to have another desk, say emerging markets, that used a similar amount of risk but only made 5 million dollars, the bank could reallocate capital for the next fiscal period from the emerging markets desk to the foreign exchange options desk. This is the kind of management decision that maximizes profitability at the firm-wide level.