Recent advances in value-at-risk methodology can be effectively applied for risk measurement and management of international equity portfolios. This article will show how these advances can be enhanced introducing a sector approach in the risk analysis.
Last week's Learning Curve showed how to perform the "drill-down" of portfolio risk. This article will show how the component VaR reports can offer crucial insights into the interactions between the different components of the portfolio in terms of risk.
Most VaR systems analyzing equity risk use a single stock market index for each country. This forces risk to aggregate excessively, and can offer an incomplete picture of the risk profile of the portfolio, due to the fact that both sector risk and specific risk, are not taken into account. An alternative way to address the problem of dealing with the risk aggregation puzzle is suggested for international equity portfolios by grouping individual positions in the corresponding industry sectors.
The problem with using only individual stock market indices for the VaR analysis are three-fold:
* The method assumes that the beta of each security with
the general stock market index captures all the risk of that
security in the context of the portfolio, as the specific risk
of that stock is diversified away for well-diversified portfolios;
* The assumption of the stability of betas over time
rarely holds; and
* The use of only one risk factor per country's equity
markets does not allow the fund manager to determine
the main components of the portfolio's diversified VaR.
As firms are moving to sector-based equity trading, especially in Europe during the lead up to the single currency, it is important to introduce the different market sectors as risk factors in the VaR analysis.
One of the main benefits of the VaR analysis is it encourages fund managers to think of the portfolio as a set of assets exposed to several sources of risk. Once the exposures to several risk factors have been identified and quantified, it is possible to analyze how those risk exposures interact with each other, which trades are acting as a natural hedge to the portfolio, and which exposures represent the largest sources of risk for the firm. With VaR it is possible to minimize the variability of portfolio's profits and losses, decide which risks are worth taking, and hedge those which may cause "too much" variability to portfolio returns.
Using stock market sectors as risk factors for the VaR analysis, the way in which the different sectors of each country contribute to the total diversified market risk can be identified; determine if any of them act as natural hedge within the portfolio and consequently how risk may be altered by restructuring the portfolio.
With the VaRdelta and component VaR technology, it is possible to take an entire portfolio's diversified VaR and additively allocate it to the individual components comprising the portfolio.
Before reaching the conclusion that a certain position is considerably increasing our portfolio risk, and therefore exposure to that particular risk factor should be reduced, it is important to introduce the analysis of diversified VaR, which can be accomplished through VaRdelta and component VaR, (see previous article).
Component VaR allows us to break down the diversified VaR into its main sources or components as well as to identify the trades that act as a hedge with respect to total portfolio risk.
With component VaR and VaR-Beta (component VaR divided by diversified VaR), risk management reports may be created by drilling down into portfolio VaR multiple ways, ie. in terms of countries, market sectors, asset classes, etc.
At the time of analyzing portfolio risk, it is possible to look at different reports. The positions could be grouped according to the market sector, figure 1, and quantify the risk of each aggregate position in each sector, both in isolation (VaR) and as a part of the overall portfolio (component VaR). A more detailed report could break the portfolio into positions in each individual country market sector. Looking at the sample report in figure 1, it is shown that the positions in the construction sector have a negative component VaR, and therefore are lowering the overall portfolio risk. In other words, if positions in the construction sector are reduced, our VaR would actually increase, due to the fact that those positions are acting as a natural hedge.
The use of VaR in the fund management industry is still in its infancy, and it is growing due in part of a regulatory effort as it gains acceptance and popularity as a legitimate and effective tool for market risk management.
Component VaR is an extension of modern portfolio theory and offers a way to determine the contributions of the different portfolio's components to overall risk after taking into account variance and covariance effects.
This week's Learning Curve was written by Carlos Blanco, head of global support services at Financial Engineering Associates, Berkeley, CA., and Jose Ramón Aragonés, professor of finance at Universidad Computense, Madrid, Spain.
