RSS FeedBy M. Isi Eromosele
Dynamic risk management involves a procedure which enables investors to adjust the risk profile of their portfolios based on clearly defined parameters. This procedure is particularly suited to institutional investors where success or failure of investment strategies can be succinctly analyzed.
As such, dynamic risk management procedures facilitate risk taking when the funding positions is within particular limits where risk taking is acceptable. However, when the financial scenario changes making risk taking less of an option, this dynamic process would slowly lower the risk outline of the investment strategy.
This is done by swapping out of risky assets into liability-matching assets to prevent the funding position from deteriorating.
Dynamic risk management procedures take place in many variable guises. The first is a one-way switching procedure where straightforward rules are put in place to sell risky assets and once sold; there are no recourse processes to reinvest in these risky assets if market conditions change.
A two-way switching procedure facilitates the sale of risky assets to be reversed.
An alternative recourse to the management of a switching strategy is the purchase of over-the-counter option strategy (OTC) through an investment bank. This arrangement calls for the bank to guarantee the payoff in all scenarios that may crop up during investment transactions.
In return for a premium, the fund is able to move the risk and governance overhead of managing the investment strategy to the bank. The result is dynamic replication which is a much more effective form of two-way switching.
This involves reproducing the expected pay-off by implementing an option strategy through trading futures, which are highly liquid instruments on a frequent basis.
The first step for a fund investment committee to overcome is how much difficult it is to take remedial action in real time as an unfolding financial situation occurs. One important issue to be resolved is the points (strikes) at which risk needs to be managed.
For an insurance fund which is subject to solvency requirements, the strikes may be well defined, but for a pension fund with a reasonably strong sponsored covenant, it may be less obvious where the strikes may be set.
Also to be considered are two key questions: Should the strategy be in put in place to work for the upside as well as the downside or just to protect the downside? Additionally, at what point should the strategy take effect or should the risk strategy always be operating in the background?
The size of the fund should have a bearing on how fast changes can be made to the risk strategy and this will have to be considered during the risk management design.
A derivative strategy may require the fund committee to sell the upside or pay a premium to also obtain downside protection. This provides more certainty in terms of implementation and desired results.
Dynamic risk management can be implemented in variable forms. To be successful, it is imperative for fund committees to reach agreement on certain crucial questions. It is vital to put a risk strategy in place that would help to improve the governance and decision making of investment committees.
M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance
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