Recent growth in the use of risk-management techniques is expected to continue this year, with some experts seeing a focus on "stress testing" and liquidity-related risks.
Risk-management oversight has moved beyond the defensive measures taken in the wake of derivatives disasters a few years ago to encompass portfolio-wide analysis of risk, experts say. Moreover, the additional information gained through risk management will be used by some to improve the risk return profile of investment assets.
Stress testing has clearly become "a hot-button issue," said Richard Singer, a director in risk management for KPMG Peat Marwick L.L.P., New York.
Stress-testing methods could have given a heads up to investors that recently took hits in emerging markets or through currency overlay programs, Mr. Singer said.
Stress testing can vary greatly, but its goal is to try to figure out how crisis situations will affect a portfolio's correlations, thereby trying to estimate a worst-case scenario. This is done though computer modeling that simulates how potential market crises might affect a particular portfolio. Such modeling complements the value at risk technique, which seeks to estimate the greatest expected loss a portfolio carries within a given confidence level.
Stress testing seeks to estimate losses occurring outside of VAR's confidence band.
"Those are the losses that concern central banks and investors," Mr. Singer said.
Well-designed stress tests can give investors a means to estimate what their losses will be under various crisis scenarios, he said. For example, an investor might simulate a default by a major financial institution, or a dramatic rise in interest rates.
Historical relationships, such as market correlations, break down during crises. Recent events in Asia demonstrate such risks and have given some investors further incentive to pursue stress testing, he said.
Other experts agree.
"Obviously what's happened in Asia has heightened people's awareness that you can't always rely on a model," said James Lockhart, managing director of consulting firm NetRisk, Greenwich, Conn. "There has to be management judgment as well."
Waite Rawls, chief risk officer with Ferrell Capital Management, a Greenwich, Conn.-based money manager and risk consultant, agreed that emerging markets investments present a good avenue for applying risk-management techniques.
Long-term, emerging markets offer attractive risk return tradeoffs, he said.
But, "short-term, (emerging markets) can wander way off the reservation," he said.
Some investors, he said, have adopted emerging markets exposure of 6% or greater as a result of optimization techniques that don't take into account greater correlations with other asset classes during market crises. During a crisis, the diversification effect of investing in emerging markets can disappear.
Mr. Rawls said that in a value at risk analysis, emerging markets "look just fine. It's only under a stress (testing) microscope that the danger shows up."
Similarly, historical relationships among various currencies have broken down in the past year, leading to unexpected underperformance from changes in currency management, Mr. Singer of KPMG said.
Currency overlay is likely to come under the risk management microscope in the coming year, he said.
Other changes are expected for this year as risk management techniques are applied to new areas, including alternative investments such as venture capital, private equity, and real estate.
Aamir Sheikh, director of risk management consulting services for consulting firm BARRA Inc., Berkeley, Calif., said measuring the risk of less-liquid investments is being tackled by BARRA executives and others.
"Liquidity risk is going to become very important," he said.
It's critical, he said, that methods be developed to better assess risk of alternative investments, given the growth of those assets among plan sponsors and the inadequate methods currently in use.
Without a means to measure and manage risks in those growing areas, institutions' only two available options - neither of which is acceptable - are to ignore the risks or decline to invest there, he said.
Liquidity risk also is an issue for listed securities, which should be another hot area in the coming year, Mr. Sheikh said.
Credit risk from the portfolio view is another area expected to be hot in 1998, he said.
Managing credit risk at the portfolio level entails analysis of how portfolios respond to large credit events, such as defaults.
"It looks at the whole spectrum of credit exposures," he said.
Risk management also may play a bigger role in the lives of corporate pension fund managers in 1998, as company managers apply enterprise-wide risk principles to pension funds.
Robert Baldoni, partner in the risk management and regulatory practice of Ernst & Young L.L.P., New York, said pension risks are being dissected by corporations that are revamping risk management from the corporate perspective.
The actions may ultimately not affect how pension funds are managed, but will increase the amount of risk measurement being performed by corporate pension management groups, he said.
"I think that we're going to see a lot more effort on risk measurement, as opposed to risk management," he said.
Risk management may lead to more proactive measures by investors in 1998.
Mr. Singer of KPMG said he has recommended to selected clients that they loosen some of their prohibitions on the use of derivatives in portfolios and on the use of securities lending.
The derivatives disasters of 1994 and 1995 have led to a change in the way investors use derivatives and invest securities lending collateral, he said. In 1998, there may be some advantage to allowing derivatives where previously banned and allowing securities lending, Mr. Singer said.
Moreover, risk techniques may be used more actively in asset allocation construction.
"The first thing people have done is try to apply (risk management) defensively. It's only beginning to show up offensively," said Mr. Rawls of Ferrell Capital.
Some institutions are realizing that risk management techniques can be used not only for monitoring, but also to create better risk return profiles, Mr. Rawls said.
