Risk treatment

Listing a risk does not deal with it. At some point the risk shows up, and somebody has to do something.

The risk framework decides in advance what that something will be. The workbook gives four choices:

• Tolerate — accept it and carry on.
• Mitigate — reduce it, usually by diversifying or by setting limits.
• Transfer — move it to someone better placed to carry it.
• Terminate — close the activity and step away.

Which one applies depends on the nature, severity and frequency of the event. A manager may use one of them, or a combination.

The order matters in practice. Managers tolerate and mitigate first. Transfer comes when those thresholds are crossed. Termination is for a risk too large to hold at all.

The definition (sections 17.2 and 17.5). In the event of a risk, the defined framework of the portfolio manager and her organisation helps in taking action towards the risk event. Given the nature, severity and frequency of such risk events, the manager takes one or a combination of four actions: (i) tolerate, (ii) mitigate, (iii) transfer and (iv) terminate or close the activity. Treatment of risk and control and monitor are the two key aspects of managing risk.

The escalation path (section 17.5.1). If the level of risk crosses the tolerating and mitigation threshold levels, managers move into transfer mode — taking actions such as floating-to-fixed swaps, swaptions and reinsurance, where the product stays with the participant but the risk moves to someone better suited to bear it. When the risk is too large to be handled by the participant for any reason, it is better to exit by terminating the activity, to protect capital, the participant's own existence and the investors' wealth.

How mitigation is actually done for non-market risk (section 17.5.2). Non-market risk — also called idiosyncratic, specific or unsystematic risk — can be addressed by diversification. The workbook's four methods:

1. Diversify the portfolio — hold a large number of constituents, say 35 or more, since it is very unlikely that all companies will sink together;
2. Add poorly correlated constituents — invest across asset classes that are poorly correlated, giving a natural hedge;
3. Monitor the constituent company — participants, rating agencies and analysts continuously watch business, operational and financial health, which gives early signals but is both time-consuming and costly;
4. Terminate — risks which are not worth carrying should be terminated.

Market risk cannot be mitigated by diversification. Section 17.5.1 is explicit that market risk is systematic, beyond the control of market participants, and that one size does not fit all. Three factors guide each participant's approach: the risk factors the investment is exposed to (equity and debt portfolios differ), the degree of leverage, constrained by capitalisation and leverage thresholds, and regulatory guidelines.

The treatment is only as good as the monitoring. The workbook insists that data analysis and monitoring are of utmost importance, with reporting to the appropriate authorities to allow timely action and avoid both monetary and regulatory penalties.

Illustrative figures, applying the workbook's four actions. A PMS runs a Rs 200 crore portfolio and its risk register produces four live events in one quarter.

Now the diversification arithmetic behind the second row. The portfolio held 18 stocks. Applying the workbook's 35 or more guide, the manager rebuilds it to 40 holdings averaging 2.5%, that is Rs 5,00,00,000 each.

The effect is not on market risk — that is unchanged and untreatable by diversification. It is on company-specific risk. A total write-off in one name previously cost up to Rs 22,00,00,000, or 11% of the portfolio. After the rebuild the worst single-name loss is Rs 5,00,00,000, or 2.5%.

The swap in the third row illustrates the workbook's point about transfer: the receivable is still on the books. Only the currency risk has moved.

Chapter 17 (Risk) states the four actions twice — in section 17.2 as the fifth step of the risk management process, and again in section 17.5 as the first key aspect of managing risk. Section 17.5.1 adds the escalation into transfer mode and the instruments used; section 17.5.2 gives the diversification methods with the 35 or more constituents figure.

Expect a direct recall question on the four actions, a scenario question asking which action fits a described event, and a question on whether market risk can be diversified away (it cannot).

• Four actions, and they can be combined. The workbook says one or a combination — a question implying only one may be chosen is wrong.
• Tolerate is a genuine treatment, not a failure to act. Market risk is normally tolerated because it is the risk the portfolio exists to take.
• Transfer does not remove the product, only the risk. The workbook's wording is that the product stays with the participant while the risk goes to someone better suited to bear it — swaps, swaptions, reinsurance.
• Diversification mitigates non-market risk only. Market risk is systematic and cannot be diversified away, however many stocks are held.
• 35 or more constituents is the workbook's own guide for diversifying non-market risk. It is a say, not a regulation, but it is the number the paper carries.
• Termination is the last resort, and the test is size. The workbook's trigger is a risk too large to be handled — not a risk that is merely unpleasant.