Transcript
Page 1: Portfolio Management & Mutual Funds

PORTFOLIO MANAGEMENT

&

MUTUAL FUNDS

Report On

Risk Management Perspective with respect to Emerging Markets

Submitted By

Moad Arsiwala

(08PMP00716)

Submitted To

Prof. Daveen B.S. Dhingra

IUD Evaluation

Date: - 11th December, 2009

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The most vital decision regarding investing that an investor can make involves the amount of risk he or she is willing to bear. Most investors will want to obtain the highest return for the lowest amount of possible risk. However, there tends to be a trade-off between risk and return, whereby larger returns are generally associated with larger risk. Thus, the most important issue for a portfolio manager to determine is the client’s tolerance to risk. This is not always easy to do as attitudes toward risk are personal and sometimes difficult to articulate. The concept of risk can be difficult to define and to measure. Nonetheless, portfolio managers must take into consideration the riskiness of portfolios that are recommended or set up for clients.

RISK

An uncertainty that the actual outcome from an investment will differ from the expected outcome can be defined as risk.

While evaluating a particular security or bunch of security i.e. portfolio investor’s give priority to two main aspects which are as under:

Expected Return Risk involved

Investor’s have a notion in their mind that a security should give maximum possible return with same level of risk or minimize the risk with respect to expected return.

The risk that the value of on- or off-balance-sheet positions will be adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices is called market risk. The main components of market risk are therefore equity, interest rate, FX, and commodity risk.

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At the top of the pyramid, we have total market risk, which is the aggregation of all component risks.

In the middle of the pyramid, we see how financial instruments are driven by the underlying component risks.

At the lowest level, market risk arises from fluctuating prices of financial instruments.

In addition to market risk, the price of financial instruments may be influenced by the following residual risks: spread risk, basis risk, specific risk, and volatility risk.

Spread risk is the potential loss due to changes in spreads between two instruments. Forexample, there is a credit spread risk between corporate and government bonds.

Basis risk is the potential loss due to pricing differences between equivalent instruments, such as futures, bonds and swaps. Hedged portfolios are often exposed to basis risk.

Specific risk refers to issuer specific risk, e.g., the risk of holding Yahoo! stock vs. an S&P 500 futures contract. How to best manage specific risk is a topic of debate. Note that according to the Capital Asset Pricing Model (CAPM), specific risk is entirely diversifiable.

Volatility risk is defined as potential loss due to fluctuations in implied option volatilities and is often referred to as “vega risk.” Short option positions generally lose money when volatility spikes upward.

Business risk is the risk of failing to achieve business targets due to inappropriate strategies, inadequate resources or changes in the economic or competitive environment.

Credit risk, is the risk that a counterparty may not pay amounts owed when they fall due.

Sovereign risk is the credit risk associated with lending to the government itself or a partyguaranteed by the government.

Liquidity risk is the risk that amounts due for payment cannot be paid due to a lack of available funds.

Operational risk is the risk of loss due to actions on or by people, processes, infrastructure or technology or similar, which have an operational impact including fraudulent activities.

Accounting risk is the risk that financial records do not accurately reflect the financial position of a company.

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Country risk is the risk that a foreign currency will not be available to allow payments due to be paid, because of a lack of foreign currency or the government rationing what is available.

Political risk is the risk that there will be a change in the political framework of the country.

Industry risk is the risk associated with operating in a particular industry.

Environmental risk, the risk that a company may suffer loss as a result of environmentaldamage caused by themselves or others which impacts on their business.

Legal/regulatory risk is the risk of non-compliance with legal or regulatory requirements.

Systemic risk is the risk that a small event will produce unexpected consequences in local,regional or global systems not obviously connected with the source of the disturbance.

Reputational risk is the risk that the reputation of a company will be adversely affected.

NEED FOR PORTFOLIO

As there is a saying that ‘we should not put all eggs in one basket’, same goes with investment don’t block or invest all the funds available in one particular security but to diversify among different avenues. This gives rise to designing of portfolio of securities which contains bunch of potential stocks which ensure the best possible return at a manageable risk level.

Beta measure is used to analyze to ensure sensitivity of security return with respect to fluctuations in overall market.

Within a portfolio it is advised not to have exposure in one particular sector but to diversify among various sectors in order to eliminate the diversifiable or the unsystematic risk which is related to one particular company or one particular sector.

Through diversification, adding of sufficient stocks in portfolio the unsystematic risk can be eliminated. But systematic risk can’t be removed as it is related with the whole economy.

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There are numerous ways of diversification:

Diversification within an Industry Diversification across industries Diversify across geographical regions International Diversification Diversification across Asset Classes.

The investor should also keep in mind the perils associated with over diversification. There should not be too many securities in the portfolio that it creates difficulty in handling them. The question is how to determine the number of securities to be maintained within the portfolio. Generally portfolio should have a mix of ten to fifteen securities. It can be inferred that the number of securities should be limited to the extent that the investor is able to earn handsome amount of return with manageable risk.

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PORTFOLIO SELECTION

Efficient Frontier

Investor’s select a portfolio which fall on the Efficient Frontier. Efficient Frontier is a group of securities within a portfolio where:

Returns are maximized at same level of risk Minimizing the risk level with same expected returns.

Generally risk level observed in emerging markets is far higher compared to developed markets. The situation prevailing in emerging markets are highly volatile which demands constant monitoring of the portfolio and up gradation in portfolio from time to time.

Sharp Optimization Model

This model is used while selecting a portfolio comprising of potential securities. There are steps involved in this particular model.

Rank Securities based on excess return to beta ratio. Find out the Cut-off point- to know the likely security to be figured in optimal

portfolio. Determine the proportion to be invested in particular security.

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MODELS USED IN PORTFOLIO SELECTION

Utility models Geometric Mean model Safety First model Stochastic Dominance Model

PORTFOLIO REVISION

It is necessary and highly beneficial to investor’s to have constant monitoring of the portfolio and to make necessary amendments in timely manner to ensure best possible return and at the same time it is helpful at times in minimizing risk. Thus, portfolio revision is necessary considering high volatility in the market.

There are many factors which affect the investor’s which make portfolio revision and up gradation necessary. This step not only ensures investor’s wealth maximization but at times helps him to minimize the losses due to high volatility observed in the market

Change in wealth Change in time horizon Changes in liquidity needs Changes in taxes Bull and Bear markets Inflation rate changes Changing return prospects

PORTFOLIO REVISION TECHNIQUES

Constant Dollar Value Plan Constant Ratio Plan Variable Ratio Plan

Generally risk level observed in emerging markets is far higher compared to developed markets. The situation prevailing in emerging markets are highly volatile which demands constant monitoring of the portfolio and up gradation in portfolio from time to time.

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EMERGING MARKET v/s DEVELOPED MARKETS

There is vast difference between the emerging markets and developed markets. Emerging are the growing markets which are new and has the potential to perform well. Naturally while designing portfolio it needs to be considered the market in which the portfolio is designed. The risk level would be far higher in emerging markets compared to the developed markets.

The portfolio selection and revision techniques which are followed become more prominent with respect to emerging markets than the developed markets. Also, such techniques are to be followed on the continual basis when the investor’s portfolio is designed with respect to emerging markets.

Emerging market tend to exhibit cyclical market behaviour due to interest rate differentials with foreign currencies. They often appreciate steadily during normal market conditions but depreciate violently in times of crisis as investors retreat to the safe haven of low-yielding currencies. High volatility and the unfavourable interest rate differential means currency risk hedging can be costly. Given the poor average performance of such hedges, many corporates question their long-term benefit.

The emerging markets possess high level of risk due to volatility observed so such techniques are to be used on continual basis to minimize losses, maintain profitability and growth of capital.

Until the last few years, the conventional view towards investing in emerging markets was that sustainability considerations too often appeared subordinate to the quest for economic growth. Emerging markets are now seen by many in the investment community as a place where good rewards can be earned.

EIRIS had just completed a review of the opportunities for responsible investment in emerging markets, which reveals the possibilities for diversification and risk management for investors as well as wider potential gains for sustainability.

The report identifies factors hindering Socially Responsible Investment in emerging markets:

Perceived lack of consistent and widespread good corporate governance.

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Continuing government ownership and control such as with many large listed Asian companies that can be a critically important variable in Environmental and Social Governance performance.

The retention of large controlling interests by families in many emerging market companies that limit the rights and influences of minority shareholders.

Even where governance, environmental or labour regulations are strong in some countries, enforcement is sometimes weak.

Doubts about the honesty of some disclosed information or its credibility. For instance, in relation to ISO14001, the reputation of those providing the certification is crucial for trusting the information disclosed.

Difficulties in engaging with companies in emerging markets. Although language may be a factor in some cases, the corporate culture of many companies is not yet responsive or attuned to international investors especially relating to environmental and social issues.

A limited number of third party organizations in these countries or regions to undertake the research required on companies. The International Finance Corporation is undertaking initiatives to facilitate and increase this research capacity

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RISK MANAGEMENT PERSPECTIVE- EMERGING MARKET

As the risk level is higher in emerging market, due to heavy fluctuations in prices of securities there is a need to have various risk management techniques to minimize the risk and at the same time maintain profitability.

Risk Management process step Management QuestionEstablish the context What we are trying to achieve?Identify the risks What might happen?Analyze the risks What might that mean for the

project’s key criteria?Evaluate the risks What are the most important

things?Treat the risks What are we going to do about

them?Monitor and review How do we keep them under

control?Communicate and consult Who should be involved in the

process?

Establish Context:

Establishing the context is concerned with developing a structure for the risk identification and assessment tasks to follow. This step:

Establishes the company and project environment in which the risk assessment is taking place;

Specifies the main objectives and outcomes required; identifies a set of success criteria against which the consequences of identified risks can be measured; and

Defines a set of key elements for structuring the risk identification and assessment process.

Identify risks:

Risk identification sets out to identify a company’s exposure to uncertainty. Every company faces different risks, based on its business, the economic, social and political factors, the features of the industry it operates in – like the degree of competition, the strengths and weaknesses of its competitors, availability of raw material, factors internal to the company like the competence and outlook of the management, state of industry

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relations, dependence on foreign markets for inputs, sales, or finances, capabilities of its staff, and other innumerable factors.

Each corporate need to identify the possible sources of risks and the kinds of risks faced by it. This requires an intimate knowledge of the company, the market in which it operates, the legal, social, political and cultural environment in which it exists, as well as the development of a sound understanding of its strategic and operational objectives, including factors critical to its success and the threats and opportunities related to the achievement of these objectives.

The risk identification process must be comprehensive, as risks that have not been identified cannot be assessed, and their emergence at a later time may threaten the success of the company and cause unpleasant surprises. Risk identification should be approached in a methodical way to ensure that all significant activities within the company have been identified and all the risks flowing from these activities defined.

A number of techniques can be used for risk identification, but brainstorming is a preferred method because of its flexibility and capability, when appropriately structured, of generating a wide and diverse range of risks.

Information used in the risk identification process may include historical data, theoretical analysis, empirical data and analysis, informed opinions, and the concerns of stakeholders. Various possible risks are already discussed earlier.

Analyze risks:

During the Risk Analysis step the company transforms risk data into decision making information. The company has to evaluate impact, probability and timeframe. This means that they have to classify and prioritize risks.

Risk analysis is the systematic use of available information to determine how often specified events may occur and the magnitude of their consequences. The analysis stage assigns each risk a priority rating, taking into account existing activities, processes orplans that operate to reduce or control the risk.

The significance of a risk can be expressed as a combination of its consequences or impacts on the company’s objectives, and the likelihood of those consequences arising.

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This can be accomplished with qualitative consequence and likelihood scales and a matrix defining the significance of various combinations of these. Table 2 shows the structure of a five-by-five matrix.

A matrix, like Table 2, can be structured according to the kinds of risks involved in the company’s objectives, criteria and attitudes to risk. For example, the specific Table 2 is not symmetric, indicating that the company is concerned about most catastrophic events, even if they are rare. This might be appropriate where human safety is threatened and the company needs to ensure the associated risks are being managed whatever the likelihood of their occurrence.

Where the impacts of potential risks are purely economic, and particularly where there may be limit to the potential exposure, catastrophic but rare events may be viewed as moderate risks and not treated in such detail.

To implement a structure like this, it is important that clear and consistent definitions of the consequence and likelihood scales are used.

Evaluate risk priorities:

Risk evaluation is the process of comparing the estimated risk against given risk criteria to determine the significance of the risk. When the risk analysis process has been completed, it is necessary to compare the estimated risks against risk criteria which the company has established. The risk criteria may include associated costs and benefits, legal requirements, socioeconomic and environmental factors, concerns of stakeholders, etc. Any risks that have been accorded too high or too low a rating are adjusted, with a record of the adjustment being retained for tracking purposes. The outcome is a list of risks with agreed priority ratings. Adjustments to the initial priorities may be made for several reasons.

Risks may be moved down. Typically these will be routine, well-anticipated risks that are highly likely to occur, but with few adverse consequences, and for which standard responses exist.

Risks may be moved up. Typically there will be two categories of risks like this: those risks that are more important than the initial classification indicates; and those risks that are similar to other high-priority risks and hence should be considered jointly with them.

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Some risks may be moved up to provide additional visibility if the project team feels they should be dealt with explicitly.

Risk evaluation therefore, is used to make decisions about the significance of risks to the company and whether each specific risk should be accepted or treated. For the purpose of risk management, risks need to be classified as primary risks and secondary risks. Primary risks are those that are an essential part of the business undertaken. Secondary risks are those that arise out of the business activities, but are not integrally related to them. For example, the risks arising out of the industry structure are primary in nature, foreign currency exposure arising due to exports are secondary in nature. To a large extent, primary risks have to be borne in order to generate cash flows. They can be covered only partly. Unlike primary risks, secondary risks can be covered to a large extent, and only a part of them are unavoidable. This distinction becomes very important while deciding on the risks to be covered.

Further, it is generally observed that when a firm faces a high degree of primary risk, it can bear less of secondary risk. A firm having a low degree of primary risk may be able to bear higher secondary risk, depending on the management’s risk bearing capacity.

Treat risks:

The purpose of risk treatment is to determine what will be done in response to the risks that have been identified, in order to reduce the overall risk exposure. Unless action is taken, the risk identification and assessment process has been wasted.Risk treatment converts the earlier analyses into substantive actions to reduce risks. Any controls and plans in place before the risk management process began are augmented with risk action plans to deal with risks before they arise and contingency plans with which to recover if a risk comes to pass.

At the end of successful risk treatment planning, detailed ideas will have been developed and documented about the best ways of dealing with each major risk, and risk action plans will have been formulated for putting the responses into effect.

Risk treatment might also include alteration of the base plans of the business. Occasionally the best way to treat a risk might be to adopt an alternative strategy, to avoid a risk or make the company less vulnerable to its consequences.

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During the response identification and assessment process, it is often helpful to think about responses in terms of broad risk management strategies. The following are the different approaches:

Risk Avoidance:An extreme way of managing risk is to avoid it altogether. This can be done by not undertaking the activity that entails risk. Though this approach is relevant under certaincircumstances, it is more of an exception rather than a rule.

It is neither prudent, nor possible to use it for managing all kinds of risks. The use of risk avoidance for managing all risks would result in no activity taking place, as all activities involve risk, while the level may vary.

Loss Control:Loss control refers to the attempt to reduce either the possibility of a loss or the quantum of loss. This is done by making adjustments in the day-to-day business activities.

Combination: Combination refers to the technique of combining more than one business activities in order to reduce the overall risk of the firm. It is also referred to as aggregation or diversification. It entails entering into more than one business, with the different businesses having the least possible correlation with each other.

Separation:Separation is the technique of reducing risk through separating parts of businesses or assets or liabilities. A firm having two highly risky businesses with a positive correlation may spin-off one of them as a separate entity in order to reduce its exposure to risk.

Risk Transfer:Risk is transferred when the firm originally exposed to a risk transfers it to another party which is willing to bear the risk. This may be done in three ways. The first is to transfer the asset itself. There is a subtle difference between risk avoidance and risk transfer through transfer of the title of the asset. The former is about not making the investment in the first place, while the latter is about disinvesting an existing investment. The second way is to transfer the risk without transferring the title of the asset or liability. This may be done by hedging through various derivative instruments like forwards, futures, swaps and options. The third way is through arranging for a third party to pay for losses if they

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occur, without transferring the risk itself. This is referred to as risk financing. This may be achieved by buying insurance. A firm may insure itself against certain risks like risk of loss due to fire or earthquake, risk of loss due to theft, etc.

Risk Retention:Risk is retained when nothing is done to avoid, reduce, or transfer it. Risk may be retained consciously because the other techniques of managing risk are too costly or because it is not possible to employ other techniques. Risk may even be retained\ unconsciously when the presence of risk is not recognized. It is very important to distinguish between the risks that a firm is ready to retain and the ones it wants to offload using risk management techniques. This decision is essentially dependent upon the firm’s capacity to bear the loss.

Risk Sharing: This technique is a combination of risk retention and risk transfer. Under this technique, a particular risk is managed by retaining a part of it and transferring the rest to a party willing to bear it.

Risk Monitor and Review:

Effective risk management requires a reporting and review structure to ensure that risks are effectively identified and assessed and that appropriate controls and responses are in place.

Regular audits of policy and standards compliance should be carried out and standards performance reviewed to identify opportunities for improvement. It should be remembered that companies are dynamic and operate in dynamic environments. Changes in the company and the environment in which it operates must be identified and appropriate modifications made to systems.

Continuous monitoring and review of risks ensures new risks are detected and managed, and that action plans are implemented and progressed effectively. The monitoring process should provide assurance that there are appropriate controls in place for the company’s activities and that the procedures are understood and followed. Any monitoring and review process should also determine whether:

The measures adopted resulted in what was intended.

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The procedures adopted and information gathered for undertaking the assessment was appropriate.

Improved knowledge would have helped to reach better decisions and identify what lessons could be learned for future assessments and management of risks.

Review processes are often implemented as part of the regular management meeting cycle, supplemented by major reviews at significant project phases and milestones. Monitoring and review activities link risk management to other management processes. They also facilitate better risk management and continuous improvement.

The main input to this step is the risk watch list of the major risks that have been identified for risk treatment action. The outcomes are in the form of revisions to the risk register, and a list of new action items for risk treatment. Risk monitor and review involves:

Choosing alternative response strategies Implementing a contingency plan Taking corrective actions Re-planning

The risk manager reports periodically to the senior managers on the effectiveness of the plan, any unanticipated effects, and any correction that the company must take to mitigate the risk.

Communication and consultation:

Communication and consultation may be a critical factor in undertaking good risk management and achieving outcomes that are broadly accepted. They help owners, clients and end users understand the risks and trade-offs that must be made. This ensures all parties are fully informed, and thus avoids unpleasant surprises. Within the risk management team, they help maintain the consistency and ‘reasonableness’ of risk assessments and their underlying assumptions.

In practice, regular reporting is an important component of communication. Managers report on the current status of risks and risk management as required by sponsors and company policy. Senior managers need to understand the risks they face, and risk reports provide a complement to other management reports in developing this understanding.

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The risk register and the supporting action plans provide the basis for most risk reporting. Reports provide a summary of risks, the status of treatment actions and an indication of trends in the incidence of risks. They are usually submitted on a regular basis or as required, as part of standard management reporting.

These traditional risk management techniques are used but it has its own limitations.

Looks at the downside of Risk (losses) Doesn’t exploit the benefits of technology advancements Fails to address & adjust to meet emerging requirements Focus is on tactical aspect and doesn’t look at the big picture (inward-looking) Allows division of risk management in departments Doesn’t force alignment with business strategy Allows selective risk management without oversight.

EXTERNAL PRESSURES-

There are numerous external pressures on the companies which require portfolio managers to devise sound risk management techniques. Some of the notable pressures are:

Regulatory environment is changing due to global financial crisis. The rating agencies, such as S&P, evaluate companies on Risk Management. There is an increased expectation by shareholders for effective risk management. Building on confidence in investment community and stakeholders. An increased expectation for improved corporate governance of risk. Organizations such as RIMS &PMI are promoting risk management at multiple

levels. SEC requires companies to describe risks that may have a material impact on

future financial performance.

INTERNAL REQUIREMENTS

Proper aligning of Risk Appetite and Strategy. Minimizing operational surprises & losses. Grab potential opportunities. Trade off between capital needs and allocation. Need to investigate interdependent risks

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Provide integrated responses to multiple risks. Need to address technology integration and dependence.

In order to meet both the external as well as internal requirements there is a need to have full proof risk management system which the traditional risk management technique fail to offer on account of many irregularities mentioned earlier.

Process should be:Must have Should have

Must be well-understood by the people who execute it.

Should be documented.

Must be implementable. Should be scalable and incremental. Must be auditable and controllable. Should be measurable.Must have an owner & an executive champion.

This calls for a need of a management technique to manage risk on all fronts i.e. Enterprise Risk Management.

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ENTERPRISE RISK MANAGEMENT (ERM)

ERM is not one event or circumstance, but a series of actions that permeate an entity's activities.

The process of ERM can be described by way of a diagram:

Tracking of current and previous issues.

Align risk management with firm’s strategic direction

Identify and assess Risk Event (Triggers/Situations)

Prioritize and report organization’s risk events

To prepare a well planned response to Risk Events when and if they

occur.

OVERVIEW OF RISK METHODOLOGIES

Communication

Control and Monitoring

Environment Scanning

Strategic Alignment

Event Identification

Risk Assessment

Risk Response Planning

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OVERVIEW OF RISK METHODOLOGIES

Market risk models are designed to measure potential losses due to adverse changes in the prices of financial instruments. There are several approaches to forecasting market risk, and no single method is best for every situation.

Over the last decade, Value-at-Risk (VaR) models have been implemented throughout the financial industry and by non-financial corporations, as well. Inspired by modern portfolio theory, VaR models forecast risk by analyzing historical movements of market variables.

To calculate VaR, one can choose from three main methods: parametric, historical simulation, and Monte Carlo simulation. Each method has its strengths and weaknesses, and together they give a more comprehensive perspective of risk.

We can include the portfolio aggregation methodology as a subcomponent of historical simulation. Before comparing these three approaches for calculating VaR, we add a quick note about linear vs. non-linear instruments.

A financial instrument is nonlinear if its price changes disproportionately relative to a movement in the underlying asset. The risk of nonlinear instruments (e.g., options) is more complex to estimate than the risk of linear instruments (e.g., traditional stocks, bonds, swaps, forwards, and futures).

To account for the discontinuous payoff of nonlinear instruments like options, risk simulations should use full valuation formulas (e.g., Black- Scholes) rather than first order sensitivities (e.g., delta).

The following table describes the three main methodologies for calculating VaR.

Methodology Applications Description ApplicationsParametric Estimates VaR with equation

that specifies parameters such as volatility, correlation, delta, and gamma.

Accurate for traditional assets and linear derivatives, but less accurate for nonlinear derivatives.

Monte Carlosimulation

Estimates VaR by simulating random scenarios and revaluing positions in the

Appropriate for all types of instruments, linear and non linear

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portfolio. .Historical simulation Estimates VaR by reliving

history; takes actual historical rates and revalues positions for each change in the market.

Appropriate for all types of instruments, linear and non linear.

From an end-user perspective, the important point to remember is that if you have significant nonlinear exposures in your portfolio, a simulation approach with full position re-pricing will generally be more accurate than a parametric approximation for estimating VaR—however, at the cost of greater complexity.

CONCLUSION

Risk management is part of any company’s strategic management. It is the process whereby methodically address the risks attaching to their activities with the goal of achieving sustained benefit within each activity and across the portfolio of all activities.

The focus of good risk management is the identification and treatment of these risks. Its objective is to add maximum sustainable value to all the activities of the company.

However considering the situation prevailing in emerging market which is far more different and highly volatile compared to the developed markets. So, it should be borne in mind of investors as well as portfolio managers that the techniques used for managing risk should be used on continual basis as far as emerging markets are considered.

The portfolio revision, up gradation techniques and ERM would give desirable results only when used with proper strategy and direction to ensure that the high risk prevailing in having exposure in portfolio of emerging markets is minimized to a manageable extent. It is clear that all risks can be minimized to the level of systematic risks which can’t be minimized or reduced as it is related to whole economy.


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