Jan 16

The 2007 FRM. How to get a jump start: Part 5 (Investment Risk Module)

by David Harper, CFA, FRM, CIPM

FRM | Risk |

InvestmentRisk

This is the fifth post (5/5) in a series getting a jump start on the 2007 FRM exam. The final module, a recent addition to the curriculum, is called Risk Management and Investment Management. This module only weighs 10% for the exam, but it's jam-packed with interesting topics. We represent the building blocks as follows:

InvestmentBuildingBlocks3

From left to right, the building blocks include:

  • Hedge funds and Funds of Hedge Funds
  • Portfolio theory and portfolio attribution
  • Risk budgeting

Regarding hedge funds, you could start to familiarize yourself with the various investing hedge fund strategies and styles. To date, the curriculum has followed Pierre-Yves Moix in Lars Jaeger's anthology, who makes a distinction by referring to style as the generic and strategy as the specific approach taken by a hedge fund manager. In hedge fund investing, style drift is ambiguous because hedge funds are absolute return vehicles. A long-only mutual fund typically benchmarks against a well-defined index; drift "away from" the S&P 500, for example, is pretty easy to identify. But it's harder to identify drift if the hedge fund doesn't track against a readily identifiable index.

In regard to strategies, Hedge Fund Research, Inc. publishes (and tracks) a great list of strategy indices. In regard to strategies. The thing to keep in mind is that you are studying risk so you want to associate each style with its risk characteristics. Specifically, each hedge fund strategy implies its own set of risk factors. For example:

HedgeFundRisks

For each strategy, ask, how does it produces alpha. Then, what risk exposures generate the alpha? Event-driven strategies like merger arbitrage have primary exposure to the deal risk premium. Fixed-income arbitrage has systematic exposure to interest rate risk, credit risk, and perhaps liquidity risk.

For portfolio theory, just go right to the robust Amenc readings on the capital asset pricing model (CAPM) and multi-factor models. Keep in mind the following:

  • The CAPM is single-factor model; it is a specific case of a multi-factor model
  • Factors can be explicit (exogenous) or implicit (endogenous). Explicit factors are determined in advance ("outside of the model"), they appeal to your common sense. They include economic factors (e.g., interest rates, GDP) and fundamental factors (e.g., earnings growth). Implicit factors are statistically extracted from the model; they are not typically open to economic interpretation
  • Mulitfactor models are either arbitrage-based (APT) or empirical. APT models dwell on factors generic to all securities; e.g., GDP. Empirical factors are specific to the security; e.g., dividend yield.

On this last point, it's not as difficult as it first seems. In both cases (APT and empirical), excess returns are a function of a risk factor multiplied by (x) the security?s sensitivity to that factor. See how the CAPM is a special case: beta is the sensitivity and the market's equity risk premium is the (only) risk factor.

So, the ATP model looks like this (focus on the right-hand side; the left-hand side is the expected excess return):

Apt3

And the empirical multifactor model looks like this:

MultiFactor

Except for the error term (residual), both are functions of: sensitivity multiplied by risk factor. In the former (APT), those risk factors generic (or common or external) to the security. In the latter (empirical), the risk factors are specific or internal to the security.

In regard to risk budgeting, we like to use the graphic below. The point is that asset allocation can be at variance with pension plan liabilities. This variance?we can see it as the risk of underperformance?can be decomposed into four layers:

RiskBudgetTerrace

From "big to small," surplus at risk (SAR) is the difference between the policy asset allocation (PAA) and the pension liabilities. Implementation risk is the difference between PAA and tactical asset allocation (TAA). Active risk for the plan is next; finally active risk per manager.

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