Dr. Philippe Jorion of the University of California at Irvine and Managing Director of Pacific Alternative Asset Management Company (PAAMCO) wrote a main portion of the risk management overview for the CAIA Level II curriculum. There are market, credit, liquidity, regulatory and counterparty risks.
Market risk is the risk of loss in financial market prices. It is also called systematic risk. To calculate market risk, all the assets in the portfolio should be used to find the possible profits and losses by using market data. The most well-known model is value at risk (VaR). This allows for tracking of any drift in investing style, hidden risks and of new fund managers, markets and assets.
Credit risk is the risk that a counterparty to a contract does not fulfill its obligation by not paying the amount or not delivering the asset owed.
Liquidity risk occurs when an investor cannot sell assets. There are two types: funding and asset. Funding liquidity risk happens when investors redeem their capital from a fund, when loans from the prime broker are not renewed or during margin calls. In these situations, the fund may be forced to sell assets to raise capital. Asset liquidity risk is the risk of losses due to the price impact of forced asset sales. These risks can be mitigated by matching the investment horizon of an investor's assets and liabilities, putting in place a lock-up period when an investor cannot redeem their capital, having a notice period before redeeming capital, creating gates to limit withdrawals to a percentage of capital and suspending redemptions altogether.
Regulatory risk is the risk that government or regulatory agencies may change the financial rules such as imposing short stock trades during the credit crisis of 2008.
Counterparty risk is almost the same as credit risk except it includes the counterparties of your counterparty.
We will be examining other topics from Dr. Jorion's writings in later posts. The source for this article can be found here.
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