A Portfolio Manager Questions a Risk Engine V:
Risk Limits Automation and Compliance Monitoring

Yannis Sardis, 26 April 2021

The application of risk limits is an essential part of the portfolio management process, to ensure that all parameters driving the implemented trading strategies comply with the pre-determined regulatory rules and the internal investment policy guidelines.

The representative PM poses questions to our risk engine, KlarityRisk (KR), regarding the automation of such a risk assessment and compliance monitoring process.

PM: My firm deploys a wide range of customized multi-asset-class model portfolios. Considering that we pre-determine the acceptable levels of allocation divergence from a model portfolio, are there ways of monitoring those without manual interference?

KR: Most certainly; a Risk Limits management module allows you to set and monitor limits against any portfolio categorizations such as asset classes, industry sectors, risk countries, currencies, as well as any custom classifications maintained in your back-office system.

PM: As a firm, we have strict compliance policy rules which stem from our jurisdictional regulatory requirements. As such, we are required to monitor our client portfolios against various risk measures, such as VaR, Expected Shortfall, Tracking Error (for our Index-Tracking funds) and Beta coefficient. How do you support such a systematic compliance monitoring?

KR: Our Risk Limits tool allows you to set limits at several layers, from thresholds applicable to a single portfolio component all the way up to thresholds applied to Groups of portfolios. In addition, Risk Limits incorporates an extensive list of metrics that can be utilized, such as the portfolio VaR, Conditional VaR, Tracking Error, Beta, Volatility, Diversification Benefit, Maximum Drawdown, Sharpe and Sortino Ratios and Component VaR.

PM: We would like to get automatically alerted whenever a limit breach occurs. How can we accomplish this in a disciplined and scalable fashion using your system?

KR: There are actually four different ways that our platform can alert you to a limit breach:

  • Utilize a wide list of available reports dedicated to the compliance monitoring
  • Utilize the system’s Dashboards functionality (compliance monitoring reports incorporated into a system’s dashboard)
  • Use our system integration facility, to get alerted via your own portfolio management system
  • Generate email notification messages once any type of risk limit breach occurs.

PM: Without getting too technical, could you explain the different types of Risk Limits that you can apply and at which level of portfolio segmentation?

KR: The risk limits can be defined and managed at different levels:

  • Component Threshold
    It applies to various portfolio segments, such as asset classes, risk countries, industry sectors, credit ratings, and allows the user to monitor the risk concentration to each particular portfolio segment against your acceptable levels.
  • Profile Threshold
    It monitors the risk exposure at a portfolio level and it is applied to the parameters of your risk model’s unique evaluation profile.
  • Global Threshold
    It monitors the risk exposure at portfolio level, regardless of the risk assessment model implemented.

PM: Can Risk Limits be applied onto a wide list of metrics to empower our overall portfolio monitoring process?

KR: Let me divide our list of metrics into three monitoring categories:

  • Exposure Limits
    They allow you to monitor the risk concentrated in each portfolio segment (asset class, reference currency, industry sector) against your acceptable levels.
  • VaR Limit
    It sets the acceptable level of a portfolio’s maximum potential loss based on the specific VaR model utilized. Your firm can set multiple VaR limits, depending on the VaR assessment model by utilizing the Profile Threshold limit type.
  • Limits on Sensitivity Metrics
    It is utilized by firms with exposures to Options or Fixed Income products, as such investments are sensitive to multiple market factors. By setting a boundary for the tracking-error of an index-tracking fund you can also ensure that it adequately reflects the index movements.

A limit can be simultaneously applied to any of the plethora of sensitivity metrics provided by our engine; indicatively: VaR, CVaR%, Expected Shortfall, Volatility, Tracking Error, Beta, Diversification Benefit, Downside Deviation, Drawdown, Sharpe and Sortino Ratio, Duration, Kurtosis, Skewness, Option Greeks.

Our next session will focus on Fixed Income Performance Contribution and Attribution models and ways of identifying the constituent sources of a bond portfolio’s performance.

FINVENT Software Solutions is a provider of financial software applications and custom engineering services. The award-winning KlarityRisk platform specializes in investment risk analytics and fixed income performance attribution reporting and it is offered to Private Wealth institutions, Asset Managers, Hedge Fund Managers and Family Offices.

Would you like to know more about our Portfolio and Risk Management solutions? Please contact us at info@finvent.com and we will get in touch.