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Set out ways to change a portfolio's exposure to risk

CFA® Level I · Portfolio Construction · Introduction to Risk Management · PM.7.c

The idea

Four responses are available once a risk is identified. It can be avoided, by not undertaking the activity - appropriate where the exposure is uncompensated or outside competence. It can be accepted and retained, with capital held against it, which is right for risks the organisation is paid to bear. It can be transferred, through insurance or by passing it to a third party. Or it can be shifted, using derivatives to change the shape of the payoff distribution. Choosing between them turns on cost and on whether the organisation has comparative advantage in bearing the risk.

Formulas

Changing exposure with futures

futures notional = (β wanted − β now) ÷ β futures × portfolio value

β wanted
the beta the investor wants
β now
the beta of the portfolio today
β futures
the beta of the futures contract, one for an index future
portfolio value
the market value of the portfolio

A negative result means sell futures to cut exposure, a positive one means buy to raise it. It changes exposure without trading the underlying holdings.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which response to risk involves not undertaking the activity at all?

  1. Risk transferWhy not: The activity proceeds and its risk is passed to another party, typically an insurer.
  2. Risk avoidance - correct
  3. Risk retentionWhy not: The activity proceeds and the risk is kept, with capital held against it.

There are several ways to respond to a risk. Risk avoidance means not doing the activity at all, so no exposure is left. Risk transfer passes the risk to someone else, such as an insurer. Risk retention means doing the activity and keeping the risk. Example: a manufacturer that decides not to open a plant in an unstable country has avoided that political risk completely. Avoidance suits risks that bring no reward or lie outside the firm's skills.

A harder one

Corvin Industries takes three actions in one quarter: it buys put options on its portfolio of marketable equities, it buys an insurance policy covering fire damage at its main warehouse, and it closes an unprofitable overseas unit. Which risk management responses, in that order, do the three actions represent?

  1. Shift; transfer; avoid - correct
  2. Transfer; shift; avoidWhy not: The first two have been swapped. Insurance passes the loss to the insurer, which is transfer, whereas options keep the position and reshape the payoff distribution, which is shifting.
  3. Transfer; transfer; avoidWhy not: Put options do not pass the risk on to another party in the way insurance does. They leave Corvin holding the equities and change the shape of the outcomes, so they are shifting.

There are four responses to a risk: avoid it, retain it, transfer it, or shift it. Put options give the right to sell at a set price, so they limit losses on the equities while Corvin still owns them. That reshapes the possible outcomes using a derivative (a contract whose value depends on another asset), which is shifting. Fire insurance passes the loss to the insurer, which is transfer. Closing the unprofitable overseas unit removes the activity and its exposure, which is avoidance. The order is shift, transfer, avoid.

The hardest tier

Which risks should an organisation retain rather than hedge?

  1. Risks that can be hedged cheaply in the marketWhy not: Cheap hedging is a reason to consider hedging, not a reason to keep the risk. Retention rests on being paid for and understanding the risk.
  2. Risks that are unrelated to its main business activityWhy not: These are incidental risks that earn the firm nothing, so they are the ones to hedge or transfer.
  3. Risks it is paid to bear and has the expertise to manage - correct

A firm earns its profit by taking risks it understands and is paid for. These should be kept. Risks that earn nothing, usually ones outside its core business, are better hedged (offset) or passed on. Rule: keep a risk if the firm has an edge in bearing it and is paid for it. Example: a bank that hedged away all credit risk would have no lending business, but currency risk on a foreign expense earns it nothing, so it is better hedged.

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