The key advantages of working with multiple risk models
And the importance of a second opinion…
The standard definition of risk is the monetary value of the loss multiplied by the likelihood that the loss may happen, where 1 is certainty and 0 impossibility. This basic concept is the starting point of any model assessing financial risks. Their efficacy depends on the size of a portfolio and the type of financial instruments included in it. Any model has its own strengths and weaknesses; for instance, one of the most widely used risk models, Value At Risk (VAR), has limitations when applied to very large portfolios, and it is not additive; a portfolio including two asset types, A and B, does not have a VAR that is the sum of the VAR calculated for asset type A and the VAR calculated for asset type B.
Hedge funds that make money out of managing high-risk portfolio ought to analyse risk according to more than one model to minimise the chances of higher losses (or higher fines) rather than higher rewards.
Even relatively low-risk asset classes may benefit from risk simulations under different logic. For instance, geopolitical risk has an absolute side and a relative side. For example, Iran may have a global geopolitical risk profile; its geopolitical risk profile for a bank in the United Arab Emirates may be different from what a bank based in Qatar needs to consider. Therefore, a multinational bank with operations in several countries, including the United Arab Emirates and Qatar, would want to assess the geopolitical risk using a common framework for all the countries where it operates but may want to use a specific model for the UAE and one for Qatar.
Last but not least, fund managers may be in a position where they must use two different risk models. For instance, the regulatory obligation for a fund depends on the country where the fund is registered, not the country where the project manager is based. So, let us look at the case where Fund Manager XYZ in London, manages Fund A registered in Luxembourg (EU and therefore under Single Market rules), and Fund B registered in the UK (outside the Single Market, following British rules). Operations pertaining to Fund A will have to follow ESMA rules, whereas those pertaining to Fund B will have to follow FCA rules. At the moment of writing this paper, there is very little divergence between the FCA rulebook and ESMA’s, but this situation will not last forever. It is reasonable to expect that the two regulatory bodies will not necessarily evolve in parallel. Therefore, it is entirely possible that they may require two different risk models in the future. This scenario already exists for those cases where a financial institution needs to follow Dodd-Frank (US) and European-based rules since the risk model required by the US is different.
Poor risk management can lead to heavy losses, or heavy fines. Being able to use more than one risk model allows for a fit for purpose risk analysis.
How ALFO SABR can help
ALFO was very aware of the importance of supporting multiple risk models when they developed their software. For ALFO-SABR, each risk methodology is a set of function calls. They are all available in the system, and two risk models can easily co-exist. ALFO SABR will recommend the best one to use among the many that are available.
Users can make their own choice, choices that can co-exist with different views at corporate and group level. For instance, a large group may decide to assess financial risk according to a specific methodology. Individual subsidiaries or country operations may prefer other methods for a variety of reasons, from regulatory obligations to preferring a method better suited to their own business model.
Hedge fund managers can use more than one system to assess financial risk, asset managers can easily meet different regulatory requirements based on the countries where the funds or the clients are located.
ALFO SABR allows users the choice and enables them to manage financial risk according to their own views while using a different model to follow corporate processes and procedures, or regulatory requirements.
Founded in 2021, we’re here to revolutionise the way financial institutions manage risks and stay competitive. Backed by senior executives from the financial markets, our vision is to provide the best and most cost-effective risk management, complex market analysis, and risk automation solutions.
Our clients enjoy pain free access to systems and AI technology they previously thought unattainable and beyond their reach. We make you better, faster. We allow you to do things you thought you could not do.
The ALFO advantage:
- Custom-tailored technology that adapts fluidly to your ecosystem
- Quality and performance essential to compete at any level
- Agility and dynamism to embrace change
- Significant Reduction of Total Cost of Technology Ownership
ALFO SABR is a multi-asset, multi-currency and multi-market real-time risk management and hedging system supporting exchange-traded and OTC instruments. Discover more about ALFO SABR