Article
June 1997: Wall Street and Technology
Institutions Put Value on Risk Practices
Institutional investors' renewed emphasis on risk management and
valuation techniques has opened up a broad new field for software developers.
Institutional investors, including pension plans and fund managers, holding complex portfolios of equities, interest rate, foreign exchange and mortgage-backed securities, are taking a serious interest in risk management technology. Whereas institutions previously relied on third party entities to perform the valuations, they will be more prone to run the analytics and models internally.
Lagging slightly behind their corporate brethren, in November 1996 a consortia of plan sponsors and money managers known as the Risk Standards Working Group, aided by New York-based consultant Capital Markets Risk Advisers (CMRA), produced a document entitled Risk Standards for Institutional Investment Managers and Institutional Investors. The guidelines stress that it is critical for institutional investors to conduct a thorough inventory of where they are at risk; this inventory should include a thorough review of pricing models and methodologies in addition to the systems used to measure risk.
According to one member of the comment group that reviewed a draft of the standards prior to their final publication, "This document, for institutional investors, is very ambitious. Oftentimes, they [institutions] rely exclusively on third party service providers to review their risks. Analytical software is a very new concept for them."
But, the CMRA standards may just be the tip of the iceberg in pushing institutions and pension funds to face up to risk management. On February 18, Rogers Casey Associates, an investment consulting firm which is a wholly-owned subsidiary of Barra, the Berkeley, Calif.-developer of analytical software to the institutional investment community, is now conducting their own exhaustive study of risk management practices in the institutional investor arena. RCB's study will draw on interviews with the 400 largest institutional investors in the US. "The institutional investor community is placing increased emphasis on the integrity of risk policies and practices," says Todd Doersch, president and CEO of RogersCasey Sponsor Services. While the topic of risk management has been much discussed over recent months, what is not known is what institutional investors are actually doing today. RogersCasey's comprehensive risk management study has been designed to begin to assemble that knowledge.
However, based on perceived anecdotal demand for both new risk measurement and valuation tools, increasing numbers of software vendors are developing products that can help institutional investors – funds and pension plans alike – assess their risk and more effectively analyze the investments already on their books. Already, the InvestWorks division of Barra, which has historically focused on helping funds to allocate assets amongst managers with different styles, has released InvestWorks Pro. The Windows-based database allows defined benefit pension sponsors to compare and contrast different investment product types, including accounts, mutual funds and commingled funds. In addition to reviewing investment product performance, InvestWorks also includes a proprietary risk weighting. Barra has plans to incorporate value-at-risk (VaR) and other portfolio risk analytics into subsequent versions of its equity and fixed income software to be released later in the year.
According to a Barra spokesman, its two core products, Aegis for equity risk analysis and Cosmos for fixed income, both are mean variance risk tools, which look at how all the assets in a particular market co-vary together. "They can both produce a distribution of possible outcomes for a one year horizon for any portfolio a manager taps into the screen," he explains. VaR would be the tail-end of a distribution that a fund manager could specify is the worst possible outcome. Barra will give the user the ability to specify the percent of the distribution upon which he wishes to measure VaR.
Jersey City-based Principia Software, which offers a relatively inexpensive turnkey, front through backoffice system known for its high level fixed income analytics, is planning to focus future marketing efforts at the corporate and fund management communities. Says Teresa Adams, the firm's director of marketing, "Corporates and plan sponsors are looking for sophisticated analytics that will let them review the risks associated with structured derivative products, but they do not have the resources to spend on big bank-sized software packages or a lengthy, custom implementation. Principia tries to include a wide range of functionality straight out of the box."
From a risk management perspective, Principia's strengths are twofold: First, the software can price a wide range of complex fixed income and currency instruments. According to product manager John Fry, the way the Principia system stores deals makes it a particularly effective valuation tool. He explains that most systems store complex deals by linking a selection of simple, "component" tickets. A relatively complex deal, he notes, could have upwards of fifty components. For reporting purposes, then, many systems have to link these components and, more critically, users have to know the interrelationships between these components to know what pricing model to use. He says, "Oftentimes, this configuration can result in users attempting to price every component of a deal and then adding them together; this practice usually results in an inaccurate price." By storing even complex deals as single tickets and allowing users to label deals by type, explains Fry, Principia avoids this problem. Similarly, the system offers a selection of risk analytics, including multiple flavors of VaR and scenario analysis.
CMOs and Prepayment Risk
Institutional investors, however, often have needs that go beyond straight equity, interest rate and currency risk management. Many funds and plan sponsors have mortgage-backed securities on their books, and these instruments are notoriously difficult to price. This is because CMOs and other similar securities do not just depend on market factors; instead they rely a great deal on the behavior of investors. Says one Chicago-based fund manager, "We have a portfolio of CMOs on our books left over from the late '80s when they were very popular. However, it is hard to quantify the risk associated with these CMOs, because their price depends a great deal on what prepayment assumptions you use." Prepayment models, which attempt to predict the rate at which mortgage holders will prepay their mortgages, try to quantify such elusive factors such as when mortgage holders are more likely to prepay in order to move, acquire more favorable financing etc.
Software and analytical firms, however, are ready, willing and able to help institutional investors to price and assess the risk associated with CMOs and other mortgage-backed securities. San Francisco-based Espiel Inc., founded by Michael Bykhovsky, who has spent over nine years developing prepayment models for major investment firms, is now offering a state-of-the-art prepayment model which can either be purchased as part of a standalone software package or including additional analytics for mortgage-backed securities. Says Bykhovsky, "We try to describe the underlying processes that go into the prepayment decision, and build our models from there. Then, we use historical market data to test our hypotheses. "
One of the toughest problems in creating a prepayment model, he explains, is that the rules governing prepayment behavior are dynamic, perhaps changing every couple of years. For fund managers with mortgage backed portfolios, this means that the prepayment models they may have been using since the mid-1980s are, for today's market, no longer applicable and cannot be trusted to generate an accurate price. This is what the Risk Standards Working Group document refers to as "model risk," and, according to Bykhovsky, it is important to review and update prepayment models on a regular basis. That is what Espiel is doing, and so far, the firm has accumulated a considerable number of satisfied clients, including Deutsche Bank's New York City office.
Another firm which offers software capable of analyzing mortgage-backed securities as well as complex bonds and derivatives is Chicago-based Derivatives Solutions. Founded in 1991, this firm's software is already used by many mainstream portfolio managers both for valuation and risk measurement. Like Espiel, Derivatives Solutions allows users to view the parameters that go into their prepayment models and adjust parameters as they see fit. Derivatives Solutions is an inexpensive Windows-based package which, like Principia, can be installed quickly and easily. In terms of risk measurement, Derivatives Solutions offers a wide range of scenario and sensitivity analyses, in addition to Monte Carlo distribution analysis.
With regard to prepayment models, Derivatives Solutions provides links to other popular prepayment models, including, for Open Bloomberg users, models based on the "TS+/- 300 Bloomberg Median PSAs" for specific collateral types, the Andrew Davidson Prepayment Model for Fixed Rate and Adjustable Rate Mortgages and proprietary models, which can be incorporated into the Derivatives Solutions system via the product's Dynamic Link Library.
While there is still room for some of the larger software vendors to address the needs of institutional investors, the market for boutique vendors is already heating up.
At the same time, the emergence of two reports – from the Risk Standards Working Group and the RCB study in progress – should reveal what are the current standard risk management practices for institutional investors.
At the very least, these documents could provide supporting evidence for pension sponsors and fund managers who are trying to justify a budget for purchasing risk models and other analytic applications.
Excerpt from chart in same issue:
Vital Statistics
Company: Principia
Products include: Principia (Supports global interest rate, foreign
exchange and equity linked instruments and associated options); special
features include: Historical and closing data feeds available for rates,
spreads, volatilities in multiple markets; Supports path-dependent options;
Flexible user-defined hedging instruments
Address: Principia Partners LLC, Harborside Financial Center, 902
Plaza Two, Jersey City, NJ 07311-3902
Contacts: Theresa Adams, Brian Donnelly (Manager of Trading Services)
@ (201) 946-0300
Fax: (201) 946-0320
Web Site: http://www.ppllc.com
E-mail: info@ppllc.com