Managing Risk With VAR

AIM 75.2: Compare the use of VAR as a risk management tool for both the buy side and sell side, respectively, in the investment management industry.

AIM 75.3: Analyze the impact horizon, turnover, leverage, risk measures, and risk controls have on risk management processes in the investment management industry.

The "sell side" of the investment industry largely consists of banks that have developed VAR techniques and have used them for many years. Investors make up the "buy side" of the investment industry. Investors are now using VAR techniques, but they have to adapt them to the different nature of that side of the business. To understand why the needs are different, we should compare the characteristics of the two "sides." Figure 1 makes direct comparisons.

Figure 1: Sell Side and Buy Side Characteristics

Characteristic

Sell Side

Buy Side

Horizon

Short-term (days)

Long-term (month or more)

Turnover

Fast

Slow-

Leverage

High

Low

Risk measures

VAR Stress tests

- Asset allocation Tracking error

VAR limits Stop-loss rules

Diversification Benchmarking Investment guidelines

Banks trade rapidly, which is why they cannot rely on traditional measures of risk that are based upon historical data. For banks, yesterday's risk may not have anything to do with todays positions. Investors usually try to hold positions for longer periods of time (e.g., years).

Having a more dynamic method for measuring risk such as VAR is also important for banks because of their high leverage. Institutional investors often have much stronger constraints with respect to leverage; therefore, they have a much lower need to control downside risk.

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