Major risk categories to be aware of
DB Advisors Asia Pacific, based in Singapore, has been working with its pension fund clients around Asia, to address their concerns with regard to due diligence and risk management, largely arising from the current financial turbulence. Managing Director Peter Kerger summarises the various risks in question.
• Counterparty risk - risk of failure or bankruptcy of market players that can lead to loss of deposits; OTC derivative contract profits being lost; transaction-based money flows or simply unsettled securities.
• Securities lending and repo risk
Counterparty and contract risk in this space should be a major concern, especially for the larger clients who engage in those activities
• Lack of liquidity or redemption risk associated with private placement funds and many or most hedge fund investments
• (Hidden) accumulating loss risk or valuation risk that can occur from failure to mark to any reasonable market price (private equity and non-listed assets as well as real estate and CDOs) related to transparency and liquidity risk in the broadest sense. This can also accumulate in the listed space, when pricing sources are not monitored for plausibility and this increases directly proportional in times of volatility
• also (hidden) leverage risk is definitely something that investors in CDO space learned over this cycle (…no free lunch)
• as well as the obvious and (hidden) credit default risk, of which many investors believed they had under control, but ignored that stability of ratings and rating transition can be a source of the problem rather than the remedy. In other words: risk in relying on ratings has increased dramatically all the way to what once was deemed free of default risk (AAA/Aaa) and is back in full swing…
• Manager / Model control risk and guideline surveillance, speedy position reporting, daily access to valuation. Single manager or key man risk involves many of the most capable portfolio management houses. It also applies to quantitative models that often lose their footing in times of structural market shifts; just like managers have a certain life cycle
• Serious fraud risk within all offshore and private wealth vehicles (Cayman Islands etc.) Not just here since the Madoff scandal.
• Forex and hedging risk and the failure of the respective methods used or not used: as many Asian clients need to avoid losses from appreciating and depreciating home currencies, resulting in natural imperfect hedging along with high forex volatility (e.g. Korea, Thailand) these are very real risks and not always fully appreciated
• Diversification/ correlation risk - finally, this has become apparent in Q3/4 2008, it hit many consultants and investors across the globe, basically exacerbated by liquidity risk. Asian clients question the validity of RiskMetrics and VaR, given time lags in volatility and the high correlation in stress times. Also the (liquidity) risk of mispricing VaR risks due to market freeze is of great (new) concern and found in across many asset classes now.