Professional Risk Management
Institution-level risk management and portfolio construction
Learning Objectives
Professional Risk Framework
Building institutional-grade risk management systems
Three Lines of Defense
First Line
Portfolio Managers
- • Day-to-day risk monitoring
- • Position sizing decisions
- • Strategy implementation
Second Line
Risk Management
- • Independent risk oversight
- • Risk limit enforcement
- • Stress testing and scenarios
Third Line
Internal Audit
- • Process validation
- • Control effectiveness
- • Regulatory compliance
Risk Governance Structure
Key Components:
- • Risk appetite statement and framework
- • Risk committee with independent oversight
- • Clear escalation procedures and authorities
- • Regular risk reporting to senior management
- • Integration with compensation and incentives
Risk Culture Development
Professional risk management requires cultivating a culture where risk awareness is embedded in all decision-making processes, not just formal risk management functions.
Advanced Portfolio Risk Metrics
Comprehensive risk measurement and monitoring
Value at Risk (VaR)
Statistical measure of maximum potential loss over specific time horizon at given confidence level.
Parametric VaR
Assumes normal distribution, fast calculation
Monte Carlo VaR
Simulation-based, handles complex portfolios
Expected Shortfall (ES)
Average loss beyond VaR threshold, provides better tail risk measurement than VaR alone.
Why ES Matters:
VaR tells you the loss threshold but not how bad losses could be beyond that point. ES fills this gap by measuring expected loss in worst-case scenarios.
Options-Specific Metrics
Gamma-Adjusted VaR
Incorporates convexity effects from options positions
Vega Risk
Exposure to volatility changes across strikes and terms
Theta Decay Analysis
Time decay impact on portfolio value
Correlation Risk
Measuring how correlation changes affect portfolio risk:
Advanced Stress Testing
Comprehensive scenario analysis and stress testing
Scenario Categories
Historical Scenarios
- • 2008 Financial Crisis
- • 2020 COVID Crash
- • 1987 Black Monday
- • 2010 Flash Crash
Hypothetical Scenarios
- • Central bank policy shifts
- • Geopolitical events
- • Sector-specific shocks
- • Liquidity crises
Multi-Factor Stress Testing
Simultaneous stress across multiple risk factors:
Example Stress Scenario:
- • Equity markets: -25% over 5 days
- • Volatility: +150% (VIX 20 → 50)
- • Interest rates: +200 basis points
- • Credit spreads: +300 basis points
- • Correlations: All approach 0.9
Reverse Stress Testing
Identify market conditions that would cause portfolio to fail risk limits:
Dynamic Stress Testing
Real-time stress testing that updates as portfolio composition and market conditions change.
Risk Limits and Control Framework
Comprehensive limit structure and monitoring
Limit Hierarchy
Firm-Level Limits
Maximum risk exposure across all strategies
Strategy-Level Limits
Limits by investment strategy or mandate
Portfolio Manager Limits
Individual trader or portfolio limits
Position-Level Limits
Maximum exposure to single names or sectors
Greeks Limits
Example Professional Limits:
- • Portfolio Delta: ±500 (equivalent share exposure)
- • Portfolio Gamma: ±25 (maximum convexity exposure)
- • Portfolio Vega: ±2,000 (volatility risk in $)
- • Portfolio Theta: -$1,000/day (maximum daily decay)
- • Single Name Concentration: ≤5% of portfolio value
Escalation Procedures
Pre-Trade Risk Controls
Automated systems that prevent limit breaches before they occur:
Professional Portfolio Construction
Institutional approaches to portfolio optimization
Mean-Variance Optimization
Mathematical framework for optimal portfolio allocation given expected returns and risk constraints.
Limitations:
- • Sensitive to input assumptions
- • Assumes normal return distributions
- • Ignores transaction costs and liquidity
- • Historical correlations may not persist
Black-Litterman Model
Enhancement to mean-variance optimization that incorporates market equilibrium and investor views.
Risk Parity Approaches
Portfolio construction based on equal risk contribution rather than equal dollar allocation.
Equal Risk Contribution
Each position contributes equally to portfolio risk
Risk-Weighted Allocation
Higher allocation to lower-risk assets
Factor-Based Construction
Building portfolios based on exposure to systematic risk factors:
Common Factors:
- • Market (beta): Systematic market exposure
- • Size: Small vs large cap preference
- • Value: Value vs growth orientation
- • Momentum: Trending vs mean-reverting
- • Quality: Fundamental strength measures
- • Low Volatility: Risk-adjusted returns
Regulatory and Compliance Framework
Professional standards and regulatory requirements
Fiduciary Standards
Professional money managers have fiduciary duty to act in clients' best interests.
Risk Disclosure Requirements
Comprehensive disclosure of investment risks and methodologies to clients and regulators.
Documentation Standards
Required Documentation:
- • Investment policy statements
- • Risk management procedures
- • Trading and execution policies
- • Compliance monitoring reports
- • Client communication records