CFA Magazine March-April

AIMRs Member Magazine for
Investment Professionals
March/April 2004
Risk
iskyy BUSINESS
Risky BUSINE
BUSINESS
SS
Defying the throes of financial risk
takes sheer grit, unwavering skill,
and a little bit of luck
A creative spin on
risk management
Measuring volatility
in an uncertain world
Modern day derivatives
PLUS
Putting risk measurement in context, the rewards of managing
intangible risk, and explaining risk to private clients

COLUMNS
March/April 2004
3
COVER STORY
In Focus
A new name to solve
an old problem.
24 Risky
BUSINESS
BY TED ARONSON, CFA
The story of risk

management past,
present, and future.
Viewpoint
Risk: The whole
versus the parts.
BY PETER BERNSTEIN
BY CHRISTOPHER WRIGHT
56 Point-Counterpoint
32 Thinking
Should derivative strategies be

used by investment managers only
to lower risk exposures?
Outside the Box

A creative spin on risk management.
BY JOHN MARSLAND, CFA, AND JOT YAU, PHD, CFA
BY SUSAN TRAMMELL, CFA
DEPARTMENTS
36 Weighty Matters
In Summary
Robert Engle on measuring

volatility in an uncertain world.
BY CHRISTINA GROTHEER
Nothing ventured, nothing gained.

Letters
Readers express their views.
Education Calendar
Upcoming AIMR and society events.

Briefs
40 Modern Day
Global Standards
Derivatives
14 AIMR expands GIPS standards
A new twist on an
ancient concept.
to private equity.
16 IPC seeks comment on updated
BY JOHN RUBINO
GIPS standards.
Advocacy
Professional
Asia-Pacific
PRACTICE
44 Portfolio Performance
50 Private Client Corner
Putting risk measurement in context.
Explaining risk to private clients.
BY CYNTHIA HARRINGTON, CFA
BY ED MCCARTHY
46 Analyst Agenda
52 Ethics Forum
The rewards of managing

intangible risk.
Can regulatory reform change

Wall Street?
BY JONATHAN BARNES
BY STEPHEN BROWN, CFA
48 Trading Tactics
AIMR, member, and society news.
54 Standards in Practice
QFII rules open Chinese markets

to institutional investors.
Shareholder engagement grows

in the UK.
BY NANCY OPIELA
BY MARK HARRISON, CFA
17 Australia set to legislate new auditor

rules, corporate disclosure.
Europe
18 Europe remains divided on adoption

of accounting standards.
United States
20 NYSE at center of controversy

and restructuring.
Canada
22 Wise Persons Committee supports

creation of national regulator.
IN SUMMARY

March/April 2004
And the day came when the risk to remain tight in a bud was
more painful than the risk it took to blossom.
Anais Nin
Given that risk is a fundamental part of investing, the best
that we can do is to take calculated risks. Such thinking has
given rise to what is commonly known as risk management.
For a primer on the subject, be sure to read Risky Business (p. 24). This article traces the evolution of the field and
recounts the lessons to be learned from cataclysmic events such as the collapse of
Long-Term Capital Management.
While the fear of such fat tail events
can make even the most confident investor
weak in the knees, there is no shortage of
experts in this area to lend critical insights.
One such expert is Peter Bernstein,
who shares his personal belief that victory
in the long run accrues to the humble
rather than to the bold in his perspective piece, Risk: The
Whole Versus the Parts (p. 5).
Another expert is Robert Engle, whose Nobel prize-winning ARCH model is helping practitioners more accurately
predict volatility, as told in Weighty Matters (p. 36).
Such models are undoubtedly an essential part of a practitioners tool kit. However, the import of human discernment
cannot be overemphasized, particularly when it comes to risk
management.
This message comes through loud and clear in Thinking
Outside the Box (p. 32), which profiles three firms offering
outsourced risk management services, each with its own creative spin on coupling theory with practice.
Similarly, Modern Day Derivatives (p. 40) tells of the
ancient roots of these popular and controversial riskreduction instruments, and explores the myriad ways that
they are being applied by innovative investors today.
Finally, our Professional Practice section features a number of other articles related to risk management, including
Putting Risk Measurement in Context (p. 44), Risk Management and Valuation (p. 46), and Risk Management for
Private Clients (p. 50).
The only thing thats really certain is that this is a profession fraught with risks. And how you respond tight in a
bud or in full bloom is up to you.
AIMR PRESIDENT & CEO
DIRECTOR OF DESIGN & PRODUCTION
Tom Bowman, CFA

tom.bowman@aimr.org
Lisa Smith
lisa.smith@aimr.org
EDITOR
GRAPHIC DESIGN
Derik Rice
derik.rice@aimr.org
Communication Design, Inc.

tim@communicationdesign.com
CONTRIBUTING EDITOR
ONLINE PRODUCTION COORDINATOR
Christina Grotheer
c.grotheer@earthlink.net
Kara Morris
kara.morris@aimr.org
COPY EDITOR
ADVERTISING MANAGER
Robin Cheslock
rjcheslock@cs.com
Jenine Kaznowski
jenine.kaznowski@aimr.org
EDITORIAL ASSOCIATE
ADVERTISING SALES
Lori Pyle
lori.pyle@aimr.org
Ray Coppola
CoppolaGP@aol.com
EDITORIAL ADVISORY TEAM
Shanta Acharya
Bashir Ahmed, CFA
Jim Allen, CFA
Jonathan Boersma, CFA
John Cabell, CFA
Jarrod Castle, CFA
Michael Chan, CFA
Michael Cheung, CFA
Josephine Chu, CFA
Franki Chung, CFA
Darrin DeCosta, CFA
Nick Dinkha, CFA
Jerry Donohue, CFA
Alison Durkin, CFA
Kenneth Eisen, CFA
William Espey, CFA
Julie Hammond, CFA
Jody Hansen, CFA
M. Mahboob Hossain, CFA
Vahan Janjigian, CFA
Andreas Kohler, CFA
CFA Magazine (ISSN 1543-1398, CPM 400314-55) is published bimonthly

in January, March, May, July, September, and November by the Association
for Investment Management and Research (AIMR). Periodicals postage
paid at Charlottesville, VA, and additional mailing offices. POSTMASTER:
Send address changes to CFA Magazine, PO Box 3668, Charlottesville, VA
22903-0668.
Statements of fact and opinion are the responsibility of the authors
alone and do not imply an endorsement by AIMR.
Copyright 2004 by AIMR. All rights reserved. Materials may not be
reproduced or translated without written permission. CFA, Chartered
Financial Analyst, and the AIMR logo are just a few of the trademarks owned
by AIMR. See www.aimr.org for a complete list.
Annual subscription rate for AIMR members is US$10, which is included in the membership dues. Annual nonmember subscription rate is US$75.
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DERIK RICE
Editor
derik.rice@aimr.org
CFA
Aaron Lai, CFA

Kate Lander
Alecia Licata
Casey Lim, CFA
Michael Liu, CFA
Bob Luck, CFA
Mark Mak, CFA
Trevor Mak, CFA
Dennis McLeavey, CFA
Roger Mitchell
Sudip Mukherjee
Jerry Pinto, CFA
Linda Rittenhouse
Christina Haemmerli Schlegel, CFA
David Shen, CFA
Larry Swartz, CFA
Jacky Tsang, CFA
Gary Turkel, CFA
Raymond Wai Pong Yuen, CFA
James Wesley Ware, CFA
Jean Wills
MAGAZINE / MARCH-APRIL 2004
COVER PHOTOGRAPHY
Getty Images 2004
VOL. 15, NO. 2
Nothing Ventured,
Nothing Gained
In Focus
CFA Institute New Name
to Solve an Old Problem
BY TED ARONSON, CFA
More than 75 percent

of you want the
letters CFA in the
organizational name.
Thats what we get
with CFA Institute
TED ARONSON, CFA
AIMR Chair
nyone who has ever gone through the process of selecting a name for
a child should be able to appreciate the discussion our organization has
gone through over the past several months. Even with just two people
involved with the selection of a childs name a mother and a father
the process still usually goes on for months. And then the family gets into the
action: your parents suggest one name, your sister has a better idea, and your great
aunt has promised the child her inheritance, but only if the child is a girl and
shares the aunts name!
Well, folks, were in the last trimester here and its time that we settle on a single name. Fortunately, we have arrived at a single name: CFA Institute. It was never
in doubt that we would include the letters CFA in the new name, which was our
starting point. Discussion since then has centered around how we should qualify
CFA. Some thought the qualifier should be international, as in CFA International. Others thought it should be institute, as in CFA Institute. Now, with the
whole family behind us members, societies, the Board, and the professional staff
its time to name this child and put him/her to bed:
CFA Institute
Setting a higher standard for investment professionals worldwide
Let me take you back, for a moment, to 1990 when AIMR was formed. It was
then that AIMR governor Charley Ellis, CFA, wrote in a letter to then CEO Pete
Morley, CFA, that he thought AIMR was a good name. A good name, he said,
until we could come up with a better one.
For the subsequent 14 years we have listened to members say that the name
AIMR was inadequate. It wasnt descriptive of the membership. It didnt leverage
our greatest asset, the CFA designation. And, more recently, our public awareness
campaign has shown us that promoting two brands AIMR and CFA is confusing to outside audiences and ultimately leads to confusion among the very people
whose perceptions our communications programs attempt to shape.
Member perception is crystal clear on this issue: you want wider recognition
of the CFA designation, identifying this as one of your top three priorities for the
organization. And more than 75 percent of you want the letters CFA in the organizational name. Thats what we get with CFA Institute, which meets all the requirements we set out to fulfill when we began this discussion last July: its memorable; its
distinctive and instantly recognizable; it is directly linked to the CFA designation.
If I needed additional reassurance that changing our name to align with the CFA
brand was the right thing to do which I didnt I was convinced by the aforementioned public awareness studies, which showed that when investors are presented with two brands AIMR and CFA their recall of either is severely hampered.
Even if I had been a supporter of keeping the name AIMR which I have not
been I would have been convinced to change my mind when more than 75 percent of members said they would vote in favor of a name change that incorporates
the letters CFA.
And if I preferred another name over CFA Institute, which, in fact, I did I
originally favored CFA International my preference has changed. I am willing to
put aside my initial favorite if that is what must be done for the name change to be
approved by members.
The comparison going forward should not be to any name other than AIMR.
Its CFA Institute versus AIMR. I will vote for CFA Institute, and I hope you will
as well.
CFA
LETTERS
Agree However
I agree completely with the concept of a name change [for

AIMR]. We operate a small firm near Mobile Alabama where
there is no awareness of the distinction between the CFA
charter and any other string of letters behind someones name.
However, after reviewing names for similar national organizations, it seems that CFA International does not meet the mark.
I recommend International Institute of Chartered Financial
Analysts, which has a more professional sound to it.
Mark Davidson, CFA
Daphne, Ala., USA
Disagree But
I disagree with Tom Bowmans support of changing AIMRs

name to CFA International. The conclusion for promoting
the name change is not supported by the premise. The premise, as stated by Tom and AIMR, is the need to raise awareness
and wider recognition of the CFA designation. The recommendation of changing the AIMR name to CFA International
does nothing of the sort. It actually leverages I would even
suggest hijacks the CFA designation and its brand power
to promote the association. AIMR has taken great steps
over its history to protect the use of the designation, including limiting the use of the designation only in appropriate
formats, as well as limiting its use as a noun. Given this, its

hard to imagine that the association would consider using the
CFA designation as the only noun in its proposed new name.
If a name change has to occur, I would suggest the historical
and more appropriate Institute of Chartered Financial Analysts (ICFA).
Dimitri Triantafyllides, CFA
Charlotte, NC, USA
AIMRS RESPONSE
Thank you to both Mr. Davidson and Mr. Triantafyllides on their
letters regarding the proposed name change. Though the name
CFA International did have strong support of the membership,
the name CFA Institute had similar support and was the overwhelming preference of AIMR societies. Though the Institute of
Chartered Financial Analysts one of AIMRs predecessor
organizations might have been a favorite, use of the term
Chartered Financial Analysts is a violation of the trademark
protection in place for the CFA designation and thus was a nonstarter for our discussions.
Please see the message from AIMR Chair Ted Aronson, CFA,
on page 3 and the article on page 9 for more information on the
Boards decision to bring the name CFA Institute to a vote as a
replacement for AIMR.
[Advertisement]
CFA
Viewpoint
Risk: The Whole Versus the Parts
BY PETER BERNSTEIN
any years ago, in the middle of a staff meeting, a

colleague passed me a scrap of paper on which
he had written, When all is said and done,
more things are said than done. When I consider the plethora of books, articles, consultants, and conferences on risk in todays world, my friends aphorism has
never seemed more appropriate. Are we never going to nail
risk down and bring it under control? How much more can
anyone reveal to us beyond what we have already been told?
In a very real sense, this flood of material about risk is
inherently risky. Sorting out the pieces and searching for
main themes has become an escalating challenge. The root of
the matter gets lost in the shuffle while we are analyzing all
the elegant advances in risk measurement and the impressive
broadening of the kinds of risks we seek to manage. More is
said than is done, or what is done loses touch with what has
been said.
If we go back to first principles for a moment, perhaps
we can put the multifarious individual pieces into some kind
of a larger framework and optimize the choices among the
masses of information we are attempting to master.
Professor Elroy Dimson of the London Business School
once said risk means more things can happen than will happen. Dimsons formulation is only a fancy way of saying that
we do not know what is going to happen good or bad.
Even the range of possible outcomes remains indeterminate,
much as we would like to nail it down. Remember always:
Risk is not about uncertainty but about the unknown, the
inescapable darkness of the future.
If more things can happen than will happen, and if we
are denied precise knowledge of the range of possible outcomes, some decisions we make are going to be wrong. How
many, how often, how seriously? We have no way of knowing even that. Even the most elegant model, as Leibniz
reminded Jacob Bernouilli in 1703, is going to work only
for the most part. What lurks in that smaller part is hidden
from us, but it could turn into a load of dynamite.
The beginning of wisdom in life is in accepting the
inevitability of being wrong on occasion. Or, to turn that
phrase around, the greatest risks we take are those where we
are certain of the outcome as masses of people are at classic market bottoms and tops. My investment philosophy has
always been that victory in the long run accrues to the humble rather than to the bold.
This emphasis on ignorance is the necessary first step
toward the larger framework we need if we hope to sort out
the flood of information about risk that assails us. Now we
can break down the problem of risk into what appear to me
to be its three primary constituent parts.
CFA
First, what is the balance between the consequences of

being wrong and the probability of being wrong? Many mistakes do not matter. Other mistakes can be fatal. No matter
how small the probability you will be hit by a car when you
cross against the lights, the consequences of being hit
deserve the greater weight in the decision. This line of questioning is the beginning, and in some ways the end, of risk
management: All decisions must pass through this sieve. It is
the end if you decide not to take the risk, but it is also the
end in the sense that distinguishing between consequences
and probabilities is what risk management is all about.
Second, expect the unexpected. That sounds like an
empty clich, but it has profound
meaning for risk management. It is
easy to prepare for the risks you
know earnings fail to meet expectations, clients depart, bonds go
sour, a valued associate goes to a
competitor. Insurance and hedging
strategies cover other kinds of risks
lying in wait out there, from price
volatility to premature death.
But preparation for the unexpected is a matter of the decisionPeter Bernstein
making structure, and nothing else.
Who is in charge here? That is the critical question in any
organization. And if it is just you there when the unexpected
strikes, then you should prepare in advance for where you
will turn for help when matters seem to be running out of
control.
Finally, note that word control. With an exit strategy
when decisions are easily reversible control over outcomes can be a secondary matter. But with decisions such as
launching a new product or getting married, the costs of
reversibility are so high that you should not enter into them
unless you have some control over the outcome if things
turn out differently from what you expect. Gambling is fun
because your bet is irreversible and you have no control over
the outcome. But real life is not a gambling casino.
These three elements are what risky decisions are all
about consequences versus probabilities, preparation for
dealing with unexpected outcomes, and the distinction
between reversibility and control. These are where things get
done, not said.
Peter Bernstein is the founder and president of Peter L. Bernstein, Inc., which he established in 1973 as economic consultants
to institutional investors and corporations around the world.
EDUCATION CALENDAR
ASIA-PACIFIC
WESTERN CANADA
27 March
22 April
24 April
Derivatives
PD CREDITS: 2.5
Evolution of the Private

Equity Market
H O N G KO N G S O C I E T Y
C A LG A RY S O C I E T Y
Internet and Media
19 May
PD CREDITS: 2.5
Global Population Developments and Implications

for Investments
5 April
B O STO N S O C I E T Y
7 April
Asset Management
Industries in China
NORTHEASTERN US
PD CREDITS: 2.5
15 March
EUROPE, MIDDLE EAST, & AFRICA

29 April
15 March
8 April
Enhancing Phone Skills
Co. Presentation:
Staples Inc.
Speaker: Dr. Edgar Loew
Regulatory Reform
and the Road Ahead
PD CREDITS: 1.5
N E W YO R K S O C I E T Y
13 April
16 March
Speaker: Dr. Joerg Wulfken
GE RMANY SOCIETY
Benchmarking Corporate
Governance in
Portfolio Analysis
P H I L A D E L P H I A , PA . , U S A
14 April
H A RT F O R D S O C I E T Y
EASTERN CANADA
17 March
Impact of Options
Accounting on EPS
MONTREAL SOCIETY
B O STO N , M A S S . , U S A
15 April
Co. Presentation:
Deutsche Telekom
18 March Broad-Based Employee

Stock Compensation
Conference
MONTREAL SOCIETY
PD CREDITS: 7
15 April
Asset-Backed Securities
PD CREDITS: 1
22 April
Regulation of Hedge
Funds
29 April
The Failing Wall Street

Model
PD CREDITS: 1
Forecast Dinner
MONTREAL SOCIETY
Effective Communication
and Presentation Skills
PD CREDITS: 6
29 March Behavior of Institutional

Investors
MONTREAL SOCIETY
10 June
Co. Presentation: Bank of

America
25 March
MONTREAL SOCIETY
26 May
International Trust and

Estate Applications
PD CREDITS: 3
12 May
Reversal of Fortune:
Housing and the Economy
PH ILADELPH IA SOCIETY
18 March Speaker: Dr. Lee Thomas
PD CREDITS: 1
31 March
The New World of Pension

Fund Management
PD CREDITS: 8
MONTREAL SOCIETY
Investing in the REIT

Industry
PD CREDITS: 1
16 March
PD CREDITS: 2
24 March Technical Analysis
Sustainable Success for

Your Investment
Management Firm
PD CREDITS: 8.5
GE RMANY SOCIETY
26 May
Resurgence of Interest in
Private Equity: Quo Vadis
PD CREDITS: 7
C A LG A RY S O C I E T Y
22 May
Speaker: William
Nemerever, CFA
29 April
30 March The State of the US

Consumer
Wealth Management
Conference
PD CREDITS: 6
H A RT F O R D S O C I E T Y
SOUTHEASTERN US
CENTRAL CANADA
20 April
Evolution of the Private

Equity Market
1 April
16 March
S A S K ATC H E W A N S O C I E T Y
Selecting and Evaluating

Outside Managers
CFA
Co. Presentation: Lexmark

LO U I SV I L LE S O C I E T Y
EDUCATION CALENDAR
17 March
Speaker: Peter Brooks
29 April
RICHMOND SOCIETY
Speaker:
Marty Fridson, CFA
23 March Speaker: Thomas Berghage

PD CREDITS: 1.5
ST. LO U I S S O C I E T Y
S A N F R A N C I S CO S O C I E T Y
24 March Speaker: David Gladstone

W A S H I N G TO N S O C I E T Y
6 April
6 May
Speaker: Chuck Hill, CFA
Speaker: Michael
Mauboussin
S E AT T LE S O C I E T Y
C H I C AG O S O C I E T Y
25 March
Speaker: Alan Lacy, CFA
Using Markets to Forecast

Markets
PHOENIX SOCIETY
RICHMOND SOCIETY
20 May
6 April
24 March Forecast Dinner
Speaker: Chuck Hill, CFA

26 May
8 April
Speaker: Frederick Coble
Speaker: Richard Bernstein
13 April
RICHMOND SOCIETY
8 June
13 April
Speaker:
Marty Fridson, CFA
N A P LE S S O C I E T Y
Speaker: Mark Tibergien

PD CREDITS: 1.5
Speaker: Richard Hokenson

WESTERN MICHIGAN CHAPTER
9 June
22 April
Speaker: Richard Hokenson
Investment Presentations
for Financial Professionals
P O RT L A N D S O C I E T Y
D E T RO I T S O C I E T Y
21 April
Speaker: Dr. William Ford

N A S H V I L LE S O C I E T Y
21-22 April Accounting Tomfoolery

and Financial Statement
Analysis
5 May
Speaker: Dan Fuss, CFA
Speaker: Bob Steers

11 May
9 May
8 April
Research for the

Practitioner III
DA L L A S S O C I E T Y
PD CREDITS: 4
Speaker: Paul Stevens

16 March
PD CREDITS: 1.5
17 March
Speaker: Steve Leuthold

PD CREDITS: 1
TUCSON CHAPTE R
P O RT L A N D S O C I E T Y
18 March Speaker: Phil Fortuna

PD CREDITS: 1.5
W E ST M I C H I G A N C H A P T E R
Speaker: David Dreman

15 April
If your region or society is not listed

here, please ask your program chair to
submit your societys educational programs to cfamag@aimr.org for inclusion
in the next issue.
18 March Rebalancing Theory and

Practice
ST. LO U I S S O C I E T Y
25 March
D E N V E R , CO LO . , U S A
Leadership and Culture

in Investment Firms
MIDWESTERN US
24 March Speaker: James Dean
AIMR Annual Conference

PD CREDITS: 14
18 March Speaker:
Jeff Diermeier, CFA
9-12 May
WESTERN US
Co. Presentation:
WCI Communities
Speaker: Fred Hassan
Interest Rate Derivatives
D E N V E R , CO LO . , U S A
15 April
N A P LE S S O C I E T Y
19 May
5 May
PD CREDITS: 1.5
24 March Speaker: Don Luskin
N O RT H C A RO L I N A S O C I E T Y
22 April
Speaker: Liz Anne Sonders
SOUTH CENTRAL US
23 March Volatility as a Source

of Returns
LO S A N G E LE S S O C I E T Y
Speaker: Ben Bernanke

CFA
AIMR CONFERENCE: For details, visit

www.aimr.org/conferences. Or, to
register by phone, call 800-247-8132
or 434-951-5500.
SOCIETY EVENT: For details, visit
www.aimr.org/socservices/socindex.asp,
or e-mail societyprograms@aimr.org.
PD CREDITS: Event qualifies for the

designated number of credit hours
in AIMRs Professional Development
Program.
AIMR
BRIEFS
In Memoriam
James Fletcher, CFA, a longtime society leader and volunteer, died on 24 December
2003 at his home in Altadena, Calif., USA. He was 63.
Fletcher was senior vice president of investments for Smith Barney, where he specialized in institutional relationships. He began his career at Hornblower & Weeks and
had worked at Smith Barney or its predecessor organizations
for many years.
During his tenure at Smith Barney, Fletcher enrolled in
the CFA Program and was awarded his charter in 1987. He
was elected to the Board of Governors of the Los Angeles Society of Financial Analysts (LA Society) in 1989, and held a host
of society positions before becoming president in 1994-1995.
Always a strong believer in the value of education,
Fletcher expanded the LA Societys educational offerings substantially during his tenure as president. One of Jims most
interesting program innovations was a luncheon during which
the management of two or three smaller capitalization companies presented, says Frank Dohn, CFA, former LA Society president and AIMR Governor. These presentations were among the most successful of their time.
In addition, he created and taught for many years the Foundations of Investments
course, which generated consistent revenue for the LA Society and provided increased
visibility in the broader business community. Fletcher also created the LA Societys
annual CFA charter recognition event and two awards the Emerging Leader Award
and the Most Valuable Committee Member Award, which are annually presented by the
LA Society Board of Governors. Recently, the LA Society voted to re-name the Emerging
Leader Award in his memory and honor.
A tireless supporter of the CFA Program, Fletcher worked constantly to advance the
program within Smith Barney, and volunteered as a CFA exam grader from 1994 to 1998.
He is survived by his wife, Laura, and two sisters.
AIMR
On the Web
The Research Foundation of AIMR
encourages education for investment practitioners worldwide and
funds, publishes, and distributes relevant research. Visit the Research
Foundation website at www.aimr.org/
research/index.html to learn more
about the Foundation and its products, to submit research topics you
would like to see addressed, to read
about the currently funded research
projects or the 11 September Memorial Scholarship Fund, or to make a
donation in support of current and
future relevant research. You can
even apply for research funding of
your own under the Proposal Submission Guidelines section.
AIMR Member Resigns

Effective 24 January 2004, Gary L. Pilgrim
of Pennsylvania, USA, resigned his CFA
charter and AIMR membership in the
course of an AIMR Professional Conduct
Program inquiry.
New CFA Advertising Campaign Goes Live

CFA Spells Trust.
That is the theme of the
next generation of the CFA advertising campaign, which went live
to audiences across the global
investment community in February. Television ads target highnet-worth investors in North America, depicting two situations
where people can benefit from seeking professional advice. In
one television spot, a diner relies on the advice of a sommelier to
select the ideal wine to complement a fine-dining experience. In a
second television ad, a struggling golfer finds his best game
only after making use of the expertise available to him from the
club professional. In both instances, a narrator makes the comparison to investing and the importance of looking for the CFA
designation in the selection of an investment adviser.
Radio and print advertisements pull from the same creative
strategies, which were tested with audiences of high-net-worth
investors and investment professionals prior to their production.
The radio ads will run primarily in North America while print ads
will run in markets around the world.
CFA
Aronson Interviewed
on Canadian Television
After a December meeting with officials at the Ontario Securities Commission, AIMR Chair Ted Aronson, CFA, spoke
about the need to include investment professionals particularly CFA charterholders on corporate boards during
an interview on Canadas ROB-TV. Who better to guide a
corporation than professional investors? asked Aronson,
who suggested the investment expertise and ethical
grounding of CFA charterholders uniquely positions them to
represent investors interests on corporate boards. Aronson
also took the opportunity to speak out on recent allegations of abuse by mutual funds, saying that if investment
professionals would pay attention to [AIMRs] rules,
requirements, and ethical standards, the markets would be
better [off ] with higher standards of integrity.
The television interview is available for viewing in the
Press Room of the AIMR website.
AIMR
BRIEFS
Members Overwhelmingly Support Name Change

In a January 2004 survey of AIMR
issue over the years, that a new name
members, more than 75 percent of
CFA Institute would be a positive
respondents said they would vote in
step in aligning the organization with
favor of changing the organizations
our primary brand.
name from AIMR to a name that incorIn the survey of members, support
porates the letters CFA. At a 6 Februwas about equal for two names: CFA
ary 2004 meeting,
Institute and CFA
the AIMR Board of
International,
Governors unaniAt issue here is whats which was the
mously selected
original recommenbest for the CFA charter, dation of a brandCFA Institute as
the name they will
ing consultant that
whats best
bring to members
was commissioned
for the organization,
for a vote at the 9
to lead the study.
May 2004 annual
At the Board meetand whats best for
meeting in Denver,
ing, the scales ultiindividual members.
Colo., USA.
mately tipped in
With 75 perfavor of CFA InstiTOM BOWMAN, CFA
cent of members
tute because of its
AIMR President and CEO
saying the organistrong support
zations name
from society leadshould be changed,
ers and because
you give members what they want,
Board members felt it was more represays AIMR President and CEO Tom
sentative of the organization.
Bowman, CFA. At issue here is whats
Adopting the name CFA Institute
best for the CFA charter, whats best
will have many benefits, according to
for the organization, and whats best for
Bowman, but none more important
individual members. It is clear from
than focusing more attention on the
what members have told us and from
CFA brand. Members repeatedly tell
what weve learned in studying this
us they want more recognition of the
CFA designation among employers,

among private investors, and among
the general public, says Bowman.
We have a multi-million-dollar public
awareness campaign in place. That
money is far better invested in promoting a single brand CFA to the
investment community.
Should members vote in favor
of the name change, the organization
plans to launch its re-branding campaign on 1 September 2004.
Gravel Nominated to Chair AIMR Board of Governors

Monique Gravel, CFA, of CIBC World Markets in Montreal, Quebec, Canada has
been nominated to chair the AIMR Board of Governors for the 2005 fiscal year,
which begins 1 September 2004. Members will select a chair, a vice chair, and five
additional governors at the AIMR annual meeting to be
held 9 May 2004 in Denver, Colo., USA. John Stannard,
CFA, of the Frank Russell Company in London, UK, has
been nominated to serve as vice chair. Gravel and Stannard will be joined on the 2004 proxy by four new nominees who would serve three-year terms if elected: Jose
Luis Velasco, CFA; Brian Singer, CFA; Margaret Franklin,
CFA; and Sam Jones, CFA. Current governor Vincent
Duhamel, CFA, has been re-nominated for a second
Gravel
Stannard
three-year term on the Board as has Gravel, whose first
term will expire 1 September 2004. Biographical information and voting procedures
will be contained in AIMRs 2004 proxy, which is scheduled to mail to all voting
members in mid March.
CFA
Notice of
Disciplinary Action
On 6 November 2003, AIMR imposed
the sanction of Prohibition from Participation in the CFA Program upon
Glenn H. Downen, pursuant to a
Stipulation and Offer of Consent for
Disciplinary Action.
AIMR found that Downen violated the AIMR Code of Ethics and
Standards of Professional Conduct,
Standard II(B) Professional Misconduct and Standard IV(B.6) Prohibition against Misrepresentation.
Downen enrolled to take the
2002 Level II CFA examination.
Although he was enrolled for the
2002 exam, Downen failed to take
the exam he was a no show.
Although he did not take the Level II
exam, Downen created a document,
purportedly from AIMR, that represented he passed the 2002 Level II
CFA exam. He presented this document to his supervisor and also verbally represented to his supervisor
that he passed the Level II CFA exam.
Downen received a compensation
increase for passing Level II of the
exam. Downens employer subsequently investigated the matter and
his employment was terminated.
Downen has consented to this
sanction and the publication of this
notice.
AIMR
BRIEFS
Investing in Yourself Event Offers Career-Savvy Advice

BY SUSAN WEINER, CFA
s investment professionals develop their careers,

they must consider industry trends and learn new
skills. Industry executives, career consultants, and
recruiters sounded these themes at AIMRs inaugural Investing in Yourself event, co-hosted by the Boston Security
Analysts Society, on 21 January 2004, in Boston, Mass., USA.
Here are some highlights of the gathering, which attracted a
capacity crowd of 425 participants.
Slower Growth Impacts Careers
Whats more, fund firms are considering additions in risk

management, controls, and compliance. As for institutional
firms, theyre making offers in sales, marketing, and, to a lesser extent, client relationship management in preparation for
raising assets. For these roles, a Rolodex, product-specific
experience, and a high level of credentials [such as the CFA
designation] are required, says Raynor.
From Gorogs perspective, Most hiring is focused on
strategic upgrading of key roles, [with an emphasis] on getting the manufacturing side of the house in order. For example, portfolio management team lift-outs are increasing for
those with strong track records.
Although investment managements projected growth rate of

Ongoing Professional Development Key
8 percent for the next decade compares favorably with other
Career development doesnt stop once an applicant lands a
industries, it is a significant drop from the 16 percent growth
job. The skills required for success change with new roles.
of the past decade, according to Mark Mandel, CFA, director
There are two S-curves in the development of an investment
of global industry research at Wellington Management Commanagement leader, according to Terry
pany in Boston, Mass., USA.
Bacon, PhD, founder, CEO, and presiAccordingly, slower growth is
dent of the Lore International Institute in
already making hiring more volatile.
Misconduct in the
Durango, Colo., USA the lower and
Mandel believes that job specialties will
mutual fund industry
upper S-curves.
continue to go in and out of favor, just
For an analyst, the best way to have
as demand for growth stock managers
has opened doors to
impact is to have the right answers,
rose and fell with their funds performhiring experienced
[whereas performance is key for portfolio
ance. As in other mature industries,
managers], says Bacon. And, generally
Specialization will be a mantra, says
senior executives for
speaking, quantitative, analytical, comMandel. People will gain an edge by
leadership roles.
munication, and decision-making skills
knowing a lot about a little, [especially
count more than softer skills, according
in research]. For example, Mandel sugto Bacon.
gests that specialties could become as
In the move from team leader to
narrow as Brazilian corporate bonds.
chief investment officer, leadership of people or of an organiFor investment professionals in the United States, the
zation comes to the fore because delighted clients are
greatest growth opportunities are predicted to be overseas.
power. Says Bacon, [Regardless of where leaders work],
Consequently, having global skills, such as speaking foreign
they take people to places they would not have gone by themlanguages or knowledge of foreign accounting, taxation, and
selves and inspire people to outperform their capabilities.
regulation, will help. Mandel recommends that research job
Shifting from the first S-curve to the second can be
candidates analyze a non-US company to illustrate their skills.
tough. It often requires leaving behind what attracted you
With capital market returns estimated to run in the sinto the profession in the first place, says Bacon. People who
gle digits for the next five to 10 years, Mandel believes that
are drawn to investment management are often not extrovertleaner organizations will depend more heavily on employee
ed types.
teamwork, creativity, and resourcefulness. Also, according to
Bacon concluded with recommendations for developing
Robert Gorog, a partner at Heidrick & Struggles in Boston,
leadership skills through self-study, leadership education,
Mass., USA, slower growth is widening the compensation gap
mentoring, peer interactions, and coaching.
between the best-paid employees and the rest of the company.
For further information on specific presentations, visit
Current Job Outlook
the Boston Security Analysts Societys Career Center at
According to both Gorog and Kim Raynor, executive director,
www.bsas.org/careers/career_center.asp.
Russell Reynolds Associates in Boston, Mass., USA, hiring is
rebounding, although slowly and selectively. Raynor says that
Susan Weiner, CFA, is a former director of investment communimisconduct in the mutual fund industry has opened doors to
cations for an investment management firm in Boston, Mass., USA.
hiring experienced senior executives for leadership roles.
10
CFA
AIMR
BRIEFS
MEMBERS
On the Move
The PNC Financial Services Group Inc.
in Pittsburgh, Pa., USA, announced that
James Allen, CFA, has been elected as
chairman and chief executive officer of
Hilliard Lyons, Louisville, Ky., USA. Currently president of the firm,
Allen has served the
organization for 23 years
in various leadership
positions. Most recently,
he has been the director
Allen
of Hilliard Lyons Asset
Management, a trust
division of PNC Bank NA, and an affiliate of JJB Hilliard, WL Lyons Inc.
Spectrum Control Inc., a leading
designer and manufacturer of electronic
control products and systems based in
Fairview, Pa., USA, announced in
November 2003 the appointment of
Paul Bates, CFA, to its board of directors. Bates currently serves as a portfolio manager for the Erie Insurance
Group in Erie, Pa., USA.
Debra Fiakas, CFA, recently founded Crystal Equity Research, a New York,
NY, USA-based research resource on
small capitalization stocks. Fiakas will
be providing research coverage of smaller companies, mostly in the communications, networking, and electronics sectors. Previously, Fiakas was a research
analyst and investment banker specializing in the micro- and small-cap sector.
Blaylock-Abacus Asset Management Inc. in New York, NY, USA a
women- and minority-owned money
management firm specializing in fixedincome assets welcomes Deborah
George as managing director of marketing and client service. George brings more
than 20 years of investment industry experience. Most recently, she
was vice president and
director of marketing
and client service at
George
Philippe Investment
Management Inc., also in New York.

In December 2003, Bed Bath &
Beyond Inc. in Union, NJ, USA,
announced the election of Jordan
Heller, CFA, to the companys board of
directors, expanding the board to 10
members. Heller is a managing director
at American Economic Planning Group
Inc. in Watchung, NJ, USA, where he
focuses on comprehensive financial and
estate planning for individuals and
businesses.
In January 2004, Jenkintown, Pa.,
USA-based Pitcairn Trust announced
that Sandon Herzlich,
CFA, has joined the
company as vice president, wealth management sales. Herzlich will
be responsible for advocating and facilitating
new client relationships
for investment manage- Herzlich
ment, trust and estate
services, and financial planning. Prior
to joining Pitcairn Trust, Herzlich
served as manager of business development for the asset management services
area within The Vanguard Group in
Malvern, Pa., USA.
New York, NY, USA-based Forbes
announced the promotion of Vahan
Janjigian, CFA, to vice president and
executive director of
Forbes Investors Advisory Institute (FIAI).
Janjigian has been with
Forbes since 1997 as
director of FIAI, where
he also serves as editor
of the Forbes Growth
Janjigian
Investor and the Forbes
Special Situation Survey.
Janjigian also serves on AIMRs US
Advocacy Committee.
George Klar, CFA, recently joined
Legg Mason Canada Inc. in Toronto,
Ontario, Canada, as vice president of
institutional client service and marketing. Klar has been actively involved in
CFA
the Canadian investment management

industry for more than 20 years as a
portfolio manager,
investment consultant,
and, most recently, as
partner at Beutel, Goodman & Company, also
in Toronto.
Patrick Mars, CFA,
has been appointed as a
member of the board of Klar
directors of Endeavour
Mining Capital Corp. based in George
Town, Grand Cayman, BWI. Mars is
currently an independent consultant
specializing in mine financing and
analysis. Formerly, he has held senior
executive positions with several Canadian investment firms, and he has
served as a governor of the Toronto
Stock Exchange and as a director of the
Investment Dealers Association of
Canada.
Janaya Moscony, CFA, founded
SEC Compliance Consulting Inc. (SEC3)
in Honolulu, Hawaii, USA, in 2003 and
recently moved the
headquarters to
Philadelphia, Pa., USA.
Prior to founding SEC3,
Moscony served as vice
president for the Asset
Management Group of
the Bank of Hawaii, also
Moscony
in Honolulu.
Zo Van Schyndel,
CFA, recently became the business
development and risk management officer for the King StarFish Hedge Fund
in Miami, Fla., USA. Managed by King
StarFish Capital Mgt. LLC, it is the
only hedge fund in the United States
that donates a specific percentage of its
profits directly to charity. Formerly, Van
Schyndel had her own consulting firm,
StarFish Financial Consulting, in
Boston, Mass., USA.
Please send information regarding a
recent promotion, job change, or professional award to cfamag@aimr.org.
11
Society
BRIEFS
The Board of the Argentina & Uruguay Chapter of Investment Professionals

welcomed Presidents Council Representative Dan Meader, CFA (standing,
third from left), to its December 2003 CFA charter award ceremony in
Buenos Aires, Argentina, where Federico Sturzenegger, director of Torcuato
Di Tella Universitys Business School, was the keynote speaker.
The Edmonton Society of Financial Analysts held

its 26th annual forecast dinner in January 2004.
More than 300 people attended the dinner, in
part to listen to speakers Peter Gibson (second
from left), Lloyd Atkinson (not pictured), and
Joshua Feinman (second from right).
The Investment Analyst Society of Chicago held

its annual dinner in October 2003 at the Four
Seasons Hotel in Chicago. Lawyer, teacher, actor,
comic, economist, father, novelist, essayist, and
expert on finance Ben Stein (sitting, second from
the left) spoke to the 550 attendees about A
Return to Traditional Values and A Bullish
Forecast for the Economy in the Coming Months.
The Vancouver Society of Financial Analysts welcomed 100 members and guests to its first charter award ceremony in December 2003. Bill
Kovalchuk, CFA, AIMR Canadian Presidents
Council Representative (right), presented Dr.
David Wu, CFA, with his charter. Dr. Wu semiretired from 28 years in dentistry and founded
the Biowest Biotech Hedge Fund one year ago.
In December 2003, the Stamford Society of

Investment Analysts (SSIA) hosted a dinner to
recognize new CFA charterholders. Each new
charterholder received a certificate of congratulations from SSIA and a copy of the Greenwich
Time newspaper advertisement honoring them.
Sixty members and spouses attended the party,
held at a club decorated for the holidays.
Fifteen new charterholders were recognized at the Society of Investment Analysts in Irelands charter
award ceremony at the National College of Ireland in Dublin. Bob Luck, CFA, AIMR vice president of
member and candidate outreach (third from right), awarded the charters.
12
CFA
One of AIMRs newest societies, the Society of

Financial Analysts-Mauritius, held its annual
general meeting in October 2003. Board and
regular members Hamalen Sunassee (far left);
Jayesh Mehta; Sanjay Jagatsingh, CFA; Bala Cundasawmy; and James Leung, CFA, enjoyed dinner
at First Restaurant in Port Louis, Mauritius, following the meeting.
Society
BRIEFS
In October 2003, the Turkey Chapter held its launch event at the Istanbul
Stock Exchange (ISE). Approximately 100 top-level financial professionals
and academics attended, including AIMR President and CEO Tom Bowman,
CFA (third from right), and ISE Chairman and CEO Osman Birsen (third from
left). Media coverage of the event included four television stations, four
newspapers, and two news channels (including Reuters). CNBC conducted
an interview with Bowman and Murat Kayahanli, CFA (second from left).
In November 2003, the German Association of Investment Professionals

(GAIP) held its annual meeting, board member elections, and fourth annual
CFA charterholder award dinner at the Maritim Hotel in Frankfurt, Germany.
Newly and re-elected board members (above) welcomed the more than 80
new CFA charterholders at the dinner where new GAIP President Andreas
Sauer, CFA (second from left), presented the charters. AIMR Vice President
of Candidate and Member Outreach Bob Luck, CFA, was the keynote speaker.
The Korean Society of Investment Professionals

hosted a CFA charter award ceremony and annual members meeting in late November 2003.
Nearly 90 members were present, including 68
new CFA charterholders.
The Luxembourg Chapter of Investment Professionals hosted its first charter award ceremony where 16 people received their charter in October
2003. The event was held in the Panoramic Room atop the Luxembourg
Hilton. Approximately 40 people attended the ceremony, including guest
speaker Daniel Broby, Presidents Council Representative for Europe, Africa,
and the Middle East (right).
Sixty-six investment professionals were awarded the CFA charter during the
French Society of Investment Professionals fourth charter award ceremony
in December 2003. Bob Johnson, CFA, AIMR executive vice president, CFA
Program Division, was the keynote speaker.
The Houston Society of Financial Analysts, in

conjunction with the Dallas Society of Financial
Analysts, held a post-exam party for candidates
sitting for the December Level I examination.
Candidates relaxed after the exam at the Hilton of
the Americas in downtown Houston, Texas, USA.
CFA
The Japan Society of Investment Professionals

held its second annual charity Christmas party
in Tokyo in December 2003. Above, Robert
Maxon, CFA (left), acting as Santa, presents raffle winner Christopher Grune, CFA, with a prize.
13
Global
STANDARDS
Bridging the Gap
HELPFUL LINKS
AIMR expands GIPS standards to private equity

BY CRYSTAL DETAMORE-RODMAN
hen AIMRs Venture

Capital and Private
Equity Subcommittee set
out four years ago to
address incongruities in the way private
equity managers calculate and report
performance, members were confronted
with not only differing regulatory attitudes but also an asset class that was
difficult to valuate.
One of the biggest headaches of
all is how to value a company that is
not yet making profits, says Carol
Kennedy, chair of the subcommittee and
senior partner at Pantheon Ventures
Limited in the UK. All of the companies in the early stages of development
in the venture industry, for sometimes a
number of years, are not yet profitable.
The subcommittee ultimately
endorsed the fair value reporting
method over the historically popular
cost-based approach. Not only does
GAAP require managers and investors
to record private equity investments at
fair value, but most private equity
industry associations have sanctioned
the practice in their valuation guidelines as well.
The fair value basis of valuation
is a focal point of AIMRs newly adopted GIPS Private Equity Valuation Principles, which extend to the private
equity sector global standards for the
ethical presentation of investment performance. Input data, calculation
methodology, composite construction,
disclosure, and presentation and reporting are all addressed in the AIMR principles. The GIPS private equity provisions which focus on fundraising
take effect 1 January 2005, though
firms are urged to adopt them sooner.
Key disclosures include the
requirements that firms document valuation practices, disclose that the procedures are available upon request, and
14
have the actual valuations reviewed by

an independent entity. From a reporting standpoint, the GIPS private equity
provisions require the inclusion of both
net and gross of fees performance statistics, as well as key multiples to help
prospective investors gauge the overall
health of the fund.
Our standards create a checklist
of types of information prospective
investors should ask private equity
managers for, AIMR Investment Performance Standards Associate Gregory
Turk, CFA, states.
It was inevitable that greater scrutiny would follow the venture capital
industrys dramatic collapse in the early
2000s. Significant growth in private
equity assets was another reason to put
valuation and performance reporting
practices under the microscope. In the
mid 90s, for your typical pension fund,
private equity was 2 to 3 percent of
the fund, and now its 5 to 8 percent,
Turk explains.
Unfortunately, the industrys growth
didnt yield more meaningful valuation
guidelines in all parts of the world. In
North America specifically, published
guidelines have been available for over
a decade, but unfortunately these guidelines were never fully endorsed. Currently, an attempt is being made by a
US-based venture capital industry association called PEIGG (Private Equity
Industry Guidelines Group) to not only
create valuation guidelines for the US
but also to have them fully endorsed by
the venture capital community.
The British Venture Capital Association was the first regional group to develop standards, followed by the European
Venture Capital Association some years
later. For well over a decade, both of
those groupings have had developed
guidelines, and the rest of the Europeans have followed as the industry has
developed, Kennedy observes. And
because the industry around the world
CFA
Global Investment Performance

Standards (GIPS), www.aimr.org
British Venture Capital Association
(BVCA), www.bvca.co.uk
European Venture Capital Association
www.evca.com/html/home.asp
Private Equity Industry
Guidelines Group (PEIGG)
www.peigg.org/pages/1/
Dartmouth College
http://mba.tuck.dartmouth.edu/
pecenter/resources/glossary.html
has developed separately, each country

has its own guidelines.
Although the GIPS private equity
standards are meant to wrap around
regional industry association valuation
guidelines, our standards are higher
level principles that should be thought
of as core principles that any private
equity firm should follow, says Turk.
We dont get into the very detail that a
private equity industry association gets
into in regard to valuation hierarchies.
Rick Hayes, senior investment officer at the California Public Employees
Retirement System (CalPERS), welcomes the heightened focus on improving reporting and valuation standards.
We have been working with all the
groups focused on these issues, such
as AIMR and the Institutional Limited
Partners Association, to move these
issues forward, he says. In running a
large portfolio, these types of issues are
critical so that we can make apples-toapples comparisons of the performance
of our investments; at CalPERS, we
manage over 350 private equity investments in the alternative investment
management program. This is a step
in the right direction.
Crystal Detamore-Rodman is a freelance
journalist with a background in small
business finance.
[ADVERTISEMENT]
Global
STANDARDS
Going for Gold: IPC Seeks Comment on Updated GIPS Standards

BY CHRISTINE MARTIN
he AIMR Board and the

Investment Performance
Council (IPC) just released
the latest version of the Global Investment Performance Standards
(GIPS) for a six-month public comment period ending August 2004.
Called the gold GIPS standards, the
proposed version will raise the bar for
firms claiming GIPS compliance and
eliminate the need for separate local
standards in many countries.
The GIPS standards are no longer
simply a minimum worldwide standard, says AIMR Vice President Alecia
Licata. With the proposed changes, the
GIPS standards now encompass much
of what the global industry deems to be
best practices in terms of performance
presentation and measurement.
The proposed version will certainly
impact local versions of the GIPS standards, such as AIMR-PPS standards,
as these versions must incorporate all
interpretations and changes to the GIPS
standards. As a result, Licata fears that
some constituents may miss out on the
opportunity to give feedback.
Although most AIMR members
know GIPS standards exist, many dont
have a perspective on the relationship
between GIPS standards and their local
version, and therefore they may gloss
over their role in the standard-setting
process to provide feedback and
consequently, the IPCs invitation to
comment, Licata says.
Yet Licata maintains that the public
commentary process is vital to the success of GIPS standards. The IPC has
broad representation geographically and
technically, but it is only so large.
Encouraging the public to think about
the practicality and applicability of IPC
proposals adds significant value to the
process, says Licata.
If we only hear the negative comments, it leaves us wondering whether
the majority of the industry agrees with
16
the proposal or whether they just dont

know about it, says Licata. All comments received are posted to the AIMR
website for others to view.
The proposed updated version of
GIPS standards includes new, modified,
and deleted provisions for which the
IPC requests comments. Provisions
anticipated to draw the most feedback
include a new provision requiring mandatory verification as of 2010, a new
provision requiring firms to provide a
compliant presentation to all prospective clients, and a provision that clarifies
that firms must provide a list and
description of composites to any prospective client that makes such a request.
Notable modified provisions
include postponing the requirement for
accrual accounting of dividends and the
requirement for carve outs to be managed with their own cash from 2005 to
2010. Licata points out that the decision to push back the effective dates for
these requirements is a direct result of
industry feedback. The IPC takes public comment very seriously, and for
these two provisions although they
are important and represent best practices it made sense to give the industry more time to implement these
requirements, she explains.
The proposed version also no
longer permits two of the three current
options for how a firm chooses to define
itself for purposes of complying with
the Standards (based on legal entity or
base currency). These deletions are
based on the idea that a firm should be
defined by how an entity is actually presenting itself to the public. Its a minor
change in the sense that it will not
affect most firms ability to claim compliance. But it is a major change in that
it captures the essence of what the GIPS
standards are all about, says Licata.
These changes illustrate the great
effort made to make the gold GIPS
standards and process as transparent as
possible. Particular attention was given
to the structure of the document so that
CFA
despite changes intended to improve

the Standards, such as the addition of a
glossary and a section on fundamental
concepts, the proposed version looks
very similar to the current GIPS standards. Even numbering was kept consistent with the current version.
One of the concentrations over the
past five years with the development of
the gold GIPS standards was adding
comparability and transparency to nonstandard, mostly private asset classes,
such as private equity and real estate.
The updated version also incorporates
provisions for other technical areas,
such as fees and advertising, which
already have been released for public
comment and finalized by the IPC and
AIMR Board.
Following the public comment
period, the IPC anticipates adoption of
the gold GIPS standards early in 2005
with an effective date of 1 January
2006. The IPCs goal is to have updated
country versions and translations also
adopted by 1 January 2006 so that all
firms complying with the GIPS standards, or a version or translation, incorporate the changes by the same date.
Some of the country versions will
lose all their differences once the modifications are adopted. For those countries, the question will be whether there
is a need for the country version to
have a brand name different from
GIPS, says Licata. In the spirit of convergence and transparency, the IPC and
the sponsors of each country version
are considering the implications of a
name change for each market.
While the gold GIPS standards
represent a triumphant milestone, Licata is quick to remind that the evolution
doesnt stop with its adoption. The
GIPS standards are dynamic, says Licata, adding that guidance for leverage
and derivatives will be up for public
comment in the near future.
Christine Martin is a freelance journalist
who writes for a variety of publications.
Asia-Pacific
ADVOCACY
Sarbanes-Oxley-Like Proposals Debut Down Under

Commonwealth of Australia set to legislate new auditor rules, corporate disclosure
BY LORI PIZZANI
bill, originally drafted in

October 2003 by the Commonwealths Treasury office,
then amended and introduced into Australias Parliamentary
House of Representatives this past
December, is on its way to becoming
law beginning 1 July 2004. The bill, if
adopted by the legislature, will beef up
auditor oversight and independence
standards as well as require companies
to enhance the disclosure of relevant
information to the market.
The Audit Reform and Corporate
Disclosure Bill 2003 was adapted from
the latest initiative in the governments
Corporate Law Economic Reform Program (CLERP), which seeks to improve
regulation over accounting standards
and auditors and increase corporate
disclosure among publicly traded companies. The provisions of the bill are
expected to be debated in early March,
with legislation finalized in April or May.
The Australian government originally took up the cause in June 2002
in the wake of similar reforms being
considered by legislative leaders in the
United States. Those US initiatives were
formally enacted in July 2002 in the
Sarbanes-Oxley Act. But while the US
system is admittedly more rules-based
and prescriptive, the Australian government chose to continue its tradition of
relying on a less restrictive, principlesbased approach.
Australias accounting profession
has historically functioned within a
self-regulatory environment. But over
the last few years, in light of global corporate scandals, a more regulated environment has taken hold.
While there is general support for
the new provisions, not everyone is
enthralled with the proposed mandates.
We had some concerns initially. We
didnt want to see a situation where
we ended up with unduly prescriptive

arrangements as a solution, says Bill
Palmer, general manager of standards
and public affairs for the Institute of
Chartered Accountants in Australia
(ICAA), which represents 40,000 members from 5,000 to 6,000 audit firms.
Of particular concern to the ICAA
is how small- to medium-sized listed
companies would comply with new
rules, especially the proposed five-year
auditor rotation requirement, Palmer
notes. Of Australias 1,500 listed companies, there are about 100 major corporations, with a second tier of 200 to
300 mid-sized companies. But, beneath
that tier lie many smaller companies,

many of which are actually smaller
than private entities, Palmer explains.
In addition, there are scores of
incorporated Australian charities that,
although not publicly traded, would be
forced to similarly rotate auditors under
this new legislation. The ICAA found
that the additional burden that the proposed law would place on the auditors
of incorporated local community groups
has caused many to consider withdrawing from auditing altogether.
Lori Pizzani is a New York-based financial journalist.
B I L L H I G H L I G H TS
Among other things, the Australian legislative bill calls for:
The restructuring of the Australian Auditing and Assurance Standards Board
(AuASB), which would make auditing standards, formulate guidance on auditing standards, and participate in the development of a single set of global
auditing standards;
Auditors to refuse an engagement if conflicts of interest exist;
Individual listed company auditors to serve no more than five successive years,
then be rotated. Also, exiting individual auditors would not be allowed to be
employed by a former audit client as a director or senior manager for two years;
Audit firms to be allowed to register with the Australian Securities and Investments Commission (ASIC) as long as they agree to provide annual statements
in lieu of the current triennial filing schedule;
Listed companies CEOs and CFOs to declare in writing that the financial records
of the company have been properly maintained, and that the financial statements
both adhere to accounting standards and present a true and fair view of the
company;
The establishment of a Financial Reporting Panel with no fewer than five members, which will mediate disputes on a non-binding basis between companies
and the ASIC regarding whether a companys financial statements provide a
true view of the company;
Persons who report breaches (whistleblowers) to be protected from civil or
criminal liability or other repercussions;
The disclosure of the remuneration of an expanded list of senior corporate
executives and directors of listed companies in the annual directors report;
The imposition of up to A$100,000 in penalties for a breach of continuous
disclosure requirements.
CFA
17
Europe
ADVOCACY
Europe Remains Divided on Adoption of

Financial Instruments Accounting Standards
BY RHEA WESSEL
ccounting scandals have

come to town in Europe,
and the unwanted visitors
seem to be here to stay.
The Italian dairy food company
Parmalat first spoiled Europes record
in December 2003 when it revealed that
it had misplaced what is estimated to
be between US$8 billion and US$13
billion. It later emerged that Parmalat
had created fictitious accounts, and
billions in assets simply vanished.
Then came Adecco, which admitted to possible accounting issues
in certain countries. The Switzerlandbased global employment agency was
promptly downgraded by analysts after
its announcement in January 2004.
The news was fodder for people trying to bring more transparency to European accounts. In 2005, listed companies in Europe will be required to report
their numbers using all International
Accounting Standards (IAS) except IAS
32 and 39. For the moment, these two
standards have not been adopted by the
European Commission (EC).
As the deadline nears for switching
to IAS, the EC will have to decide
whether these standards on accounting
for financial instruments will be adopted. The standards require companies to
record derivatives at fair market value
rather than historic cost.
Those who support the standards,
including AIMR, the International Accounting Standards Board (IASB) based
in London, UK, and the Financial Accounting Standards Board (FASB) of the
United States, say the standards protect
investors and are an important part of a
complete picture of a companys health.
The current standards are the best
available standards, and Europe cannot
simply continue without standards on
financial instruments, they argue. Furthermore, those in favor say European
18
dissenters are making the disagreement

a political one because they lack a compelling argument. And, if Europe fails
to adopt the standards, the transatlantic
effort to converge standards could be at
risk, supporters say.
Those against the standards, namely European banks and insurance companies, argue that they would bring
volatility to accounts, and that volatility
wouldnt reflect underlying risk.
There are no standards

in Europe dealing with
financial instruments
and Europe has almost
no derivatives on its
balance sheets, except
for the few companies
that are using IAS.
These things can
destroy companies.
Weve got to get derivatives on the balance
sheet.
SIR DAVID TWEEDIE
Head of the IASB
There are no standards in Europe

dealing with financial instruments
and Europe has almost no derivatives
on its balance sheets, except for the few
companies that are using IAS, says Sir
David Tweedie, head of the IASB.
These things can destroy companies.
Weve got to get derivatives on the
balance sheet.
Sir David adds: I only know what
I read in the press about Parmalat, but
it sounds like derivatives are involved.
This raises the question, Did they use
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derivatives to try to recover their losses

or did the derivatives cause the losses?
According to news reports, Parmalat
used derivatives and other financial
transactions during the past years.
Supporters of the ongoing
improvements to IAS 32 and 39 say
that the complicated nature of derivatives makes the standards imperfect,
but no one has yet come up with a better standard. International accounting
standards are created through a long,
tedious process of consultation with
any group that cares to share its view
on the issues put forth.
A lot of companies just arent accustomed to the type of discipline [required
by IAS 32 and 39], says Wayne Upton,
a spokesman for the IASB.
As Good as It Gets
Ken Wild, the London-based global

leader for International Accounting
Standards at Deloitte Touche Tohmatsu,
says a root problem with IAS 32 and 39
is its foundation in the system of costbased accounting. Were basically in a
cost-based regime, but were imposing
value into it, Wild says.
The controversy is about the methods by which IAS 39 would account for
derivatives used for hedging, and the
financial instruments they are supposedly hedging. Under the standard, firms
would have to account for the derivatives on their balance sheets at their fair
market value, with changes in the fair
value reported in periodic net income.
Firms would have the option of 1)
continuing to use traditional cost as the
basis for reporting the hedged instrument, or 2) valuing the hedged instrument (by periodic remeasurement) at
fair value.
Another sticking point is the argument by those who oppose IAS 32 and
39 that derivatives should be valued at
historical cost. Even though the cost of
a derivative is frequently zero, recording that cost at historical value doesnt
make sense because a change in interest
rate can swing an asset to a liability or
vice versa.
Europe
ADVOCACY
Arguments for historical costs just

dont work on derivatives, says Upton.
You can solve a problem by hedge
accounting, but you dont solve it by
pretending that the derivatives are
worth zero.
Bob Herz, chairman of the FASB,
said the United States learned this lesson the hard way: I dont know how
you can carry derivatives at a zero
amount. We saw in the United States in
the early 1990s all of the problems
associated with that. Thats what led to
the United States changing standards
around derivatives.
Even with the inherent problems
in accounting for derivatives, Wild says
an incomplete set of standards isnt the
answer, and IAS 32 and 39, in their
current form, are the best standards to
date. IAS 39 is stacked with problems, Wild says. If you said to me,
Do you like 39? Id say no. But does

Europe have to have a standard? Yes.
Is it the best we have? Yes.
Herz concurs: You cant have a set
of accounting standards that has a big
hole in it.
Hot Potato Politics
The disagreement about IAS 32 and 39

has been elevated to the political playing
field, with dissenters saying the IASB is
trying to force an American-based standard on European companies. Supporters say politics was brought into the
mix to make up for a lack of empirical
evidence that shows that the standards
are harmful to certain companies.
Jim Leisenring, the liaison between
the IASB and the FASB, suspects that
constituents garnered support from the
EC when they saw that their argument
was failing.
B E T W E E N A R O C K A N D A H A R D P L AC E
As the head of the International Accounting Standards Board (IASB), Sir David
Tweedie is accustomed to politicking. In fact, he is known for the pleasure he gets
out of a robust discussion.
This penchant serves him well as Sir David pushes on with his mission: adopting the best possible international accounting standards (IAS).
In the fight surrounding IAS 32 and 39, Sir David has seen the level of political
interest swell. In July 2003, French President Jacques Chirac wrote to the president
of the European Commission, Romano Prodi, to say that IAS 32 and 39 could
have harmful consequences for financial stability. And, according to press reports,
European Central Bank head Jean-Claude Trichet has expressed concern that the
standards could reduce the ability of banks to respond to market shocks.
One European-based observer, who asked not to be identified, said some
European players were hoping to gain compromises on IAS 32 and 39 with compromises on unrelated European issues.
Sir David is not interested in compromises. He has a narrow focus, and hes
not into the compromise game, the person said, adding, Sir David just wants
to get it right. He is not worse than any other standard setter.
The IASB is undergoing a previously scheduled review of its constitution that
is to take place every five years, and those unhappy with the IASB may use the
chance to further voice their concern. Some critics say the board needs to listen
more intently to concerned parties, has become too theoretical, and has too much
on its agenda.
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What I find disturbing is that

when the EC approved standards for
2005, IAS 39 was in existence. Why
now did they decide that IAS 39 is
unacceptable? says Leisenring. He
adds, I cannot answer why a politician
would want to obfuscate the information that goes to the market.
Insurance companies and banks
that oppose the standards have said
their interests and the complexities of
their businesses werent considered
enough in the formulation of the standards, according to press reports.
Convergence Kaput?
The current disagreement on IAS 32

and 39 is significant because of its
potential impact on two grand projects:
efforts to harmonize transatlantic capital markets and transatlantic convergence of accounting standards. If the
EC fails to adopt IAS 32 and 39, European-based multinationals with listings
in the United States may still have to
submit their accounts under US rules.
In the investment community,
people would like to be able to compare
a major European company with a major
American company in the same sector.
The best way to do that is with comparable accounting numbers, says Herz.
On the matter of financial instruments, US and European accounting
rules are essentially converged. However, if the European Union doesnt
require companies to adopt IAS 32 and
IAS 39, a separate accounting regime
will remain for Europe.
In the United States, our enthusiasm for convergence would be dealt a
blow, I think, if in fact Europe says it is
in favor of convergence but then says it
wants line item vetoes, says Herz.
So, the question remains: Will IAS
32 and 39, with all their glory and
imperfections, be adopted by the EC? It
appears to be a game of wait and see.
Rhea Wessel is a freelance journalist based
in Frankfurt, Germany. Her stories have
appeared in Barrons, the Wall Street Journal, and the Christian Science Monitor.
19
United States
ADVOCACY
Bolstering Corporate Governance: NYSE at

Center of Controversy and Restructuring
BY LORI PIZZANI
n 2002 and 2003, the New York

Stock Exchange (NYSE) was
among the securities industrys
regulators dictating changes to
bolster corporate governance at public
companies, banish securities analysts
conflicts of interest, and restore
investors faith in the capital markets.
But, as last year unfolded, the NYSE
found itself at the center of a firestorm
of scrutiny that resulted in the forced
resignation of NYSE Chairman and CEO
Richard Grasso and an array of significant structural changes being made to
the worlds largest stock exchange.
The 211-year-old NYSE annually
serves 85 million direct and indirect investors. As of year-end 2003, it boasted
a global market cap of US$16.8 trillion.
It all began in March 2003, when
the US Securities and Exchange Commission (SEC) asked the NYSE, along
with other self-regulatory organizations,
to undertake a review of its own corporate governance policies and report
back on potential improvements. The
NYSE assembled a special committee,
and, on 5 June 2003, released a report
offering 10 recommendations. Included
was a reform under which the NYSE
would disclose in its annual report the
compensation of the chairman, the
directors, and the four highest paid
NYSE officers. It also suggested prohibiting NYSE senior officers from serving on the boards of listed companies.
In August, when Grassos previously undisclosed, but rumored, US$139.5
million total compensation package was
revealed by the NYSE, a new conflict of
interest controversy arose this time
with Grasso on the hot seat. Critics
charged that Grassos lavish pay package compromised his role as the regulator of listed companies and tainted the
reputation of the NYSE. Grasso supporters pointed to the apparent failings
20
of the NYSE board members who knew

of, and willingly approved, the comprehensive package. Grassos package
included an annual salary of US$1.4
million, a target annual bonus of at
least US$1 million, and other monies
accrued under various NYSE benefit
plans and deferral agreements.
Although Grasso conceded to
relinquishing US$48 million of that
package because of the controversy, the
NYSEs board of directors ultimately
asked for, and received, Grassos resignation on 17 September 2003.
CEO of Goldman Sachs Group, as

NYSE CEO and a member of the
board of directors beginning 15 January 2004. Reed relinquished his CEO
title, but remains interim chairman
until a replacement is named.
3. The creation of a parallel 20-member
board of executives, which will serve

in an advisory role to the NYSE
board of directors. Members will be
appointed by the NYSE board of
directors, and will be comprised of
constituents of the broker/dealer
community, specialist firms, floor
brokers, institutional investors
(including large public funds),
exchange-listed companies, and a
representative of individual investors.
The new board of executives will
meet six times a year to discuss
membership issues, listed company
issues, and public issues all related
to market structure and performance.
The board of executives will meet
several times throughout the year
with the board of directors.
NYSE Reed-efines Governance
On 21 September 2003, the NYSE board

appointed John Reed, former chairman
and co-CEO of Citigroup, as NYSEs
interim chairman of the board and
CEO. In early November, with Reed at
the helm, the NYSE proposed and
members subsequently approved
sweeping changes to the exchanges
governance structure, including:
4. The hiring of a new chief regulatory
officer who will report directly to a

newly established regulatory oversight
and budget committee comprised
solely of independent directors.
Among other things, the committee
will determine the exchanges regulatory plan and programs. On 8 January 2004, the NYSE board named
Richard Ketchum, general counsel at
Citigroup, to the new post effective
2 June 2004.
1. The installation of a board of direc-
tors, all of whose six to 12 members

for the first time in the exchanges
history would be independent of
NYSE management, members, and
listed companies. Board members
must meet at least quarterly, and must
all stand for election each June. The
NYSE board of directors, as fiduciaries
for the exchange, have oversight for
regulatory functions, govern listed
firms, monitor marketplace performance, and are responsible for hiring
and firing and approving management compensation.
5. Increased transparency, with the
2. The appointment by the board of
directors of an individual to serve as

chairman and a separate individual to
be named CEO (unless the board
decides that one person may serve
both roles). On 18 December 2003,
the new NYSE board of directors
appointed John Thain, president and
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NYSE board of directors publishing

an annual proxy statement detailing
board membership and compensation, the exchanges political contributions, charitable activities, and the
means by which members and
investors may communicate with
board members. Restructured board
committees will also annually disclose
the compensation of the NYSEs top
five officers, as well as how board
nominees are selected.
United States
ADVOCACY
Splitting the Role of Chair and CEO
According to new data from the

National Association of Corporate
Directors in Washington, DC, USA,
50.4 percent of 5,000 public companies
polled between February and June 2003
now separate the role of chairman from
CEO, up from 45 percent in 2001,
largely due to corporate scandals.
A separation of powers can be
helpful in improving corporate governance, but it doesnt guarantee effective
control, said Scott Stewart, professor
at Boston Universitys School of Management. The key consideration, in my
opinion, is the person you place in
charge his or her honesty, intelligence, and energy level not necessarily the governance structure. On
the flip side, he adds, such a split can
reduce the effectiveness of a good leader.
The separation of these functions
is much more common in Europe, says
Betsy Atkins, president and CEO of
Baja, LLC, a venture capital firm in
Coral Gables, Fla., USA. There are
many strong advantages to having a
separate chairman. The chairman has
the sole focus of coordinating, energizing, communicating, and leveraging
maximum contribution from the
board, she says. That separate role can
be useful where a company is in turmoil and the CEO needs to focus on
corporate repositioning. Atkins adds:
The CEO is the operational leader,
and, given a choice between spending
time with the board or leading the company, it is far better to focus on leading
the company.
Although the debate over splitting
roles isnt new, there has been a trend
in the United States to augment a combined chairman/CEO with a lead director who serves many of the functions
that a non-executive chair would,
Atkins explains.
On 30 December 2003, Symbol
Technologies in Holtsville, NY, USA, a
publicly traded company, named a new
non-executive chairman in a move to
separate roles and bolster corporate
governance. The new chairman had
previously served as the boards lead

director. Symbol had been under SEC
scrutiny for accounting problems,
resulting in a restatement of financial
results between 1998 and 2002, and it
had seen two CEOs exit.
The biggest advantage to splicing
functions is that it allows for checks
and balances and prevents any one person from having too much power, notes
Peter Lieb, senior vice president and
general counsel at Symbol. Moreover,

it allows for another persons unique
perspective. But, a good personality fit
between the non-executive chairman
and the CEO, who must work closely,
is a must, Lieb adds. If there isnt a
good personality fit, the working relationship can be strained and can create
its own set of problems.
Lori Pizzani is a New York-based financial journalist.
REGULATORY
Update
Mutual Fund Reform

On 15 January and 20 January 2004, the US SEC released for public comment proposals designed to increase investment company governance, and require investment advisers to adopt code of ethics requirements, respectively.
The SECs proposed investment company governance reforms would: require
that 75 percent of a fund boards members, and the chairman of the board, be
independent; mandate that independent directors meet in separate session at
least once per quarter; and authorize the independent directors to hire employees
to help them fulfill their fiduciary duties. It would also require directors to
make annual assessments of their board operations, evaluate the effectiveness
of board committee structures, and ask trustees to introspectively determine if
they oversee too many funds. The rules would also mandate that advisers retain
copies of materials boards used to consider advisory contracts for six years.
Comments, due by 10 March 2004, may be made via e-mail to
rule-comments@sec.gov, with reference to File No. S7-03-04 in the subject line.
The rule requiring investment advisers to adopt codes of ethics for supervisory
personnel would: have advisers detail expected standards of conduct, including

compliance procedures; require access persons to initially, then annually, report
securities holdings as well as transactions including proprietary mutual fund
trades; mandate obtaining adviser approval before investing in initial public
offerings or private placements; and require employees to acknowledge formal
receipt of ethics codes. It would also safeguard non-public information about
client transactions and restrict dissemination of information.
Comments, due by 15 March 2004, may be made via e-mail to
rule-comments@sec.gov, with reference to File No. S7-04-04 in the subject line.
These two sets of proposals follow a trio of regulatory mandates that the SEC floated for comment in December 2003. These earlier rules, if finalized, would: mandate a hard 4:00 p.m. market close for submitting fund trades, make fund buy
and sell orders irrevocable, and require the designation of a chief compliance officer. They would also require fund advisers to disclose in prospectuses the risks of
frequent trading and the companies policies on such, describe under what circumstances fair value pricing would be used, and describe breakpoint discounts and
conditions for eligibility.
CFA
21
Canada
ADVOCACY
Wise Persons Committee Supports

Creation of National Securities Regulator
BY DEREK DECLOET
blue-ribbon panel formed by

Canadas finance department
recently released a report
recommending the creation
of a national securities regulator
endorsing an idea that AIMR has been
advocating for years.
The Wise Persons Committee
(WPC) appointed in March 2003 to
review securities regulation in Canada
says in its report that the federal and
provincial governments should cooperate to build a single regulator administering a single code that would replace
the countrys patchwork of provincial
and territorial agencies, as Australia did
during the 1990s.
There is a new and unprecedented
consensus for change, says the report
of the committee, led by Michael
Phelps, the former chief executive officer of Westcoast Energy Inc. Today,
Canada is the only major industrialized
country without a national securities
regulator [its] securities regulatory

architecture must change so that our
capital markets become a source of
comparative advantage.
There was a time when Canadian
businesses seeking to raise capital were
primarily located in the same region as
the investors who bought their securities, continues the report. In those
days, Canada was well-served by a
provincially-based regulatory structure.
Those days are gone.
The WPC report says the national
government in Ottawa should pass a
new securities act that would apply
everywhere. To take into account
regional concerns, the law would be
administered by a nine-member group
of commissioners from across the country. Ontario and Quebec, where most
senior public companies are located,
would be guaranteed two spots each,
while British Columbia (BC) and Alberta the traditional home of the junior
markets would each have at least one.
Under the WPCs proposal, once
the new regime is in place, the federal

government would be required to consult provincial governments before
making any changes to securities law.
It would not proceed with any change
that was opposed by a majority of
provinces representing a majority of
the population.
The drive to create a national regulator has been around for decades, and
several previous attempts to create one
have failed, usually because the provincial governments are reluctant to give
up their authority over securities matters. The matter was given new urgency,
though, by several high-profile Canadian scandals in Canada in the late 90s,
including the Bre-X Minerals gold fraud
and the accounting shenanigans that
led to the collapse of entertainment
company Livent Inc.
I think it can be done, and I think
it should be done, says David Yu, cochair of AIMRs Canadian Advocacy
Committee. Yu says it is amazing that
Canada is one of the last countries to
have no national securities body: If
[regulation] is run by one organization,
it is certainly better than being run by
a group of people. It makes life simpler
A I M R R E P R E S E N TAT I V E S P R E S E N T M E M B E R S V I E W S
The week before the release of the Wise Persons Committee
(WPC) report, AIMR representatives took their views directly
to Canadas most powerful securities regulator: David Brown,
chairman of the Ontario Securities Commission (OSC).
Brown has been pushing for his own version of a single
regulator, though, unlike the WPCs, his vision is that the
provinces would pool their current powers under a single
agency. David Yu, co-chair of AIMRs Canadian Advocacy Committee, presented the results of the 2003 AIMR survey showing
a large majority of CFA charterholders favors a national regulator. They didnt know that, says Yu, adding that AIMRs
views are valuable to the provincial regulators because they
represent a more balanced perspective between buy-side and
sell-side firms than many other organizations.
In Canadas largest province, it appears the opinions of
AIMR members and others are having an impact at the political level. Gregory Sorbara, the new provincial finance minister,
recently came out in favor of the national regulator concept,
reversing a position taken by his predecessor, who had instead
22
CFA
endorsed small reforms to the provincial system.

AIMR offered to conduct future surveys on areas of interest to the OSC, Yu says. We want to initiate this relationship
on a more frequent basis.
During the meeting, AIMR Chair Ted Aronson, CFA, outlined the organizations campaign to get more investment professionals appointed to corporate boards. The initiative aligns
well with one of Browns pet projects: to improve the performance of audit committees. Under new rules slated to take
effect at the end of March in most of the country, public companies would be required to have independent, financially
literate directors on their audit committees.
Yu says he hoped to set up similar meetings with provincial regulators in other key provinces, including Quebec,
British Columbia, and Alberta.
In addition to Yu and Aronson, the AIMR delegation
included Toronto Society of Financial Analysts President Margaret Franklin, CFA, and AIMR staff liaison Linda Rittenhouse.
Canada
ADVOCACY
and less costly.

AIMRs Canadian members made
a loud call for such reforms in a survey
conducted last year. Ninety percent of
the more than 600 respondents said the
present system needs reform; about
three-quarters said a single national
regulator was the solution. Nearly half
felt that the competitiveness of Canadas
capital markets is poor.
AIMR members even appear to like
the way WPCs report suggests resolving the issue. A majority of respondents
58 percent said any reform effort
should involve the federal government,
which has largely stayed out of securities matters but would take a lead role if
the committees report is implemented.
Yu presented the surveys preliminary results to the WPC in July 2003.
The fundamental objective of any market regulatory system is to provide an
environment for markets that promotes
and enhances investor confidence and
protection, he said in his testimony to
the committee.
To achieve that, Canada needs a
securities system with consistent
enforcement and harmonized rules, he
said, and at a reasonable cost. Eightyone percent of respondents to the
AIMR survey described the cost of
doing business in the current setup as
high; only eight people one percent
said it was fairly low.
AIMRs position is backed by some
of the countrys largest investment
groups, such as Fidelity Investments
Canada Ltd. and the Investment Counsel Association of Canada (ICAC),
which represents a number of large
buy-side firms. Anecdotally, I can tell
you it takes less than three weeks and
very low cost for an investment counselor to register with the US SEC, says
Timothy Burt, CFA, who is ICACs president. Seldom, if ever, can registration
be accomplished in any Canadian
province in less than four months, and
it often takes longer.
Despite the strong level of enthusiasm in the investment community for
the single regulator idea, there are indi-
cations the WPC report could still end

up a victim of federal-provincial power
struggles a Canadian political tradition that led to the demise of previous
attempts to establish a national body.
Alberta, Quebec, and British
Columbia dislike the WPCs idea and
prefer instead the so-called passport
system under which provinces would
retain control over securities laws but
would simplify rules so that companies
and market participants would deal only
with regulators in their home province
to access the markets nationwide.
[Canadas] securities
regulatory architecture
must change
so that our capital
markets become a
source of comparative
advantage.
WISE PERSONS COMMITTEE REPORT
Quebec, in particular, has long

been a vehement opponent of giving
over power to a national regulator, and
the provinces securities commission
did not even bother to write a comment
letter or testify to the WPC.
Just centralizing regulation in a
single commission would not create the
regulatory nirvana many proponents
suggest, said the submission by the
British Columbia Securities Commission (BCSC).
Under our decentralized system,
we have to coordinate efforts to handle
these matters effectively, the BCSC
said. However, a lot of securities regulation is local. Despite all the talk about
money zipping around at the speed of
light, regulation is about the conduct of
people, and that requires on-the-ground
knowledge.
AIMRs survey, however, found that
BC members are only slightly less likely
CFA
to support a single regulator 68

percent said it was the best solution
(compared to 76 percent nationally).
The single regulator proposal has more
than three times as much support as
the passport system among AIMR members in BC. Even in Quebec, a single
regulator won over a majority in the
survey though many respondents
there would prefer a national body that
is run collectively by the provinces
with no federal role.
Yu admits that the opposition of
some provincial governments reduces
the odds of success. Its difficult to
envision it happening soon, given the
political landscape in Canada, he says.
It takes somebody to spearhead it.
But the Phelps committee is urging
the federal government to press on anyway, and quickly. It solicited legal opinions that said Ottawa has the right to
have control over securities matters
under Canadas constitution. While
provincial cooperation would surely be
preferable, it is not necessary, its
report says.
Should Canadas capital markets
be eroded through insufficient attention to this important issue, they
would not easily be restored, concludes the report. The direct negative
impact on the economy, and the welfare of individual Canadians, would be
pronounced.
New finance minister Ralph
Goodale has given cautious signals
that he likes the reports conclusion.
The committee was not Goodales idea,
but, he says: I will say very clearly
that this is an issue that just cannot be
left to wither away. Its far too important for that.
It is doubtful anything will happen
soon, though. A national election is
expected as early as April 2004, and the
government is unlikely to tackle such
a contentious issue before then, meaning
any action will probably have to wait
until late 2004 or 2005 at the earliest.
Derek DeCloet writes for The Globe
and Mail in Toronto, Ontario, Canada.
23
Risky
BY CHRISTOPHER WRIGHT
Unexplained meltdowns. Position blowups. Rogue traders.

Elegant models that turn to dust and roil markets. Such is
the world of risk management. Yet, despite the availability
of sophisticated statistical risk models, managing risk
requires more than mathematical wizardry. One must go
beyond the models to fully grasp the essential aims of risk
management and understand its limitations.
This article traces the historical development of risk
management from the 1950s forward. In this way, we will
gain a full appreciation for where we are in the story and
for where risk management is headed in the future.
Hold on to your security blanket; this is no ordinary
bedtime story.
24
CFA
BUSINESS
T H E S T O R Y O F R I S K M A N A G E M E N T PA S T, P R E S E N T, A N D F U T U R E
PAST IS PROLOGUE
ur story starts out harmlessly enough with the

advent of modern portfolio theory in the 1950s
when Markowitz, Tobin, and Sharpe concluded that
there is no reward without risk and systematically tied portfolio risk to interactions between portfolio components for
the first time. Diversification and hedging grew out of their
work with pricing risky assets (CAPM), asset correlations,
and volatility (beta). Standard deviation, which could be
easily applied to stocks and bonds, became the primary measure of risk.
The publication of the Black-Scholes options pricing
model in 1973 was a watershed event in the history of risk
management. Shortly after the first options exchange opened
its doors in Chicago, MIT professors Myron Scholes and
Fischer Black developed a mathematical formula for the fair
pricing of options based in part on the current price and
average volatility of a stock. Financial managers could use
the formula to create risk-free positions (e.g., building on
the idea of using put options to cancel out the risks of holding equities). Large losses were now theoretically impossible.
The model was further developed by Robert Merton,
who showed that it could be used more broadly. The model
was subsequently adopted in commercial loan credit-scoring
and in valuing debt, deposit insurance, oil exploration leases,
and other contracts depending on the uncertain future
value of an asset.
The Black-Scholes options pricing model is the bedrock
of the modern practice of risk management. The field of
financial risk management really began to take off when risk
became quantifiable, says Leslie Rahl, founder and president of Capital Market Risk Advisors, Inc. The Black-Scholes
model contributed substantially to the growth of the derivatives markets and the practice of risk management in the
ensuing decades. Hedging risk with futures, options, and
swaps entered the mainstream.
The Black-Scholes model depends on the share price,
which changes constantly. Thus, the option price the model
produces quickly goes out of date. A way was needed to
instantly recalculate option values in order to eliminate risk
continuously. In work credited to various people, the problem was solved, and dynamic hedging was born.
Dynamic hedging is the continuous, computer-driven
modification of portfolio positions to maintain hedges in
CFA
the face of changing market prices. Also known as portfolio

insurance, dynamic hedging is a method for synthetically
replicating put options.
Which brings us to the stock market crash of 1987,
a significant event in the history of risk management. The
Dow Jones Industrial Average went down 508 points in one
day, or 22.6 percent (and a total of 769 points or 31 percent
in four days) a 20-standard deviation event. Dynamic
hedging products sold like hotcakes in 1985 and 86, but the
October 87 crash showed that it doesnt always work, says
MIT financial engineering professor Andrew Lo, PhD.
When people went to cash out of stocks and [get] into
bonds, herd behavior made stocks fall faster, and investors
were down 20 to 25 percent before they could get out,says
Lo. Its a funny kind of insurance that works when you
dont need it and doesnt work when you do. The ensuing
debate about portfolio insurance really changed minds about
risk management.
The 1990s saw a series of spectacular financial disasters.
Take the case of Metallgesellschaft in 1993 when it incurred
a US$1.3 billion loss in oil futures. Or several more famous
cases. In 1994, Orange Countys positions in leveraged derivatives betting on low interest rates caused US$1.7 billion in
losses and pushed the county into bankruptcy.
Rogue trader Nick Leeson brought down Barings Bank
in 1995 when he lost US$1.4 billion in unauthorized futures
and options trading. Barings went bankrupt and was later
sold to ING. Sumitomo Corporation lost US$2.6 billion in
copper futures trading in the years running up to 1996.
A TURNING POINT
ne of the most significant turning points in the history of risk management, according to Lo, was the
collapse of Long-Term Capital Management (LTCM)
in 1998. Myron Scholes and Robert Merton, who shared a
1997 Nobel Prize for their work in options pricing, reentered
the stage among the principals of LTCM, a billion dollar US
hedge fund earning 40 percent returns in leveraged fixed
income arbitrage, straddles, and futures.
Dazzled by such luminaries of modern finance, other
market participants gave LTCM preferential treatment
extending unlimited credit and exempting LTCM from margin
requirements. (The halo effect was also an ingredient in the
Enron story.)
25
Most of LTCMs activities involved arbitrage between

Treasuries and more complex instruments with credit and
liquidity premiums. When Russia declared a debt moratorium in August 1998, LTCMs counterparties began demanding more collateral to cover widening spreads. LTCM lost
US$550 million in a single day something LTCMs models
showed could only occur once every 800 trillion years.
It was feared that a default by LTCM would spark a
mass close-out in derivatives markets and cause mark-tomarket values to spiral downward. There was also concern
that an unknown number of other firms had begun to imitate LTCM and that a market meltdown was in the offing.
With nothing less than the fate of the entire global financial
system thought to hang in the balance, Alan Greenspan,
chairman of the US Federal Reserve Board, and others
arranged for a bail-out. A consortium provided US$3.6 billion in additional capital to reassure markets, and LTCMs
positions were gradually liquidated over the next two years.
By the time it was over, LTCMs partners had lost
US$1.1 billion. The question is obvious: How could such
smart people get it so wrong?
LESSONS LEARNED
he 1987 crash Orange County Barings Bank

LTCM. What lessons have been learned from this sordid history?
Those four events taught us totally different lessons
and, hopefully, risk managers have integrated them into their
thinking, says Rahl. It is highly unlikely that the future
will resemble the past, but the important point is that, given
the frequency of supposedly once-in-a-lifetime events, any
approach to risk management will have to emphasize stress
testing and what if analysis.
A recurring feature in the blowups of the 1990s was the
amassing of positions by junior personnel or subsidiaries
without the knowledge or comprehension of senior management. Risk managers took note and began to place emphasis
on the risk management process asking the right questions, curbing incentives to take unwise risks (moral hazard),
and focusing on other facets of adequate supervision.
LTCM also gave people a new appreciation for liquidity

risk the inability to unwind positions and get out when
you need to, Lo says.
Another lesson of LTCM has to do with the cascade
effect of herd behavior. Attracted by outsized profits, other
large financial institutions had begun to replicate LTCMs
methods and positions with implications for the entire global
financial system. While the stakes may not have been as high
in the 1987 crash, herd behavior and liquidity risk figured
in that crisis as well.
Perhaps the final lesson of LTCM is humility even
the smartest people can fail to devise models that adequately
capture market complexities (model risk).
THE PRESENT VAR
here do things stand today? Standard deviation

is no longer the risk measurement tool of choice.
Standard deviation is driven equally by the upside
when what people really care about and consider risky are
surprises to the downside. New measures have been developed focusing on downside surprises. One of these, shortfall,
measures the probability of falling below a prespecified
benchmark return.
But, by far, the primary tool in use today to examine
the downside is value at risk (VAR). According to Professor
Lo, new risk measures were needed after options portfolios
became common in the 1970s. Options have complex payoff
structures unlike stocks and bonds. The nonlinear risks
posed by options gave rise to the need for new risk analytics.
The main tools in use today VAR, stress tests, and scenario analysis grew out of the derivatives industry, which
developed significantly in the 1970s.
VAR was next widely adopted among banks and bank
regulators as the basis for bank capital requirements, Rahl
says. VAR was also being used in the broker-dealer community and was beginning to be discovered on the buy side
prior to LTCM, she says. VAR spread out from there to
mutual funds and nonfinancial corporations.
VAR is the maximum amount a portfolio can lose over
a specified holding period at a given confidence interval.
Concern about tail events has led firms to supplement VAR with stress testing and scenario
analysis, which ask how portfolios would perform under more extreme sets of assumptions ...
26
CFA
Illustrations: Robert Meganck
It results in a statement such as the most this portfolio can

lose over the next 24 hours is US$1 million with a 95 percent probability. There are three basic methods used to
compute VAR: correlations, historical data, and the Monte
Carlo method.
Historical patterns are not always a reliable guide to the
future, especially in times of market turbulence. Maybe the
next 10 years will not look like the last 10 years. This has
led to greater use of the Monte Carlo method, which relies
on predictive math and computer simulations to compensate
for deficiencies in historical loss data. Monte Carlo programs
easily run through a large number of complex scenarios
derived from a range of values for interest rates and other
macro factors.
A variation for calculating VAR, which is particularly
favored by hedge funds, uses Principal Component Analysis
(PCA). PCA attempts to reduce the data needed to calculate
VAR by combining redundant variables into artificial supervariables (principal components), which account for most
of the variance in a large number of risk factors. The calculation uses the smaller set of principal components, which
are themselves uncorrelated.
One advantage of VAR is that it can be used to disaggregate total risk and uncover the main threats to portfolio
value, which may stem from interest rates, macroeconomic
conditions, or other factors. VAR is touted as a tool that can
uncover such hidden concentrations of risk.
VAR has weaknesses. Different firms calculate VAR differently; there is no gold standard for the tool. Also, VAR only
looks at asset prices and does not account for all risk to
the portfolio. Notably, operational risk (about which more
is said below) is left out of the equation.
CFA
VAR is fine 95 percent of the time, but what about the

other 5 percent? Studies of historical data show that the risk
of major market moves is orders of magnitude higher than
normal distribution tables would suggest. One published rule
of thumb holds that any financial market can expect at least
one daily price move of four standard deviations or more
every year. Risk managers are advised not simply to disregard
the statistical outliers but to remember that return distributions can and do break out of the normal range and show fat
tails to the downside.
Concern about tail events has led firms to supplement
VAR with stress testing and scenario analysis, which ask how
portfolios would perform under more extreme sets of assumptions concerning interest rates, currency movements, commodity prices, and the like. LTCM made financial managers
aware of the need for stress testing, says Rahl. Reportedly,
LTCM didnt stress test enough and didnt ask what would
happen if the Russian ruble collapsed.
In scenario analysis, risk managers consider worst-case
scenarios to anticipate extreme conditions and ask, What
if theres a crisis? It is said that all correlations go to one
in a crisis that markets all go down together in extreme
conditions. As such, diversification as a risk management
tool has its limits. Planning an exit strategy to address liquidity risk is something that would have helped LTCM. Risk
managers also look for hidden risk factors such as credit
downgrades that can cause disproportionate losses or even
make a position blow up if the factor value changes slightly.
MEASURING FAT TAILS
everal additional measures of downside tail risk have

been developed. Semivariance resembles shortfall but
penalizes outliers more by squaring the tracking errors,
thus capturing tail risk more effectively. Monte Carlo has
been adapted to model expected return distributions with
fat tails and run bimodal scenarios to predict performance
under normal and crisis conditions.
Finally, Extreme Value Theory (EVT) purports to predict
the chances of events that have never occurred. EVT has
been used to forecast possible losses from extreme events
including catastrophic operational losses in various contexts (finance, insurance, capital allocation, environmental
monitoring, etc.).
One current debate is whether the risk of tail events is
quantifiable, whether it is really possible to price the infinitesimal odds of very rare events and factor them as ordinary
operating losses. To Lo, Its a bit like asking what are the
27
Fat Cats with Fat Tails?

B A N K S A N D T H E N E W B A S E L I I C A P I TA L A C C O R D
new framework for bank capital requirements, known

as the New Basel Capital Accord (Basel II), is undergoing final revisions and is expected to be in place
in large internationally active banks by 2007.
Basel II is the product of the Basel Committee on Banking Supervision (BCBS), which is composed of bank regulators
and reports to the central bank Governors of the Group of
Ten industrialized countries.
The committees pronouncements do not have the force
of law. Implementation is proceeding by way of rulemaking
in the United States and legislation in the EU. Reportedly, the
US Federal Reserve Board expects Basel II to apply initially
in the United States to the 10 largest internationally active
banks and also to another 10 that voluntarily opt in, bringing
two-thirds of the total assets of all US banks under Basel II
when it takes effect.
The case for Basel II is that current regulations fail to
account for variations in the risk exposure of individual institutions, resulting in anomalies. Banks lending to AAA-rated
companies have the same minimum capital requirements
under the current one-size-fits-all approach as banks with
BBB-rated firms in their loan portfolio.
Not all institutions engage in equally risky activities,
says Shyam Venkat, a partner at PricewaterhouseCoopers.
Venkat leads the firms financial risk management practice
for the financial services sector. Why subject the more conservative institutions or those that do a better job of managing their risks to the same capital requirements? he asks.
The new accord makes a capital charge for operational
risk explicit for the first time. Operational risk is the possibility of loss arising from inadequate or failed internal
processes, people and systems, or external events, which
varies from bank to bank. Fraud might be the primary risk for
a bank in the credit card business. Complex derivatives
might be more of a factor for a full-service institution offering structured transactions.
Operational risk measurement is relatively new and
underdeveloped compared to other sectors of risk management. But historical loss data the key to developing operational risk measurement is rapidly piling up and statistical analysis is proceeding apace at many banks. The
measurement of operational risk is in its infancy, but I am
confident that these measures are already directionally cor-
28
CFA
rect and provide reasonable estimates of actual risk, says

Joseph Sabatini, managing director and head of corporate
operational risk at JP Morgan Chase.
Basel II lays out a menu of choices for calculating capital charges associated with credit risk and operational risk.
A bank has some discretion in choosing the approach it
deems most appropriate. The more sophisticated approaches rely on the banks internal risk models. With respect to
credit risk, a banks own assessment of risk can provide
inputs to the committees capital ratio formulas, which will
stay on the books. In contrast, a floor for operational risk
may only be in place for the first two years.
The expectation of the banking industry is that the floor
will be removed and that banks will be allowed to determine
their own capital set-asides for operational risk if their internal models meet Basel II standards for, among other things,
depth and breadth of historical loss data.
Some observers worry that banks are susceptible to
low-frequency, high-severity tail events arising from operational risk that cannot be tamed by centralized controls.
Someone who doubts the accuracy of operational risk statistical analysis today is absolutely correct, but is missing
the point, says Sabatini. A measure thats off by a few
degrees still provides the basis for improving risk management. In other words, a rough measure is better than no
measure at all.
It has been estimated that a large bank will need to
spend upwards of US$100 million to comply with Basel II.
Some in the industry argue that competitive pressure is forcing banks to develop risk management capabilities anyway,
but an unidentified banker was explicit in a July 2003 media
report about wanting a payoff i.e., lower capital requirements from this huge investment.
Smaller US banks complain that Basel II will give an
unfair competitive advantage to larger banks that can afford
to implement sophisticated risk-evaluation systems. Smaller
banks, it is argued, will be stuck with Basel IIs standardized
menu choices, resulting in higher capital charges.
The ACB (Americas Community Bankers) wants a simpler internal ratings system that can be used by smaller
banks. Venkat agrees that the cost of implementing Basel II
is a problem for smaller banks. You dont need a Bentley to
drive a short distance every day, he says.
typical grazing habits of albino spotted tigers. If you havent

seen too many of them, you cant really study their properties.
Or, as a controversial FDIC staff study on the new Basel
II Capital Accord (see story, p. 28) put it in December 2003:
No one knows how to measure the hundred year-flood plain
for a large complex bank. Measuring the risk of extreme tail
events in ever-changing bank loss distributions will always
be an inexact science. Placing exclusive reliance on banks
statistical estimates of the likelihood of these tail events is
not an acceptable way to protect the deposit insurance funds
or, ultimately, the taxpayer.
Lo continues: We have successfully modeled fat tail
distributions and can estimate them statistically, but we dont
yet know what economic forces produce them. The greatest
benefits to be gained from rare events, he says, lie not in
mathematical modeling but in simply acknowledging that
rare events exist and changing portfolio management practices accordingly.
Of course, this is easier said than done because human
beings tend to dismiss the possibility of catastrophe out of
hand. We dont think about the chances of getting hit by a
bus on a daily basis, but they are not always trivial, says Lo.
We act as if the true chances of low probability events are
zero but they can kill you financially.
People do move back into a flood plain after flood waters
have receded, and Professor Lo worries that now we have
the dog that didnt bark the lack of any major blowup
in the hedge fund world over the past few years has caused
many investors to forget the important lessons of 1998, making hedge funds more popular than ever.
The best that can be done with respect to the pricing
of tail event probabilities is to pool them and treat them
as a portfolio, says Shyam Venkat, a PricewaterhouseCoopers
partner who leads its financial risk management practice
for the financial services sector.
Pricing low-frequency, high-severity events as one-offs
is prohibitively expensive, Venkat continues. But institutions attempt to rationalize taking on tail risks by adopting
a portfolio approach and considering them as a basket of
things that wont all happen at once. The limitations of this

approach become obvious during times of market stress
when a number of risks come home to roost at the same time
and all correlations go to one, as discussed above.
There is a split of opinion after LTCM as to where the
greatest gains in risk management are to be made. The solution, Robert Merton said in a 1999 New York Times Magazine
interview, is not to go back to the old, simple methods.
That never works. You cant go back. The world has changed.
And the solution is greater complexity. Others dismiss the
efficacy of more complex valuation methods and want more
government regulation, starting with additional public disclosure of risks by financial institutions. A third school of
thought says it is time to recognize that risk management is
an art, not a science, and to emphasize the managerial and
judgmental aspects of risk management.
As CMRAs Rahl puts it, Its tempting to want a single
number to express risk, but risk is a very complex being that
doesnt lend itself to a single number. Process transparency
is a more important risk tool than an actual number, she
says: Hedge funds and other financial firms need to communicate with investors to assure them of the robustness
and consistency of the risk management process.
Its tempting to want a single number to express risk,

but risk is a very complex being that doesnt lend itself to a single number.
Leslie Rahl, Founder and President, Capital Market Risk Advisors, Inc.
CFA
29
THE FUTURE WHERE IS RISK MANAGEMENT HEADED?
ntriguing research is opening up new frontiers in risk

management. Academics are looking into credit and
liquidity risk and new ways of estimating default probabilities. They are also trying to develop more sophisticated
statistical techniques for unstable correlations that would
model how markets act in tandem in a crisis. Lo calls this
phase-locking behavior and likens it to the phenomenon
of fireflies flashing on and off in unison.
Myron Scholes and others are working in chaos theory
to explain why once-in-a-lifetime events such as Orange
County or LTCM seem to keep happening every three or
four years. Lo has abandoned this line of research for now,
finding markets much more complex than physical phenomena such as turbulence.
Where is the field of risk management headed? It has
been predicted that financial innovation will continue to the
point where financial managers have the ability to quantify
nearly all risk and are engaged in stripping out all layers of
risk until investors end up with precisely the risks they are
most willing and able to bear.
In this vision of the boundless unbundling and repackaging of risk, some debt and equity instruments might
become obsolete. Equity securities, currently a bundle of
aggregated risks (market risk, specific risk, etc.), could give
way to layered risk-linked contracts with specific payouts.
Rahl agrees that this is the future. Weve been living
this vision incrementally since the early 1980s, she says.
I dont see it stopping.
Lo finds the vision compelling and cites total return
swaps as an early example where parties have cut up and
redistributed risk. However, he sees some hurdles to overcome before investors not to mention regulators
become comfortable with the total unbundling of risk.
LTCM called into question the wisdom of relying purely on
mathematical models. The numbers are one thing, but how
do you really tell if your counterparty is reliable enough to
bet your pension fund on a five-year swap? he asks.
It has also been predicted that some of the best financial
firms 20 years from now will derive their revenue from intellectual property associated with the unbundling and repackaging of risk rather than from monetary capital. Rahl agrees
that intellectual property will provide new revenue sources
for financial firms but argues that monetary capital will
always play a part. People need it, so firms providing capital
will still exist, although they might take new forms, she
says. If traditional firms no longer provide capital, somebody else will.
Lo also buys the intellectual property argument, to some
extent. However, he says that firms will not invest as heavily
in this area as others predict because legal protection for
intellectual property is uncertain. Merrill Lynch may have
successfully defended its cash management account and collected royalties as a result, but financial patents are still few
and far between. The issue for Lo is that the primary means
of protecting new financial risk products is through trade
secrets, which are considerably more porous.
Another prediction is that the risk unbundling process
will usher in a new era in which capital markets are nearly
perfect and the global economy enjoys unprecedented efficiency and stability. Well, yes and no, Rahl says. The valuation issue will remain. Im reminded by the signs I see
driving around Connecticut: We buy junk; we sell antiques.
Clearly, value is in the eye of the beholder, she says.
The world is too complex, Rahl continues. There
are different economies, different currencies, and different
The models give some guidance but dont provide absolute bounds of certainty.
There are always tail events that surprise you.
Shyam Venkat, Partner, PricewaterhouseCoopers
30
CFA
People have forgotten the lessons of systemic risk that LTCM taught, and, with everyone using
value at risk as their risk measure, we could be on the precipice of another crisis.
Andrew Lo, PhD, Financial Engineering Professor, MIT
supply-and-demand needs. Im not sure you can achieve

equilibrium across all these forces. Markets are connected in
some ways but isolated and regional in others. Arbitrage will
continue because its hard to remove all the arbitrage possibilities when they are driven by different factors.
Lo is also a skeptic. Markets are an evolving ecology,
he says. New risks arise all the time.
THE LIMITS OF RISK MANAGEMENT
hat claim can be made for risk management when

it reaches its inherent potential?
There are loose statements in the literature
about normalizing, evaluating, and taming risk, but no
responsible commentator claims that risk management can
completely eliminate all risk. Dealing with any manifestation of risk is still as much art as science because risk is
unpredictable by definition, Venkat says. The models give
some guidance but dont provide absolute bounds of certainty. There are always tail events that surprise you.
Absolute certainty and security aside, many commentators are confident that risk management will prove even more
beneficial in the future than it is today. We will have a full
appreciation of how much risk were taking to make a certain
amount of money, says Rahl. We will be able to view all
investment decisions on a risk-adjusted basis defining risk
broadly to include reputational risk, legal risk, Spitzer risk,
etc.
Venkat believes that risk management will continue to
evolve and ultimately result in better decision making across
all facets of a business. The risk element will be baked into
strategic decisions and explicitly considered in, for example,
deciding which new business to go after, he says. As time
goes on, constituents will want to know more about a firms
internal risk management practices before deciding whether
to invest. Risk management will apply more broadly in the
future and the process will continue to adapt to include new
manifestations of risk that arise all the time, he says.
The field of operational risk management is relatively
new and underdeveloped, but, even so, practitioners believe
that it is already improving bank management and daily
operations. The value proposition is quite compelling, says
Joseph Sabatini, managing director and head of corporate
operational risk for JP Morgan Chase.
As the field of operational risk develops, Sabatini says,
banks will understand operational risk more systematically
and will be able to reduce their loss experience, lower the
relative amount of capital required to support this risk class,
CFA
and raise overall productivity by standardizing and leveraging

firm-wide risk management processes where appropriate.
Lo sounds a more skeptical note about the inherent possibilities of risk management. We will be able to associate
the right bundles of risk with the right people who will hold
them at the right time, he says, but the numbers dont
always tell the whole story. He cites a distinction between
risk and uncertainty made by economist Frank Knight, who
worked in the 1930s. What was the probability in the 1990s
that the Internet would succeed? Lo asks. Thats not something you can measure.
Some observers go beyond saying that risk management
cant possibly account for everything. They claim that risk
management can in some instances make things more dangerous. Peter Bernstein wrote in 1995 (after Orange County),
An explosive demand for novel forms of containing risk is
developing, some of which, I fear, may in the end make markets more risky rather than less.
Reportedly, some bankers believe that the new Basel II
Capital Accord (see story, p. 28) is dangerous because it could
increase systemic risk by tightening credit in times of recession when credit ratings are falling. Deterioration in corporate credit ratings could require banks with corporate lending
exposure to increase retained capital by 300 percent, according to a Deutsche Bank estimate.
An ING Barings representative was quoted in December
2003 as saying that Basel II is already making bankers more
cautious, and is causing them to curtail lending in troubled
economies such as that seen in Germany. More German companies are expected to issue high yield bonds as a result.
Lo zeroes in on the universal acceptance of VAR, the
main measurement of risk in use today. VAR has made
markets more unstable because now theres a new common
variable we will all respond to when there are fluctuations,
he says. Its like everybody in the boat moving to the left at
the same time. Risk management has unintended consequences, he says. People have forgotten the lessons of systemic risk that LTCM taught, and, with everyone using value
at risk as their risk measure, we could be on the precipice
of another crisis.
The one true path to developing a fuller appreciation
of risk, according to Lo, is to experience more blowups.
What doesnt kill us will make us stronger, he says. Sweet
dreams ...
Christopher Wright is a freelance writer in the Washington, DC,
USA, area.
31
Thinking Outside the

RISK MANAGEMENT FIRMS
PUT A CREATIVE SPIN
ON COUPLING THEORY
WITH PRACTICE
BY SUSAN TRAMMELL, CFA
T H E R I S K M A N A G E M E N T I N D U S T R Y H A S E V O LV E D B E Y O N D A
one-size-fits-all approach to managing the risk of a portfolio. Today, sophisticated analytical tools covering the spectrum of financial instruments are standard equipment among risk managers. Of the small universe of firms offering outsourced risk management services, we surveyed three that, we believe, represent a cross-section of solutions. In sparest
terms, a risk management system is bundled software that quantifies various measures of the risk in a portfolio. How that
value is arrived at, however, is as much a matter of rigorous application of risk assessment tools as creative interpretation of the outputs.
All risk managers focus on identifying, measuring, and reporting on the financial risk of portfolios. Some clients, however, need more elaborate services than others. Specific requirements are driven by their portfolios exposure to different
classes of risk, the complexity of the positions, and the demands of regulatory compliance, to name only a few of the considerations that impact the selection of an outside risk manager.
Most of the tools used by providers are standard in the industry. The methodologies and processes by which each firm
integrates theory with practice, however, are proprietary. Underlying the diversity of their solutions is the shared belief that
managing risk requires a multidimensional approach.
A SIMPLE REQUEST
t was 1989 and Sir Dennis Weatherstone, the new chairman of JP Morgan, asked that a report be delivered to him
every afternoon measuring and explaining the total risk
exposure of his firm. Sir Dennis got his reports, and the analytical resources used by the staff were published online in
the RiskMetrics Technical Document. The paper brought
together the best practices for assessing financial risk. Since
it was freely available, it was widely disseminated and closely
examined by academics and the financial community. Constructive criticism led to several revisions as its methods
were adopted by banks, asset managers, hedge funds, government agencies, and other users.
By 1998, JP Morgan decided that it could no longer
meet the call for its risk management services with in-house
resources and spun off the RiskMetrics Group. The founding
team of 25, still based in New York, has since grown to a
staff of 210. The firm has a presence in seven offices located
in the United States, the United Kingdom, Japan, and Singapore. JP Morgan retains a position in the group.
We employ over 200,000 individual risk factors
equities, fixed income, currencies, volatilities, commodities,
32
CFA
spreads, etc. in our simulations and calculations, explains

Gregg Berman, head of Institutional Business at RiskMetrics.
For example, our solutions can help clients better understand the extent to which their positions may be correlated,
both within a given asset class as well as across asset classes.
It is able to do this because our methodologies are geared
toward estimating the idiosyncratic risk between similar
positions, in addition to broader market risks.
POWERFUL SOLUTIONS
erman points out how misestimating correlations can

cause banks to overfund or underfund their capital
requirements, compelling them to take action. In the
first instance, he says, banks with portfolios of similar stocks,
bonds, and combinations of both often proxy each position
to a general asset class factor. Risk analytics can reveal that
a portfolio is more diversified than expected because issuerspecific risks at least partially cancel each other out. Thus,
risk analytics may keep a bank from overestimating risk and
overfunding capital requirements.
On the other hand, risk measurement tools may reveal
underfunding. An asset manager tracking a benchmark
sometimes assigns a broad factor to each position. This can

lead to a loss of information about the differences in risk
between the positions in the portfolio and those in the
benchmark. In this case the tracking error can be much
higher then expected, Berman says, especially if results are
tuned to common reporting cycles (such as monthly or
quarterly). In such cases, RiskMetrics ability to update
volatilities and correlations on a daily basis become critical.
Risk management systems such as RiskMetrics pull in
data directly from custodians, prime brokers, and other
sources. Users can usually classify risks at different levels of
aggregation, such as by factor, asset class, strategy, geographic
region, and fund manager. The magnitude of theoretical application and computational horsepower that a risk management
firm delivers may well be superior to anything that a single
client could develop in-house, and certainly more affordable.
ANSWERING THE CALL
ike RiskMetrics, BlackRock Inc.s external risk management business began in response to external requests.
The $294 billion asset management firm was launched
in 1988 as a boutique investment manager and was partially
spun off in 1999 from PNC Financial Services Group, which
retains a majority stake. At first, BlackRock built up an analytic infrastructure to support its own asset management
business. Then clients began asking the firm to provide them
with certain risk management reports on portfolios managed
by others.
At first, we didnt know how to respond to the requests
in a systematic way, recalls Ben Golub, managing director
and head of the Portfolio Risk Management Group at BlackRock. Eventually, we realized there was a bona fide demand
for these services, and we began to accommodate it.
A major push came when BlackRock got a call from
General Electric to help with Kidder Peabody, an investment
banking and brokerage firm that it had acquired. Kidder
was going through major financial distress, and its staff was
quickly dwindling. GE retained BlackRock to provide consulting and analytics, as well as the hedging for Kidders
positions. BlackRock found itself providing analytical and
consulting services unrelated to an asset management assignment, and its outsourcing business took off.
As the complexity of the markets continued to
increase, and as the range of instruments that ended up in
fixed-income portfolios became more diverse, the resources
required to have a state-of-the-practice infrastructure grew,
Golub says. While BlackRock was a relatively fast growing
asset manager, it was unreasonable to assume that its organic
asset management business alone could support the costs
required to manufacture those analytics. By spreading the
cost of development over many clients, providers such as
BlackRock are able to stay on top of the game.
Although the concept of offering risk management solutions dates back to the mid-1990s, BlackRock Solutions
adopted its name only a few years ago. Today, more than 250
CFA
professionals provide risk management reporting on over

US$2.3 trillion. BlackRock, a publicly traded company headquartered in New York, has seven other offices in the United
States, United Kingdom, Japan, and Hong Kong.
With the external demand for the groups services
increasing, Golub, who was co-head of BlackRock Solutions,
realigned his responsibilities in 2003 to focus on managing
risk for one of its most important clients: the asset management business of BlackRock, Inc.
THE 90/10 RULE
nvestor Analytics, LLC came out of the starting gate in

1999 with the self-appointed mission of getting clients to
outsource their risk monitoring and management activities
as a way to cut costs and improve service. There were really
a number of driving factors that led us to start the company,
says Damian Handzy, managing director and a co-founder.
One of them was the lack of available tools to the portfolio
managers and fund-of-funds managers. If you wanted quantitative risk management, you had to build it in-house.
For obvious reason, Handzy explains, that is an inefficient way of doing it. If you have five firms and each of
them is going to build its own solution, 90 percent of the
work is overlap. We wanted to build a platform where our
clients could get 80 or 90 percent of the functionality they
really want by outsourcing it and have the cost savings from
the economy of scale that we can pass on to them, he says.
The other 10 percent we can custom-build for them, or they
can choose to keep totally proprietary. Call it the 90/10 rule.
VAR/EQUITY RISK
LABEL
VALUE
PERCENT
LODGING
2,010
26%
AUTO PARTS & EQUIPMENT
1.644
21%
OFFICE FURNISHINGS
1,029
13%
RETAIL
933
12%
ENTERTAINMENT
924
12%
TOYS/GAMES/HOBBIES
689
9%
HOME FURNISHINGS
586
7%
Robust risk management solutions can graphically represent the analysis

of a portfolios total risk exposure with clear, intuitive pictures. In the chart
shown here, RiskMetrics Groups software has depicted a sample portfolios
value at risk in the form of a pie chart that parses the portfolios total risk
exposure on a sector-by-sector basis.
33
Investor Analytics information processing engines statistically analyze portfolios across major asset classes, focusing on the risk exposure in the portfolios. The results are
presented in easy-to-use reports accessible via the Web.
A European client started with us about a year ago,
Handzy recalls. Within the first two months, the client discovered that the reports coming from the administrator
about the portfolio were incomplete and sometimes misleading. In addition, the client had separate risk engines to handle each of its asset classes, making it difficult to understand
the firms risk exposure. As a result of outsourcing risk management to Investor Analytics, Handzy explains, the client
gained a better understanding of its holdings and an integrated view of the market risk it was facing.
Investor Analytics, which is based in New York, provides value-added services in three ways. The first, as the
earlier example illustrates, is clarity of reporting. The second
is the companys proprietary risk tools, which are able to go
into what-if/scenario analyses and look at incremental, or
marginal risk. This helps clients to better understand the factors that contribute risk to a portfolio. Handzy describes a
typical situation with hedge funds that claim to have low
correlation with the S&P 500. One of our analyses is an
attribution of risk to various factors, one of which could very
well be the S&P 500. It essentially tells you how sensitive
you are to movements in that fund, instrument, or index.
Finally, clients make Investor Analytics reports available
to their own investors, thereby improving their client services and their own marketing effort.
STRESSING THE DATA
isk analyses typically start with the standard VAR

(value at risk) probability-based measure of loss
potential for all the subcategories in a portfolio and
then build on that information using processes that challenge less technical managers. Quantifying risk within and
across portfolios requires the input of many variables and
the flexibility to respond to conditions that are changing
constantly. Although the mechanics for applying risk management theory to practice may differ among providers, all
offer clients a means of carrying out stress tests, sensitivity
analysis, and simulations of possible scenarios.
Stress testing looks at the impact on risk levels of
extreme market moves. Particularly since 1998 when credit
spreads widened to a degree and for a time span that nearly
defied the laws of probability, managers have been alert to
the possibility of the virtually impossible.
If you know the volatilities of your various securities
and their correlations, you can calculate VAR, Handzy
explains. How do you figure out the volatilities and correlations? The standard way is to base them on history. But you
can also say, What if the volatility triples? What if the correlations all go to 1? Thats actually a numerical interpretation
of, What if we go to war? or What if the market crashes?
When a client comes to us and asks for the replay of a
34
CFA
Sensitivity analysis enables users to monitor the optionality in financial

instruments, a source of interest rate risk. BlackRock Solutions analytical
platform, for example, allows users to customize mortgage prepayment
models.
scenario, its typically a historically bad one or a hypothetical

nightmare the crash of 1987, the Fed tightening of 1994,
or September 11th. The volatility of stocks in the United
States was not 20 percent right after September 11th it
was more like 40 percent. So, the numerical model of replaying September 11th is hiking up the volatility and making
the correlations between stocks and bonds what they were in
the weeks following September 11th.
New ways of modeling operational risk such as extreme
value theory (EVT) have emerged to quantify huge potential
losses beyond three confidence levels. Standard measures
such as delta factor models are good predictors only of frequent losses that are small. EVT models look at losses above
a certain size. The result of combining the two approaches is
a more sobering view of the loss exposure in an operation.
SENSITIVITY ANALYSIS AND SIMULATIONS
ensitivity analysis subjects portfolio data to possible

shocks and captures their degree of susceptibility to
events. A client banks balance sheet, for example, will
be analyzed for its sensitivity to the different components of
interest rate risk. This might be its exposure to repricing risk
caused by changes in interest rates that may make the
institutions borrowing more expensive while it holds a portfolio of fixed-income assets or the option risk embedded
in the prepayment features of purchased mortgages.
Says BlackRocks Golub, There have been a number
of instances where clients have had very bad experiences
because they didnt appreciate the degree of prepayments
and the degree of optionality that was embedded in their
position. Or, in attempting to hedge, they may not have
matched off the negative convexity of the position properly.
Particularly in the fixed income markets, Golub
explained, practitioners focus on the parametric risk measures. If interest rates move by 100 basis points, what hap-
pens? If the two-year spot rate moves by 100 basis points,

what happens? What if volatility moves by 10 basis points,
or prepayment speeds accelerate by 25 percent? The first
component of any risk analysis that we do is to calculate
exceedingly precise parametrics, trying to understand the
sensitivities of the portfolio to specified events.
Finally, simulations give managers a chance to create a
suite of scenarios based on the statistical properties of the
markets: volatilities, correlations, and even the history itself
of how the markets have performed. When you develop an
entire simulation of potential outcomes, you dont get one
valuation change, RiskMetrics Berman says. You get a
whole suite of changes in valuation.
OUT OF THE BOX
f there is one service descriptor that keeps cropping up

among providers, it is transparency. In order for managers
to integrate a risk management service effectively into their
operations, they need to understand how it works. Gone are
the days of black box solutions, where a client handed over
its transaction details and then struggled to decipher the risk
profile generated by the numbers.
Todays risk management systems work across asset classes, giving an enterprise-wide view of risk. Parametric tools
are increasingly client interactive as risk management firms
adopt a hosted, application service provider (ASP) model to
deliver their services. Reports give clients multiple views of
risk matrices whose underlying data is mined, mapped, and
three-dimensionally modeled.
Clients have come to expect their outsourced solutions
to be flexible and scalable. Methodologies employed throughout system modules should emphasize consistency. Client
due diligence on providers should include their long-range
plans to keep their applications updated.
Perhaps most importantly, third party firms act as

repositories of information that would be off-limits to any
one client. In 2003, RiskMetrics launched Hedge Platform,
a risk management service for hedge fund managers. The
platform collects data sent in by clients electronically and
then aggregates the information so that managers can do
stress testing and run other reports. The details of each fund
are kept confidential.
AND ONTO THE CUTTING EDGE
edge Platform is only one of many service modes that

Risk Metrics offers, which encompass market risk and
credit risk measurement and reporting, data sets from
global providers, financial advisory services to high-net-worth
individuals, and research. The firm also recently launched its
pioneering CreditGrades methodology, which links credit
spreads and equity through a Merton-style process*. It allows
estimates of issuer-specific credit spread risk on an individual
name basis and as part of a correlated portfolio.
BlackRock Solutions gives clients a chance to utilize its
services in three ways. The service bureau is able to return
the risk of a given set of positions with a customizable
reporting suite. Clients can also create their own portfolios
and compute certain elements of the risk using the firms
online analytic calculators.
At the high end is the Aladdin suite, an enterprise-wide
system that provides all the front, middle, and back office
functions required to operate a large fixed-income manager.
Many of the techniques used at BlackRock Solutions are
the application of ideas published in Risk Management:
Approaches for Fixed Income Markets, co-authored by Golub,
who holds a PhD in finance.
Handzy describes Investor Analytics risk management
platform as a flexible hierarchy that accommodates any
portfolio. The firm offers a menu of industry standards
approaches to risk measurement, although it can also
customize risk analyses that are proprietary to the client.
Analytical results are displayed on their screens, and clients
can play around with different settings in an interactive
mode. Handzy, who holds a doctorate in nuclear physics,
recently co-authored a simplified alternative to Monte
Carlo simulation.
With the headline-grabbing blowups of several asset
management firms in the late 1990s, it is tempting to think
that practitioners focus on risk is a recent phenomenon.
Handzy is more philosophical. Its not that we now know
that risk is an important part of investing, he says. Weve
always known it. We just forgot it for a while.
Susan Trammell, CFA, provides business plan writing and
market research services through her New York, NY, USA,
consulting firm.
*Financial economist Robert Merton developed what is known as a structural

An example of a custom Investor Analytics screen, showing summary risk
analysis information at the multiple levels of a fund-of-funds portfolio. The
different tabs across the top lead users to more in-depth analysis.
CFA
model for the pricing of bonds. RiskMetrics uses this class of models in its
CreditGrades methodology to relate the equity and spread levels for an issuer
given a known debt level.
35
Weighty
Matters
ROBERT ENGLE WEIGHS IN ON MEASURING VOLATILITY IN AN UNCERTAIN WORLD
BY CHRISTINA GROTHEER
AUTOREGRESSIVE
CONDITIONAL
HETEROSKEDASTICITY
is quite a tongue twister.
Fortunately, Robert Engles Nobel
Prize-winning ARCH model is
much easier to put into practice
than to pronounce, according to
the many practitioners who today
rely on ARCH, and the subsequently
developed GARCH model, to more
accurately predict volatility.
Engle was thrilled to be a co-winner
of the 2003 Nobel Prize for economics, but he certainly hasnt lost his
head. True, he is flattered that the
Royal Swedish Academy called his ARCH
model an indispensible tool, but he
insists that human input is still a vital
component: Statistics cant solve all
the problems for you; its only another
input. You have to come up with your own
judgments as to whether you think the
past is still relevant for what youre doing.
36
CFA
MAGAZINE
MARCH-APRIL 2004
What first got you interested in creating more realistic volatility models?
I was on sabbatical from UCSD at the London School of Economics, and I was interested in a macro-economic problem that had been posed by Milton Friedman. He
taught that the cause of business cycles was not inflation itself but the uncertainty of
inflation because a businessman who knew what the prices and costs were going to
be in the future would decide in a very rational, sensible way whether or not to build
a plant. But if he didnt know what the costs and revenues and prices were going to
look like in the future, he might be risk-adverse and not build his plant.
So it was uncertainty that was important. And, of course, if you thought that was
the cause of a business cycle, then it should vary over time because it must be that its
more uncertain when were having recessions or when were about to have recessions
than it is when were having a good growth period. So, I was looking for a model of timevarying volatility, but it was inflation volatility that I was interested in, not financial
volatility. It turned out it didnt actually work very well for business cycles, but it
worked wonderfully well for financial markets.
when you try to measure

volatilities youve got to figure
out whats the best way to measure
something that is changing.
Your autoregressive conditional heteroskedasticity or ARCH

model is a bit complicated for everyday practitioners to grasp. What
are the practical applications of ARCH?
The idea of it is really very simple. Its a way to try to measure the
volatility of something, and particularly were interested in the
volatility of a portfolio or an asset. But, when you try to measure
volatilities, it turns out theyre not really constant over time, so
youve got to figure out whats the best way to measure something that is changing.
What financial practitioners relied on before the ARCH-type models came along
were more fixed windows. That is, you look at the volatility over the last month, or
over the last week, or maybe over the last few years to give you an estimate of what
the volatility is today and what it is likely to be in the future. The thing thats difficult
is that you dont know which window to use. If you use something like a five-year window, youll include a lot of information that may not be very relevant for today. And if
you include just a one-week window, then you would have a very noisy estimate.
So, the ARCH model gives us the best of both of these worlds by using the
weighted average of past volatility, where we give high weights to recent volatility evidence and small weights to the distant past. Thats kind of all it is.
But then the question comes, Where do you get the weights? And I think maybe
this is the most important part of what the ARCH model does. It gives you a way to
figure out what the weights ought to be by looking at historical experience. That is,
you could form the optimal forecast with any set of weights anytime in the past. And
you could see how close it was to predicting the variance of the next period. And you
adjust the weights to optimize that prediction. This is called maximum likelihood,
and it gives you a way of estimating what the weights ought to look like.
How challenging has it been to bridge the gap between academic theory and putting
your models into practice?
I think its the ultimate goal of every academic to have our methods used, so I totally
enjoy looking over the shoulders of practitioners as theyre putting my models into
practice. They have lots of problems that never occurred to me, and some of them are
quite important. These issues create interesting areas for future research.
Nothing happens straightforwardly. One of my interesting experiences was when
this was being done at an investment bank in New York in the mid 90s. It turned out
that the GARCH [generalized autoregressive conditional heteroskedasticity] models
were all predicting higher volatility than the market was giving. And the question was,
Why didnt the GARCH models come down to the levels of volatility of the markets?
CFA
MAGAZINE
MARCH-APRIL 2004
37
It turns out that this was a record low period of volatility, and I think the GARCH
models were expecting that it would ultimately come back up again. So, at any point
in time, they were an overestimate, but then the volatility in the markets came back
with a vengeance in the late 90s and today. Now, it doesnt look like such a surprising event, but it was pretty hard to understand at the time.
Im curious about your new book and your dynamic conditional correlation models,
which perhaps take GARCH a step further because they are multivariate?
Exactly. The GARCH model has been so successful in looking at volatilities of single
assets that researchers all over the world have been developing various alternatives
multivariate models for years. But they tend to be so complicated and relatively
unreliable that they havent actually caught on in the same way that univariate
GARCH models have.
Ive recently proposed a new class of multivariate models, which I call dynamic
conditional correlations [DCC], that seems much more stable. The initial evidence is
very promising on how they could work for big systems. Its a way of combining a
bunch of univariate models to build a structure where you can estimate correlations
and volatilities of large numbers of assets all at one time. So, that gives us a lot more
tools for the portfolio manager who wants to accurately predict risks and calculate the
trade-off between risk and return.
How can DCC models help practitioners incorporate multiple measures of risk?
If you try to calculate the risks of a portfolio, you typically calculate something called
value at risk. Your audience probably knows that this depends not only on the volatilities of the assets but also on the correlations between them.
But, one of the puzzles is that we dont know whether correlations are actually
constant over time or not. So, when you go to calculate value at risk, you typically rely
on things like the betas of the stock or something even simpler than that. Maybe youll
assume that all stocks have a beta of one. But it would be ideal to be able to use recent
information as an important input to figuring out what the correlation structure really
is at this point in time.
The DCC models essentially do the same thing for correlations that ARCH models do for volatilities: they do weighted averages of past correlation information,
which give the most weight to recent information and tiny weights
to distant past information. Theres some difficulty because you have
The GARCH model has been
to make sure that all the correlations lie between plus and minus
one, and even all the correlations between all the portfolios have to
so successful in looking
have this kind of property. So, there are some constraints that make it
a
little complicated, but its pretty stable and easy to implement.
at volatilities of single assets
that researchers all over the

world have been developing
various alternatives
How new are your DCC models?
I talked about them a lot last year and this year. I gave a lecture series
at Erasmus University in Rotterdam in May, which Im supposed to turn
into a book for Princeton University Press on a whole variety of aspects
of the DCC model. The book is actually coming a little slowly because
so much is going on with the Nobel Prize stuff, but Ive given a lot of talks
about it since Ive been on sabbatical here in Europe. And the credit risk people are
very interested in it, and the portfolio people are interested in it. Theres a lot going on.
What changes have you seen in risk management over the past decade?
Well, value at risk is less than a decade old, if I recall. Theres been an enormous
change in risk management; it has become systematized and regulated. It was never a
high-level position in the investment banks in the past, but now the risk manager typically has the ear of the CEO. So, the role of the risk manager has dramatically
changed over the last decade.
38
CFA
MAGAZINE
MARCH-APRIL 2004
Where do you see the field going from here?
Robert Engle, PhD, is the

Michael R. Armellino Professor of the Management of
Financial Services at New York
Universitys Stern School of
Business. In October 2003, he
was named a co-recipient of
the Nobel Prize for economics
as a result of his work on
time-varying volatility (the
ARCH model).
His research has introduced
some of the most influential
concepts in modern econometrics: ARCH/GARCH models, cointegration, weak exogeneity,
band spectrum regression,
common features, autoregressive conditional duration
(ACD), the CAViaR model, and,
most recently, dynamic conditional correlation. In well
over 100 academic journal
articles and four books, he
has applied these methods
to analyze equities, options,
currencies, interest rates,
and market microstructure.
Today, Engle is a frequent
speaker and consultant for
financial institutions. He
holds a PhD in economics and
an MS in physics from Cornell
University.
It seems to me that all banks face a dilemma, which is that the

risk manager is paying attention to risk, and the portfolio manager is paying attention to return. I think theres going to have
to be more integration between risk management and the models of return.
Suppose everybody is doing risk management exactly the
same way, and the volatility of a stock goes up. Well, the risk
manager of every company is going to tell portfolio managers to
sell this stock, so its going to go down. Well, that could be the
right thing, but it might not be the right thing. It might be that
this stock has high volatility, but maybe it should go up because
of the higher expected return.
There are a lot of issues like that, which I think require more integration between
the expected return and the risk profile. I think that is going to happen over time,
because for what Ive just described, if the stock price falls like a stone, theres some
hedge fund out there thats not tied down by risk management thatll buy it up. And
pretty soon the investment banks will realize that theyre not optimizing.
What will be the risk management tools for the future?
I think one of the interesting problems thats not been solved is the risk of portfolios
of derivatives. As soon as you have derivatives with different underlying assets, we
dont really know how to do risk management we dont know how to design portfolios very well with these. I think thats a problem that academics are going to have
something to say about, and practitioners are going to develop some good ways of
measuring those kinds of risk.
A second topic, I think, is credit risk, where the correlations of asset returns are
allowed to be much more estimated. The emphasis now on what are called copulas is
a movement in that direction. And I think this is going to lead to some new estimation and implementation tools that will help both the credit derivatives market and
credit risk managers do a better job.
How has the risk management landscape changed as a result of the tools youve
developed?
Well, in risk management, there are several alternatives that are widely used. GARCH
models explicitly are one of them. What the development of the GARCH model, and
the ARCH model, has done is to try to make a scientific way of deciding which methods are working better and which ones are not working as well. I dont think that
everybody should run the same model, but I think that as soon as you compare them
with standard volatility models like the ARCH and GARCH models, you can assess
the quality of different risk management systems.
JP Morgan Chases recent filing shows that total derivatives receivables on balance
sheet now exceed the US$70 billion size of its commercial and industrial loan book
by more than US$10 billion. Does this concern you?
I teach futures and options at NYU, so we talk about the risk of derivatives all the
time. The trouble is that theres not a simple answer, because its not that derivatives
are risky. In fact, derivatives are designed to avoid risk, and theyre described over and
over again as a solution to risk management problems.
On the other hand, the same derivative used in a different way is extremely risky.
When you look at the derivatives disasters of history, typically its where derivatives
are used not to reduce risk but to increase leverage. So, I dont think derivatives are
by themselves good or bad, its just that they can be abused. But there are lots of things
that can be abused if the risk management controls arent in place.
Christina Grotheer is a contributing editor and an editorial consultant to CFA Magazine.
CFA
MAGAZINE
MARCH-APRIL 2004
39
CUTTING-EDGE HEDGES PUT A NEW TWIST ON AN ANCIENT CONCEPT

BY JOHN RUBINO
40
CFA
ANCIENT BEGINNINGS
derivative is a contract that derives (hence the
name) its value from something else. Its function
is to divide the risk associated with the underlying
asset into pieces, allowing the pieces to be sold to
different parties, each of whom is theoretically best able to
handle it. In the first recorded derivatives deal, Aristotle recounted that Thales bought the rights to some local olive
presses because he expected a good harvest. The harvest was
indeed good, and the value of
the presses soared, making
Thales a nice profit.
Notice how this contract
divided up the risks: The
owners of the presses got
money up front, thus minimizing the danger of a bad
harvest making their equipment temporarily worthless.
Thales paid to assume that
risk in return for the chance
to profit if the harvest went
well. Each got what they
wanted and ended up, in
their own minds, better off.
Note also that the risks did
not go away; they simply
changed hands.
Over the next three millennia, derivatives, to the
extent they were employed at
all, departed only slightly
from this original design. In
the 1800s, the Liverpool
Cotton Exchange did a
thriving trade in to arrive
contracts. In the 1970s, US
and European multinationals
embraced financial futures,
Illustration: Robert Meganck
The 15th of July 2002 dawned with the global markets in a

state of high anxiety. Telecommunications giant WorldCom
had just defaulted on US$30 billion of debt, much of it
owed to a handful of major banks. JP Morgan Chase alone
was on the hook for US$3 billion, with Citigroup and several others not far behind. Even for giants like these, such
a hit would be devastating.
And then nothing. No money center bank failures, no
massive layoffs, not even an embarrassing earnings restatement. The banks, it turns out, had hedged most of their
WorldCom exposure through a new derivative called credit
default swaps. The toxic
loans were still on their
books, but the risk that the
loans wouldnt be repaid
had been peeled off and
sold. When WorldCom collapsed, the banks, though
chastened, were more-orless unscathed, while the
insurance companies and
speculators on the other
side of the swaps (i.e., the
counterparties) absorbed
the losses.
Welcome to the world of
modern derivatives, where
virtually the only risks a
sophisticated company is
stuck with are those it
chooses to retain. Interest
rate fluctuations, currency
turmoil, even bad weather
and errant economic reports
you name it, Wall Streets
financial engineers have designed solutions. Well run
through some of the more
common cutting-edge hedges in a minute, but first, a
little background.
which were standardized, exchange-traded forward sales of

money rather than things. Next came stock options, the nowfamiliar calls and puts which give their owners the right,
or option, to either buy (call) or sell (put) shares of a given
stock at a set price before a predetermined date. These contracts, though more complex than their predecessors, would
still have been easily grasped by Thales and Aristotle.
FAST FORWARD TO TODAY
portfolio for an income stream based on a variable rate that

more closely matches your deposit profile. Because in a positive yield curve environment, when short-term variable rates
are lower than long-term fixed, you earn a smaller interest
spread, but youve eliminated your interest rate risk and
locked in an acceptable profit on your deposits.
The crucial thing to understand about this and most
other swaps is that when the deal is struck, no money changes
hands. The income streams are calculated on a notional
amount, but neither side actually sends this money to the
other. A swap thus has no initial financial impact for either
party, and only shows up later on, as changing markets give
the two sides offsetting positive and negative values. Swaps
are then marked to market on their owners balance sheets.
hree things happened to usher in the modern age

of derivatives: the financial and commodities
markets went global (which is to say they became
far more risky and complicated), computers and
calculators made possible the near-instantaneous crunching
Currency Swaps
of vast amounts of data, and Fischer Black, Myron Scholes,
Assume that the bank in the previous example expects to
and Robert Merton figured out how to value options. Things
receive a loan repayment of 10 million British pounds two years
really heated up after the Black-Scholes options pricing model
hence. The true value of this payment depends on the dolwas developed, notes New York-based derivatives consultant
lar/pound exchange rate, and will shrink
William Margrabe, PhD.
if the dollar soars against the pound (not
As options and futures spread into
Things really heated up after the
very plausible at the moment, but you
every corner of the global economy, the
get the point).
financial engineers at Bankers Trust and
BLACK-SCHOLES
Instead of just accepting that risk,
Credit Suisse First Boston began creating
options pricing model
you find a UK bank that is expecting the
whole new classes of derivatives with
equivalent amount of dollars (about 14
forbidding names like inverse IOs and
WAS DEVELOPED.
million) two years hence, and enter into
quantos. These were, by and large, pria currency swap. You agree to exchange
vate contracts between corporate counthe income streams from the two loans
terparties, which didnt trade on estabWILLIAM MARGRABE, PhD
so that each bank is paid in its home curlished exchanges. Instead, they were
Founder and President
The William Margrabe Group
rency. And voila, youve each negated the
over the counter, and for the most part
risk of a decline in the others currency.
unregulated.
But, and this crucial point bears repeatThe seminal event in this process
ing, the total amount of foreign exchange risk in the system
was the development of the swap, a contract in which two
has not diminished. Each side, in minimizing one risk, has
parties exchange a series of cash flows at specified dates in the
voluntarily taken on another.
future. Swaps, it soon turned out, had an extraordinary number of applications and advantages, and in less than two
Equity Swaps
decades theyve come to dominate the global derivatives marNow pretend that youre running a mutual fund, and you
ket. Some of their most popular variants are:
expect bonds to outperform stocks in the coming year. Simply
Interest Rate Swaps
selling your stocks and buying bonds with the proceeds
For banks, one of the trickiest challenges is matching the
would create an unacceptably large taxable gain, so you enter
duration of assets and liabilities. That is, if money is coming
into a swap where you agree to pay the total return of the
in via deposits with an average life of two years, but youre
S&P 500 over the coming year while receiving a fixed interest
making loans with an average life of five years, you profit from
payment.
a positive yield curve in which long-term rates are higher than
If stocks fall, you receive the amount of the decline plus
short-term rates. But if the yield curve should go negative,
the contractual fixed rate. If stocks rise, you pay out their
with short rates rising above long, youll have to replace your
return minus the fixed rate. For the duration of the swap
short-term borrowings at rates that are higher than those of
youre protected against a decline in stock prices.
your loans.
Credit Default Swaps
The solution? Do an interest rate swap in which you
These, youll recall, are the contracts that saved WorldComs
agree to exchange the fixed-rate cash stream from your loan
CFA
41
lenders in 2002. They function like an insurance policy in

which a creditor pays an up-front or continuing fee in return
for the counterparty agreeing to cover whatever losses result
from a borrower defaulting on its loans. Note the scalpel-like
precision: This swap peels the default risk off of the loan without affecting the other risks, such as changes in interest rates
or currency values.
But swaps arent the only innovative risk management
tools around these days. Some others of interest include:
Weather Derivatives
Not so long ago, most companies dealt with storms, heat
waves, and droughts the way the rest of us do by enduring
them. But with the introduction of Heating Degree Day (HDD)
and Cooling Degree Day (CDD) derivatives came the ability to
hedge against aberrant weather. A degree day is a measure of
how much a days average temperature deviates from 65
Fahrenheit in a given area. An average daily temperature of,
say, 40 Fahrenheit would generate a daily HDD of 25. If you
can calculate the damage such a deviation from the norm
causes your business, you can hedge it with such a contract.
Weather derivatives are part of a new class of derivatives
that dont depend on an underlying asset, says Don Chance,
CFA, finance professor at Louisiana State University and
author of Analysis of Derivatives for the CFA Program. The
whole theory of pricing derivatives is based on the notion of
arbitrage. That is, traditional derivatives begin with an
underlying asset, and from there you can figure out what the
derivative should sell for [in order to] completely eliminate
the risk [of owning the asset].
However, continues Chance, you dont actually own the

weather. This makes these contracts hard to price, and perhaps explains why they havent taken off the way many
thought they might. But because so many companies are
directly affected by the weather (think ski resorts, regional airlines, hotels), I think [weather derivatives] have a lot of
room to grow, he says.
Economic Derivatives
Now lets say youre a hedge fund with an interest rate position equivalent to $100 million of 10-year Treasuries. The US
employment report is due out tomorrow, and youre worried
that a higher-than-expected number will send interest rates up
and the value of your portfolio down. The solution: Options
on the US payroll report introduced in October of 2002 by
Goldman Sachs and Deutsche Bank.
There are several ways to combine these calls and puts
into a useful hedge, says Oliver Frankel, a managing director
in Economic Derivatives at Goldman Sachs. One simple strategy would be to determine the size of the required hedge and
buy a sufficient number of calls. Given the duration of a 10year note, and some assumption about the response of 10-year
rates to payrolls, a risk manager might decide that he wants to
be paid $15,000 per thousand jobs above the call strike. If the
number of new jobs comes in 50,000 above the strike, he
would get paid $750,000, enough to offset a rate move of
about 10 basis points, says Frankel.
U S I N G D E R I VAT I V E S W I S E LY
s perceptive readers may have already gathered,
theres a lot of overlap in the effects and capabilities of the various instruments. Options and
futures can be combined into synthetic swaps,
for instance, while several different swaps might mitigate a
given risk. And how do you tell if you even need an external
hedge? Sorting all this out is a subject for a whole series of
books and MBA courses, but here are a few general guidelines:
Global Derivatives Exposure

National Value, 1999-2003
US$ Trillions
190
170
Hedge at the Enterprise, Not Divisional, Level

150
Robert Brooks, SouthTrust Professor of Financial Management at the University of Alabama, recalls a consulting job at
an insurance company where they had receiver swaps at one
division and payer swaps at the other, which completely netted out. If they would have just recognized at an enterprise
level the risks that they had, they could have avoided the
fees. The lesson: Worry about the residual risk after youve
netted everything else out.
130
110
90
70
1999
2000
2001
2002
*Through June 30
Source: Bank for International Settlements
42
CFA
2003*
Develop In-House Expertise

Most derivatives are sold rather than bought, says Brooks,
since the banks developing the newest instruments understand
them far better than do corporate treasCapital reserve requirements were easy
urers and money managers. This kind of
to administer when all banks did was
CAPITAL RESERVE
knowledge gap often leads to higher fees
make loans. But those innocent days are
and less-than-optimal results. So users of
long gone. How much capital should a
derivatives have no real choice but to
securities firm reserve against an inverse
were easy to administer when
become experts on both their internal
IO? What about an insurance company
risks and their derivatives of choice.
that owned a slice of a CBO? How should
all banks did was make loans.
Once youve devised a hedging strategy
a bank treat a complex swap with a hedge
internally, then go to the Street and get
fund such as LTCM? Overwhelmed by
competitive bids, says Brooks.
this complexity, Regulators abdicated to
FRANK PARTNOY
Author, Infectious Greed
One key to devising a hedging stratthe market and permitted companies to
egy is an understanding of the distincuse their own models flawed or not
tion between symmetric and asymmetric
to determine whether they were in
instruments, says Brooks. Symmetric derivatives include swaps
compliance with minimum capital requirements.
and futures, which dont normally require an up-front payment
Whats their macro risk?
but carry downside risk that is the mirror image of their upside
As the nearby chart illustrates, the notional value of derivapotential (hence the term symmetric). Asymmetric hedges
tives exposure the vast bulk of which is in the form of
such as options, on the other hand, charge a premium but
interest rate and currency swaps has exploded in recent
carry risks that are limited to their up-front cost. A call, for
years to more than five times global GDP. But, because notioninstance, has theoretically unlimited upside, but a downside
al values arent real, the amount of risk implied by this $170
thats capped at 100 percent of its premium.
trillion figure is impossible to nail down. The net risk is
The cost of a given hedge, meanwhile, depends on the
zero, says Margrabe, because for every short theres a long.
liquidity and transparency of its market. The market for interBut there is net credit risk, says Chance, if large numbers of
est rate swaps, for instance, is so huge and liquid, and comcounterparties start defaulting on their bets. Attempts to
petitive bids are so readily available, that its easy to place an
quantify just how much of the notional value of derivatives is
accurate value on a given contract. The market for, say, fivereally at risk conclude that the figure is around 2 to 4 percent,
year municipal tax exempt swaps, is smaller and more
or between US$3 trillion and US$7 trillion.
opaque, says Brooks, and therefore is likely to involve higher
transaction fees.
requirements
Are derivatives driving the global debt binge?
FINANCIAL MASS DESTRUCTION

sed wisely, derivatives are clearly good things for
individual companies. But their impact on the
economy as a whole is, to put it mildly, controversial. Legendary investor Warren Buffett rocked
the derivatives world in early 2003 when he labeled the
instruments weapons of financial mass destruction, which
pose mega-catastrophic risks. Is he right? Again, thats a discussion for several books and many years. But the main questions are fairly straightforward:
To what extent are derivatives being misused?

Though swaps and options have valuable roles in a modern
global economy, like any other powerful tool, they can be misused. In fact, says University of San Diego law professor and
former derivatives broker Frank Partnoy, one of their main
functions is to facilitate the avoidance of taxes and regulation.
This regulatory arbitrage, says Partnoy, has had a profoundly corrupting influence on global capitalism, one which regulators are ill equipped to counter.
In his book, Infectious Greed, Partnoy observes that,
CFA
Debt creation has shifted into high gear virtually everywhere,

with US total debt now exceeding US$34 trillion, or three
times GDP. How much of this is due to lenders newfound
ability to hedge their risks is unknowable, says Partnoy, but
the existence of derivatives clearly creates incentives for
additional lending and borrowing.
And the big question where exactly are all

the risks that are being peeled off and sold?
Slicing, dicing, and selling risks doesnt make them go away.
So, if banks emerge unscathed from the next WorldCom,
someone else wont. Credit derivatives have been used by
banks to shift the risk to insurance companies, says Partnoy.
This means traditional notions of where credit risk is housed
dont apply any more. For analysts and investors, the result
is a very different world, concludes Partnoy, in which, companies that dont seem to be lenders can, from an economic
perspective, become lenders overnight.
John Rubino, a former financial analyst, is the author of How to
Profit from the Coming Real Estate Bust and Main Street, Not
Wall Street.
43
Portfolio
100
90
K E Y P O I N TS
PERFORMANCE
80
70
Different risk measures succeed for

different applications.
60
50
40
30
Compensation structures are changing

to reward those who meet risk budgets.
Putting Risk Measurement in Context

Why one size does not fit all
BY CYNTHIA HARRINGTON, CFA
P RO F E S S I O N A L P R AC T I C E
t the core of portfolio management is the desire to limit

risk and maximize return.
Achieving that lofty goal isnt
always so easy, however, largely because
risk is difficult to define as well as to
measure. But professionals continually
try to improve on ways to look at risk
in the attempt to avoid it, to manage it,
and to talk with clients about it.
The world is becoming more scientific, says Daniel Cashion, CFA,
director, BARRA, Inc., in New York. NY,
USA. Looking for the repeatable
process of measuring portfolio risk is
one of those areas that has improved
dramatically over 20 years ago.
With the improved processes
comes an awareness that no single risk
statistic stands on its own. Some work
for some asset classes, some for more
than one, and others work best in combinations of more than one. A discussion of the usefulness of risk-adjusted
returns must set the individual measurements in their proper contexts.
In fact, when used for certain asset
classes, risk measures may have fans yet
be decried by others. Mean variance
works quite nicely for efficient classes
such as large cap value stocks with no
derivatives. But for those with return
distributions that dont fall on a beautifully symmetrical bell curve, those that
are lumped to the left or right of mean
or have long tails or fat tails, new tools
are needed.
Making the Grade
Primary among the non-normal assets

are hedge funds. When looking at
things the least bit complicated, for
instance any manager with an alpha
greater than 5 or 6, theres likely something unusual about the return, says
44
Lawrence Pohlman, PhD, director of

research for PanAgora Asset Management. Investors should look at more
than a couple of summary statistics in
this case.
Pohlmans Boston-based firm manages US$11 billion and promotes strategies that distinguish alpha from beta in
overall portfolio management. Say an
event happens three times in the recent
past that, on a normal distribution, happened three times every 10,000 years,
says Pohlman. Evaluating the reasons
for the increased frequency is an opportunity to do some education on mean
standard normal distributions.
Professionals give better grades to
some risk measures than others for
assets with non-normal distributions.
Cashion, for instance, ranks beta a C+
for normally distributed assets but a
B+/A for hedge funds. Because hedge
funds look for market neutral exposure,
the measure provides greater informational value, he says.
The original risk-adjusted performance statistic gets mixed grades as well.
William Sharpe revolutionized the
investment world in 1952 with his
measure of risk as volatility versus historical returns above the risk-free rate.
The Sharpe ratio is easy to use and easy
to calculate, so it is in wide use even
after 50 years. But for many, its not
enough. The Sharpe ratio gets a C-,
says Cashion. It cant be applied equally across asset classes. A 0.8 Sharpe on
bonds means something different than
a 0.8 ratio on equities.
To some, the information ratio (IR)
solves this problem. The IR displays the
relationship of the returns over a
benchmark and the volatility of those
returns. Unlike the Sharpe ratio, the
IR means the same thing for bonds and
stocks, says Cashion.
To others, the IR falls into the cate-
CFA
MAGAZINE
Important risk information is often

found in a combination of statistics,
not a single measure.
gory of the worst measures. Lots of

mistakes are made from the use of the
IR, says Pohlman.
As with other statistics, the IRs
future may not resemble historical data.
The IR may also not be useful as a single indicator. If one managers IR is
3 and anothers is 1, the difference is
significant, says Pohlman. But, I
wouldnt count on the difference
between a 1.5 and a 2 unless I had lots
of other information on the managers.
The other deterrent to usefulness
of the IR goes back to hedge funds and
the use of derivatives. While options
and futures can provide excess returns
in certain periods, these managers dont
do a great job generating returns versus
risk. Every so often, they get their
clocks cleaned, says Pohlman. Investors have to look beyond one risk measure to see what managers are really
doing to produce returns.
Leveraging Risk
The IR can work well in conjunction

with the technique of risk budgeting.
Risk budgets allocate tracking error, or
deviance from the benchmark, among
the different asset classes. The use of
leverage to increase the IR can thus be
managed through the risk allocations.
The best IRs come from leveraging up
or leveraging down, says Pohlman.
That requires some adjustment to the
overall risk budget to allow for greater
risk for leveraged managers.
Risk budgeting encompasses the
measures effective for normal and for
non-normal distributions. Developing
the risk budget is a process that ranges
from defining the risk to be budgeted to
divining a method for calculating the
risk to nailing down the implementation challenges. In the end, the plan
MARCH-APRIL 2004
sponsor has a method to evaluate

return on risk, not return on assets.
The method of managing portfolios
also is broad enough to evaluate the
interaction of active and passive risks.
The latter is the driving force behind
the application at the Ontario Teachers
Pension Plan Board (OTPP), North
York, Ontario, Canada. I think we
used to do what most people do, and
that is to control active risk, says Leo
de Bever, senior vice president at OTPP.
But that approach really attacks the
wrong problem. Our job is not to beat a
benchmark; our job is to pay pensions.
At OTPP, they use historical value
at risk (VAR) as the measure of risk.
Maximizing VAR
Using VAR to budget risk helps to control risk, but according to de Bever, the
process has a larger purpose. We look
across all available strategies and see if
any of them are worth looking at, he
says. When were asking if we want to
be in the equity market to the extent
we have been, all of a sudden were
having a much more involved discussion than when we used less dynamic
methods of allocating resources.
We needed the ways to identify
perceived opportunity, says de Bever.
Our focus now is much more on the
interaction of active and passive risks.
One of the important steps in
T H E TO P R I S K M E A S U R E M E N T TO O L S
Beta
Relative movement of investment versus a benchmark
Sharpe ratio
Volatility of investment versus historical returns in excess of

risk-free rate
Standard deviation
Measure of range of numbers in sample
Excess returns
Difference between actual return and benchmark return
Residual risk
Volatility of excess returns
Information ratio
Excess returns over residual risk
VAR
Probability of portfolio losses exceeding some specified

price within specific period of time
Risk budget
Method for tracking the risk per unit of reward
VAR is a technique for estimating the

probability of portfolio losses exceeding
some specified price, usually within
some specific period of time. We focus
the risks on a 1-in-100 times event in
individual portfolios, and then aggregate across portfolios, says de Bever. If
we can assume all active programs are
uncorrelated, then the aggregate risk is
the square of the individual risks.
Individuals manage their portfolios
to stay within ranges coded green, yellow, and red. Managers approaching the
red zone have some explaining to do.
Even our fundamental bottom-up
managers are very quantitative-oriented, says de Bever. We have to be careful, however, to structure incentives.
Managers get a bonus for earning high
returns on risk, and we dont want to
limit what an individual can earn.
implementing a risk-budgeting system

is the upgrade of the computer and
accounting systems. OTPP calculates
and evaluates the components of the
risk budget daily. The system depends
on daily pricing of liquid and illiquid
investments, and increased computing
power contributes greatly to the effectiveness of all risk measures. Think
about how computers allow the nonnormal techniques to become the
norm, suggests Cashion.
Whether measuring or modeling
or making decisions, theres great
uncertainty at the end of all techniques.
The tools might be best used as the
basis for talking about the specific risks.
First, practitioners and clients have to
come to a common ground of understandability and practicality of the
tools, says Cashion.
CFA
MAGAZINE
Imagine if clients asked about

how normal returns were for all classes,
even large, mid, and small cap value,
poses Cashion. Imagine talking with
clients about how small caps and certain sectors and classes are not very
well-behaved. Then use the testing on
different models to address the problem
rather than pretending it doesnt exist.
The search for the perfect measure
continues. Several recent developments
appear frequently in the academic literature but havent yet caught on with
many investors. Consider the Fouse
index, suggested by Bill Fouse of Mellon
Capital Management. This index incorporates the investors utility for a risky
outcome, which is the expected return
minus some fraction of the risk, where
the fraction of risk is an expression of
the investors degree of risk aversion.
Another measure that addresses
investor sentiment measures downside
risk, or the frequency of negative
returns. Weve kicked around the
Sortino ratio that measures downside
risk for a long time, says Pohlman,
but weve never gotten into it.
New methods will be developed,
and current measures effectiveness will
be better known through practice and
testing. But, in the end, the measures are
just tools. The most sophisticated models
will always require human skill and discernment to interpret and apply them.
Cynthia Harrington, CFA, is a financial
journalist with 20 years experience in the
investment business.
RECOMMENDED RESOURCES
Developing and Implementing a Risk-Budgeting
System
Improving the Investment Process Through Risk
Management
2003 AIMR Conference Proceedings (aimrpubs.org)
Risk-Adjusted Performance Measures
and Implied Risk Attitudes
Abstracted in The CFA Digest, Nov. 2002
(aimrpubs.org)
Innovations in Risk Measurement
Equity Portfolio Construction
Benchmarks and Investment Management
2003 Research Foundation of AIMR Publication
(aimrpubs.org)
MARCH-APRIL 2004
45
Analyst
K E Y P O I N TS
AGENDA
The market is rewarding management

of intangible risk.
Higher returns are the result of
competitive advantages and better
use of resources.
Risk Management and Valuation
Lowered costs of capital can also be

achieved.
The rewards of managing intangible risk

BY JONATHAN BARNES
hats the reward for risk

management? For many
investors, a precise
answer to that question
is often tough to find.
Tougher still is gauging the reward
for a firms risk management of intangibles those hard-to-grasp areas such
as human capital, labor relations, and
environmental management largely
unmeasured and absent from financial
statements. But as new metrics come to
light, investors are seeing that companies that can manage intangible risk are
raising their returns above their less
skilled or less interested riskmanaging competitors.
Intangible Risks, Tangible Rewards
Bijan Foroodian, CFA, is the managing

director of investment management at
Innovest Strategic Value Advisors, a firm
that specializes in rating companies
management of their intangible risks.
There is a relationship between
companies that are managing these risks
and the performance of these companies, Foroodian says. You can regard
the ratings from two perspectives. [One],
as a way of assessing the risks within
the companies. And [two], as a way of
assessing their expected performance.
The companies with higher ratings
have a higher expected performance.
A shining example (using real historical performance) is Innovests
November report on the European electric utilities sector. Share price returns
of firms rated above average (at managing intangible risk) outpaced those of
below-average-rated firms by approximately 39 percent over a three-year
period ending July 2003.
Companies were rated on how well
they managed more than 60 non-tradi-
46
tional business factors, including

investor risk associated with tightening
environmental regulations, growing
consumer demand for environmentally
responsible energy, and higher corporate social responsibility standards.
In addition to outperformance in
share price, companies that best managed intangible risks also posted top
results in other valuation measures. For
instance, operating profit margin: 15.8
percent versus 7.8 percent for low-rated
firms. And P/E: 21.2 percent versus 8.9
percent. Or return on equity: 16.9 percent compared to 11.2 percent.
In another independent report
using Innovest data, share prices of US
companies that rated highest at managing the environment outperformed by
9.5 percent annually (from July 1997 to
December 2002) over their lowest-rated
competitors. That finding prompted the
reports authors to conclude that there
was an eco-efficiency premium in the
US equity market.
Gerald Gay, PhD, professor of
finance at Georgia State University,
agrees that managing intangible risks
has its rewards. But he cautions against
applying easy labels, especially the
notion that investors pay a premium
for risk management.
You have to think through the
economics, and paying a premium
doesnt mean anything, says Gay.
Now if youre telling me all else
being equal that a firms got good
governance structures in place, good
internal control mechanisms, good
oversight then maybe this would be
a firm that would be less susceptible to
major lawsuits, less susceptible to management engaging in fraud.
While attention to ethical issues
has been seen by some as a money pit,
Foroodian says that firms that manage
those issues are actually achieving com-
CFA
MAGAZINE
As measurement of intangible risk

increases, so will the rewards for
managing it.
petitive advantages from a more efficient use of resources. That, in turn,

translates to higher returns.
You can look at community relations the interaction between a company and the actual consumers, says
Foroodian. If a company doesnt have
good relations from that perspective, it
could be negatively influencing end
users of its product. Or it could be negatively affecting [its workforce]. We see
companies with poor human resources
management that end up having high
turnover of staff and lower productivity. These things are bound together.
From Managed Risk to
Market Reward
To arrive at a rating, Innovest typically

assesses a company in more than 100
areas of intangible risk, from ability in
handling customer relationships to
human rights in emerging markets to
employee motivation in its workforce to
brand value.
Specific risks are identified for each
industry. Information is gathered from a
range of sources: corporate documents,
government reports, and non-government organizations. Interviews with
senior management are held, and then
all factors are fed into an intangible
value model, resulting in a rating
somewhere from AAA to CCC.
Foroodian says the ratings are
intended for investors as an overlay to
their existing investment strategies.
A typical fund, he says, would
employ our ratings in terms of the
alpha associated with companies that
have higher ratings and are better from
an intangible value perspective. For
MARCH-APRIL 2004
instance, investors may adopt an

approach where companies judged to
have superior management of non-traditional risks (a AAA-rated company)
may be overweighted in a portfolio, at
the expense of another company that
has received a low rating. Other
investors may take a view that CCCrated companies [should] not be eligible for inclusion in a portfolio at all.
In this way, Foroodian continues,
companies [with] above-average ratings are rewarded by attracting access to
capital. Top-rated companies also enjoy
marketing and reputational benefits
from achieving a best-in-class rating.
The Rewards Are in the Returns
Stephen Dillenburg, CFA, portfolio

manager at Summit Investment Partners, is seeing many of the same things.
In scoring S&P 500 firms in their management of intangible (stakeholder)
risks, Dillenburg found that firms with
high TSI (Total Social Impact) scores
performed best in six of eight categories.
The biggest gap appeared among
companies treatment of employees,
with shares of top-decile firms returning 26 percent higher than bottomdecile firms in 2003. Another eye opener was among companies treatment of
customers a 22 percent difference.
Nearly as exceptional was another
category: risks associated with engaging in cartels, spheres of influence, or
excessive/unfair patent protection.
(We downgraded Microsoft on this
one, obviously, says Dillenburg.) That
category revealed a 16 percent outperformance by the highest scoring firms.
I cant give you answers for [all
the results], admits Dillenburg. People are making judgments on competitive business practices. Maybe some of
that is working its way into the market. Investors saw that Microsoft was
hammered for antitrust, and if you
look, tech stocks were up dramatically,
but Microsoft was only up 9 percent.
But its not a perfect fit. Corporate
treatment of owners and investors the
hot topic of 2002 showed the opposite effect. Companies that treated shareholders the worst performed the best.
Dillenburg interprets that as a
U N S P O K E N VA L U E
As recently as the mid-1980s, financial statements captured at least 75
percent on average of the true market value of major corporations. In
the intervening years, however, that
figure has dropped to 15 percent on
average, according to Intangibles:
Management, Measurement, and
Reporting by Baruch Lev, professor
of accounting and finance at New
York University.
If true, then 85 percent of value is
left unspoken for, and its risks and
rewards, unexplained.
Thats the hole that Innovest
Strategic Value Advisors wants to
fill. Innovest rates more than 1,700
companies worldwide on intangible value drivers, and is currently
assessing the climate risk exposure
of the worlds 500 largest corporations, the future liability of which
could be as high as 40 percent of a
companys total market capitalization, it estimates.
market reaction companies previously punished in share price snapping

back to life. Overall, he says, the top 50
TSI-scoring firms in the S&P 500
returned about two percent more than
the bottom 50.
Dillenburg puts it this way: What
is the risk for stock ownership? The
risk is that the future does not equal the
predictions for the future. The whole
premise of the TSI is that stakeholder
treatment is really the best indicator of
management quality and predictability of earnings. [And] if youre comfortable with a companys ability to meet
predicted future earnings, you typically
accord that stock a higher P/E ratio.
A company that scores very highly
is likely to be more predicable because
theyre managing the risks associated
with their stakeholders to the best of
their ability, adds Dillenburg.
As at Innovest, determining how
well firms are handling that task is key
to finding firms that can outperform.
What I do, says Dillenburg, is I put
together 10 benchmark questions in
CFA
MAGAZINE
each of the stakeholder categories.

They fall into three general areas. First,
does a company have a policy with
respect to its stakeholders? Is it available? Is it well articulated?
[Second], we look at implementation of those policies, he says. There
are lots of companies that have a nice,
glossy policy, but you see absolutely no
implementation. You dont see worker
training, for instance, you dont see a
commitment to health and safety issues.
[Finally], we look at results, in
two ways, Dillenburg concludes.
Companies receiving awards: bestplace-to-work awards, safety awards,
environmental awards. Or, on the other
hand, are they always subject to lawsuits? Are they paying a lot of fines and
legal settlements because of issues
theyve neglected?
The answers to those questions,
says Dillenburg, will say a lot about a
companys bottom line.
Its not just managing market risk
[anymore], adds Gay, but also operational and reputational risk everything. More and more firms are paying
attention to all sources of risk that
could someday lead to large losses.
That day has already come for
many companies. For others, attention
to the many aspects of intangible risk
may be the secret to success.
Thats where intangible value
builds its foundation, says Foroodian.
Its a combination of all of these factors
that, over a period of time, has an
impact on a companys performance.
Jonathan Barnes is an author and a financial journalist who writes primarily for
Investors Business Daily.
Intangibles: Management, Measurement,
and Reporting
By Baruch Lev (Brookings Institution Press, 2001)
Mark-to-Future: A New Risk Measurement
Approach
Abstracted in The CFA Digest, Summer 2000
(aimrpubs.org)
Innovest Strategic Value Advisors
www.innovestgroup.com
Total Social Impact
www.totalsocialimpact.org
MARCH-APRIL 2004
47
Trading
K E Y P O I N TS
TACTICS
With its QFII scheme, China has taken

a first step in opening capital markets.
Institutional investors gravitate toward
large-cap A-shares and bonds.
Milestone or Millstone?
US-based Securities Industry Association (SIA) views QFII restrictions as

onerous and urges reform.
QFII rules open Chinese markets to institutional investors

BY NANCY OPIELA
ith its Qualified Foreign

Institutional Investors
(QFII) scheme opening
its US$500 billion Ashares market (free float around US$150
billion) to foreign investors, the Peoples Republic of China (PRC) has taken
a giant step forward into the global capital marketplace.
Rules that took effect in December
2002 allow foreign institutions meeting
stipulated requirements to invest in
Renminbi- (RMB) denominated Ashares, treasuries, convertible and corporate bonds traded on the Shanghai
and Shenzhen stock exchanges, and
other financial instruments approved by
the Chinese Securities Regulatory Commission (CSRC). Later, the purchase of
stocks through initial public offering
and additional shares issuance was also
permitted, though due to technical
reasons, the exchanges temporarily
banned QFII from repurchasing state
bonds and trading corporate bonds.
By the end of 2003, 10 investment
banks had been granted quotas worth
US$1.7 billion. Due to issues ranging
from restrictions on entering and exiting the market to worries over corporate
governance, foreign investors initially
preferred dipping their toe in to test
the waters rather than a full plunge,
notes Kenneth Luh, director and head
of China research, Credit Suisse First
Boston, but that caution is beginning
to ease as, in recent months, the A-share
market has gotten a lot cheaper.
Waiting for Something to Crystallize
However, Luh expects A-share performance to be limited this year, mainly

because of a structural issue: state dominance. Two-thirds are state shares,
which are not tradable. The government
48
has been trying to convert state shares

to tradable shares, but thats facing very
strong resistance from existing investors
in the A-shares market, he says.
The beginning of the current sort
of bear market for A-shares started in
the summer of 2001 when the government announced plans to convert state
shares to tradable shares. Its been a
continuous effort since then to come
up with a new plan that would be
acceptable to everybody. With no plan
in place now, investors are waiting for
something to crystallize.
With the government currently
focused on banking sector reform, Luh
says its likely to be 2005 before a resolution is reached a turning point that
would prompt institutional investors to
take a more aggressive stance in equities.
In the meantime, QFII favor the
relative safety of large caps and plays
on Chinas growing economy. Were
interested in quality A-share companies
in sectors that are not available in the
Hong Kong market, such as transportation, power, basic materials, and automotive, says Nicole Yuen, head of
China equities, UBS AG. We look for
companies of a sufficient size, in terms
of market cap and liquidity, with attractive valuation, good earnings growth,
and quality management with good corporate governance.
With a favorable current yield and
speculation on re-valuation of the RMB,
many institutional investors view state
or treasury bonds as a better bet than
A-share stocks. Luh notes his research
shows as much as 50 percent of QFII
capital is tied up in bonds, a fact he
allows could be due to the requirement
that QFII must invest their total quota
within three months of their approval.
He explains, Often firms will use debt
instruments as a place to park the money
until they find interest for equities.
CFA
MAGAZINE
The projected impact of QFII on China

includes improved corporate governance plus the introduction of fundamental analysis and long-term investing.
Restrictions on QFII
While enthusiastic about investment

opportunities in China, the New York,
NY, USA-based Securities Industry
Association (SIA) is on record saying,
current QFII requirements are onerous
and limit the utility of the program.
Specifically, SIA objects to the requirement that a QFII commit at least US$50
million equivalent (currently more than
1 percent of total market capitalization)
in a special QFII account.
In addition, SIA dislikes the limitations on QFII ownership, both individually and in the aggregate, and the
requirements that the principal amount
in the QFII account remain in the
account for at least one year (three
years for closed-end funds), with subsequent remittances required to be
approved by the State Administration of
Foreign Exchange and principal withdrawal only permitted in stages.
We urge China to continue the
process of making its securities markets
more attractive to investment by abolishing the QFII regime in favor of a
forward-looking policy encouraging
unimpeded investment in the domestic
market, says SIAs David Strongin.
Impact on China
According to Yasheng Huang, a professor at the Massachusetts Institute of

Technologys Sloan School of Management and author of Selling China: Foreign Direct Investment During the Reform
Era, its not the infusion of capital that
will have the greatest impact on China.
China has plenty of capital, and, in
fact, it is exporting its capital abroad,
MARCH-APRIL 2004
UBS AG
US$ 600 million
Morgan Stanley Dean Witter Co., Ltd
US$ 300 million
Citibank Markets Ltd.
US$ 200 million
Deutsche Bank AG
US$ 200 million
HSBC
US$ 100 million
ING Bank N.V.
US$ 100 million
Credit Suisse First Boston
US$ 50 million
Goldman Sachs
US$ 50 million
Morgan Chase Manhattan Bank, NA
US$ 50 million
choice of a custodian bank, and each

QFII quota. Thats a lot of news. And
people on the PRC versions of CNBC
have speculated intensely on what
stocks are good investments because of
their potential to be QFII targets.
All that press has not been lost on
local investors. Says Donghuan, Prior
to QFII, local investors believed that the
market was only for speculators gambling and almost all listed companies
had no value as long-term investments.
QFII have changed the publics mind
and enhanced their confidence in the
market. Learning the operative theories
from QFII, local investors have begun
to reconsider their own investments.
Nomura Securities Co. Ltd.
US$ 50 million
Slow and Steady Wins the Race
QFII APPROVED BANKS

The 10 investment banks with approved QFII quotas are:
he notes. The biggest contribution of

QFII will be weakening the state ownership of the Chinese listed companies
and bringing higher corporate governance standards to management of the
corporate sector and the Chinese securities industry.
Wu Donghuan, Zhonghao Law
Firm, Shanghai, China, says the gradual
opening of the PRCs capital market will
result in optimized corporate structures
and increasing transparency for the
countrys listed companies. China needs
foreign capital to invest in China as well
as advanced management and investment
skills to be used in China, he notes.
In fact, Yuen reports she already
sees substantial progress in corporate
governance with companies UBS covers. Access to management is improving, and our discussions are invariably
informative. For the market at large,
there is still a lot to be improved, but
we are happy with the progress so far.
In Luhs view, these changes have
been driven largely by Chinas internal
regulators. As QFII invest more in
equities, institutional investors approach
to stock selection based on management
quality and demand for information
disclosure will have a more significant
impact, he says.
Additionally, Walter Hutchens,
Robert H. Smith School of Business,
University of Maryland, College Park,
Md., USA, notes that PRC policy mak-
ers, including CSRC chairman Shang

Fulin, have repeatedly expressed hopes
that QFII will imbue PRC stock trading
with a new perspective one based on
fundamental analysis and long-term
investing, not speculative trading for
the short term.
PRC speculators are not trading
the way they do because they dont
know how to do value investing, says
Hutchens. They can buy Buffett in
most any bookstore in China. But they
may rationally decide the quality of
public disclosure does not support that
style of investing. Moreover, policy
moves do dramatically influence these
markets, so trading on speculation
about policy is not irrational.
The Key to Investor Behavior
Indeed, Hutchens says QFII may

rationally act like irrational PRC
traders. If QFII are putting in capital
based on expectations that the RMB
will be revalued, they are already treating these markets as policy markets
just as PRC investors do, he explains.
It seems institutional economics, not
the origin of capital and its managers, is
the key to investor behavior.
Hutchens also notes the QFII system
drove a lot of financial sector news in
China last year: Prospective QFII
announce their application. Then they
announce the CSRC approval, the
approved list of custodian banks, each
CFA
MAGAZINE
In its inaugural year, the QFII scheme

has moved ahead in a positive manner.
Several QFII already have requested
their quota be increased. QFIIs may
simply want bigger quotas because they
think the PRC bear market has already
bottomed out and prices will continue
to improve, says Hutchens. For the
PRC, perhaps the recent spate of quota
increases is designed to be a market
stimulant.
Progress for the QFII scheme will
be a combination of China gradually
relaxing investment restrictions and
QFII becoming more aggressive as they
get more familiar with the market.
While the door to Chinas capital markets has swung open, it could be three
to five years before Chinas QFII program can deliver on its potential for
investors and for China alike.
Nancy Opiela also writes for the Journal
of Financial Planning and Focus, Fidelitys magazine.
QFII: Chinas Gateway to International Capital:
Qualified Foreign Institutional Investor Explained
EuroBiz magazine, Nov. 2003
Private Equity in China: Why the Time is Right
The CFA Digest, Nov. 2002 (aimrpubs.org)
Derivative Strategies for Asian Equity Portfolios
Evolution in Equity Markets: Focus on Asia
Gloom or Boom for Global Markets?
AIMR Webcast (aimrdirect.org)
MARCH-APRIL 2004
49
Private
K E Y P O I N TS
CLIENT CORNER
Private clients often lack the analytical

background to interpret traditional
portfolio risk measures.
Risk Management for Private Clients

Going beyond traditional quantitative measures
BY ED MCCARTHY
50
nstitutional investors use a variety

of sophisticated portfolio risk
measurement and management
techniques, but many of those
tools have not been widely available to
private clients. According to Robert
Rice, chief executive of Occam Financial Technology a financial software
developer and consulting firm in East
Sussex, UK part of the reason for the
scarcity is economics.
If youre managing a pension fund
thats worth several billion dollars, you
will want to pay very close attention
to the risk youre undertaking, and the
pension fund trustees have a right to
expect that, says Rice. Because the
fund is very large, you can afford to have
highly paid people working full-time
looking at these technical aspects.
When it comes to private clients,
Rice continues, the problem is that the
portfolios are much smaller and, at
least until recently, it hasnt really been
cost-effective to apply these techniques
to each and every one of them.
Its not just a question of having
the techniques available, however.
Institutional investors and their consultants understand how risk measures
are calculated, and they recognize the
logic behind, and inherent limitations
of, risk management strategies. While
some private clients have strong analytical backgrounds and are comfortable
with quantitative analyses, financial
advisers should be cautious about
assuming too much investor expertise.
I dont think the traditional quantitative measures are a meaningful way
to explain risk to private clients, says
Todd Owens, CFA, a portfolio manager
with the Oklahoma City, Okla., USA,
money management firm of James
Baker & Associates. They are useful
for a portfolio manager, but private

clients dont want a bookish explanation of risk they want something
down to earth. Measures such as standard deviation are not the type of
answer I would use to explain something meaningful to private clients.
Defining Risk
Even if a private client understands the

measures, his definition of risk might
be very different from the institutional
investors, which could result in the
adviser measuring risks that dont concern the client. For example, institutions typically target a benchmark to
evaluate their portfolios relative results.
Private clients may use a benchmark
for reference, but they are more likely
to evaluate their portfolios absolute
performance.
Brett Barth, a partner at BBR Partners in New York, NY, USA, works
exclusively with high-net-worth families. He has found that these investors
take a long-term perspective because
they are planning for successive generations. They are less focused on shortterm relative performance versus the
market and much more on long-term
Private clients often focus on absolute

returns instead of relative returns.
Advisers should measure private
clients risk tolerance and educate
them about the potential impact of
portfolio volatility.
A range of risk management techniques
are available to advisers, depending on
the clients requirements.
absolute performance, he says. The

greatest risk they face is not underperformance versus the market but a drawdown of principal in periods of meaningful negative performance.
This concern with absolute return
is understandable because losses diminish the private clients personal financial security. In contrast, institutional
portfolios are usually managed by
trustees and their consultants on behalf
of employees or other stakeholders. The
trustees have a duty to manage the funds
properly, but they are less likely to be
emotionally involved in the process.
Measuring Risk Tolerance
The shift in focus from relative to absolute risk requires advisers to acknowledge their private clients risk tolerance
level to avoid building inappropriately
risky or excessively conservative portfolios. Measuring risk tolerance is a chal-
M E A S U R I N G R I S K T H R O U G H P SYC H OM E T R I C S
Designing a questionnaire to measure risk tolerance accurately is a specialized
skill. Geoff Davey, managing director and CEO of FinaMetrica (formerly ProQuest), a
Sydney, NSW, Australia-based company that has developed financial risk tolerance
assessment software, points to two challenges. First, there is no physical manifestation of risk tolerance, and second, there is no natural unit of measurement.
The FinaMetrica Risk Profiling System draws on psychometrics for its methodology. The company worked with the University of New South Wales Applied Psychology unit to develop a questionnaire with 25 questions. Investors can answer
the questions online or in print, and test takers receive a score that ranks their
risk tolerance relative to previous participants. FinaMetrica also has a methodology for the adviser to compare a clients score with the risk inherent in various
investment strategies. Over 500 Australian advisers use FinaMetrica with their
clients, and approximately 100 American firms work with the test.
CFA
MAGAZINE
MARCH-APRIL 2004
lenge, however, particularly in the early

stages of the adviser-client relationship
when the adviser lacks market-tested
experience with the client.
Grace Lau, CFA, president of
PacWest Financial Management, Inc.,
in Phoenix, Ariz., USA, has new clients
consider their reaction to potential
market losses. Before we sign on a
client, we complete a questionnaire for
risk assessment, she says. We restate
the statistical concepts in laymans
terms. One of the questions is, If your
portfolio value drops 15 percent, how
will you react? Will you lose sleep over
it or will you say, Im investing for long
term so it doesnt bother me.?
Owens has been working with the
FinaMetrica (see sidebar) for the past
18 months to estimate new clients risk
tolerance. He reports that clients have
reacted favorably to the questionnaires
non-technical language, and the scores
have been a valid indicator of the
clients subsequent risk tolerance. His
work with FinaMetrica also provided
an unexpected benefit. When you discuss risk tolerance with a client, you
can inadvertently guide them to a profile where you think they belong. You
become overconfident with your own
assessment. Using FinaMetrica removes
my bias from the process.
Educating Clients
If clients arent comfortable with statistical portfolio risk measures, how can
you make them understand the riskreturn tradeoff? Several of the advisers
interviewed for this article rely on
Monte Carlo simulations (MCS) to convey uncertain outcomes. Chris Cordaro,
CFA, chief investment officer with
RegentAtlantic Capital in Chatham, NJ,
USA, uses MCS to show clients how a
changing asset allocation influences the
likelihood of achieving a financial goal
such as adequate retirement funds.
Although Cordaro was concerned
at first that clients would have a problem understanding the MCS analysis,
he reports that the majority of them
grasp the concept of variable outcomes
without difficulty. He points to daily
weather forecasts, which express the
likelihood of inclement weather as a
probability, as one reason that clients

understand forecasts that include
uncertainty. Another reason: The recent
bear market has been a reminder that
equity prices do not always increase.
Roger Gibson, CFA, president of
Gibson Capital Management, Ltd. in
Pittsburgh, Pa., USA, spends an extensive amount of time educating new and
existing clients about portfolio risk. He
leads clients through a series of educational meetings before the firm makes
any investments. His goal is to have
clients understand the case for diversification across a broad range of asset
classes, and his experience has been
that investors can master the concept of
investment risk. Ive dedicated my professional life to learning how to communicate these concepts to clients,
says Gibson, author of Asset Allocation:
Balancing Financial Risk. Weve taken
clients with no financial investment
background at all, steered them through
the process, and theyve been able to
make good investment decisions for
themselves.
Managing Risk
Assuming the client understands the

potential volatility in his portfolio and
his ability to tolerate that risk, what
steps do advisers take to manage the
investment risk? All sources for this
article stressed the role of adequate
diversification across asset classes
the all-weather strategy, as Gibson
calls it. Some advisers also work with
non-traditional assets.
Barth works extensively with alternative investments such as hedge funds
and private equity arrangements to
reduce the volatility in clients portfolios. We look at allocations to strategies, not asset classes per se, so our
overall portfolio allocation is really an
allocation of multiple strategies, he
says. We include positions that would
be considered alternative, such as longshort equity and absolute return strategies, and traditional hedge fund strategies such as convertible arbitrage or
merger arbitrage. One of the things we
like about some of those investments is
that they tend to be less volatile than
traditional strategies. That means the
CFA
MAGAZINE
client probably gives up some upside

performance but also much of the
downside risk, so he ends up having a
much smoother portfolio performance.
Diversification isnt always attainable, at least in the short run, if the
client cannot sell an investment, for
example. In those cases, traditional
hedges, such as options-based strategies, are useful for specific risk management needs. Paul Emata, CFA, CIO for
PNC Advisors in Wilmington, Del.,
USA, uses hedges with numerous highnet-worth clients, although it can be
difficult to convince clients of the need
to hedge positions during a bull market.
Depending on the clients needs,
Emata has recommended collars, variable prepaid forward sales, and puts
and calls. The techniques can be presented with the logic that different
types of hedges are appropriate for different types of markets, he says. For
example, collars are more appropriate if
you want to freeze a value. You would
want to freeze a value when markets
are high, so when markets are fully valued, thats the time to think about
implementing collars. For a sideways
market outlook, covered calls might be
the best bet.
Private clients often have a different view of risk than institutional
investors. Measuring and managing that
portfolio risk and then communicating the resulting analysis and strategies
effectively to the client is a realistic
goal for advisers willing to adapt their
tools and techniques as needed.
Ed McCarthy is a freelance writer and
author in Warwick, RI, USA.
Future Strategies for Private Wealth Management
Risk Management Versus Risk Measurement
Improving the Investment Process Through Risk
Management
The Fundamentals of Risk Measurement
By Chris Marrison (McGraw-Hill, 2002)
Asset Allocation: Balancing Financial Risk
By Roger Gibson, CFA (McGraw-Hill Trade, 2000)
Step Right Up
Bloomberg Wealth Manager, Sept. 2002
MARCH-APRIL 2004
51
Ethics
K E Y P O I N TS
FORUM
Many of the US SECs regulatory

duties are delegated to the NASD, the
stock exchanges, and the accounting
profession.
One solution to the United States current regulatory structure is to merge
the various self-regulatory organizations (SROs) into one national SRO.
Scandal and Fraud

Can regulatory reform change Wall Street?
BY STEPHEN BROWN, CFA
52
all Street history is

replete with paroxysms
of fraud, scandal, and
manipulation. Most
occurred at the apex of a bull market
when optimism was high and due diligence low. In the past, the financial fallout was contained within the upper
crust: The wealthy were the primary
cons of corporate malefactors and unctuous stock promoters. Today, the
assembly-line worker is as likely to fall
victim to Wall Street malfeasance as the
Manhattan socialite, for more than 95
million Americans own stock.
Historical Perspective
Despite increased democratization and

regulation of equity markets, fraud persists. Whats more, the fraud is often
imitative at that: Accounting chicanery
was the fraud de jour of the 1930s following the stock market crash of 1929.
One clever ploy of the era was to create
labyrinths of holding companies, each
sired to conceal the others financial
frailties. Such sleight of hand produced
the most notorious failure of the post1920s bull market, the collapse of the
vast, high-flying utility Middle West
Utilities, which, in hindsight, was the
archetype for todays Enron.
In reaction to these abuses, the US
Congress passed the Securities Act of
1933 and the Securities Exchange Act
of 1934 to empower the newly created
US Securities and Exchange Commission (SEC) with restoring confidence to
Wall Street. The theory of the SEC
when it was originally created and
financed was to deter fraud, notes Joel
Seligman, Ethan A.H. Shepley University Professor and dean of the school of
law at Washington University in St.
Louis, Mo., USA. The emphasis was
on reviewing documents by issuers and

raising questions before securities went
to market.
The SECs mandate worked, at
least initially. But over time its resolve
and investor skepticism waned. The
bull market of the late 1960s and early
1970s preceded the implosion of the
Nifty 50 stocks, which, in turn, culminated in more accounting scandals.
In subsequent decades, trouble
again followed ebullient markets. In
1987, the stock market crashed, the
junk-bond market unraveled, insidertrading scandals proliferated, savings
banks dissolved, and real-estate investment trusts caved. Following this widespread bust, a tsunami of regulatory
lawmaking flooded the financial markets.
Unfortunately, the new edicts
proved effete over the long haul; fraud
not only persisted, it proliferated. Fast
forward a decade to 2001. WorldCom,
Enron, Adelphia, Andersen, Tyco, Global Crossing, and Qwest are all charged
with financial statement manipulation.
Since post-SEC period records have been
kept, we are currently beset with more
scandal than ever, according to Charles
Geisst, author of 100 Years of Wall Street
and professor of finance at Manhattan
College in Riverdale, NY, USA.
The most recent addition to financial infamy is the US$7 trillion mutual
fund industry. In late 2003, Canary
Capital Partners LLC a multi-milliondollar hedge fund accepted a US$40
million settlement with the New York
State Attorney Generals office. The
charges: It engaged in illegal trading
with several large mutual fund companies that potentially cost investors billions of dollars. Look for more fines in
the future; a survey of 88 mutual funds
by the SEC found that late trading
might have occurred in as many as 10
percent of the firms surveyed.
CFA
MAGAZINE
Paroxysms of fraud occur roughly

every 10 years, regardless of the
degree of regulatory oversight.
Why Regulation Fails
The SEC is the regulatory overlord of

the securities markets key participants
the stock exchanges, broker/dealers,
investment advisers, mutual funds, and
public utility holding companies.
Nonetheless, many of its regulatory
duties are delegated to the National
Association of Securities Dealers
(NASD), the stock exchanges, and the
accounting profession.
Unfortunately, these entities often
lack the incentive to challenge transactions that might self-enrich or inflict
political discomfort. Whats regulatory
is political, says Bill Singer, partner at
Gusrae, Kaplan & Bruno PLLC and a
former exchange regulator. [Because
of elections], every four years people
leave the SEC, so it cant retain qualified individuals. The self-regulators
arent much different.
The SEC relies on these self-regulatory organizations (SROs) to police
trading floors; it routinely approves
SRO rules and disciplinary decisions.
During quiet periods, the relationship
works. SROs are fine performing daily
chores, says Geisst, but they have
never turned up any major problems
when it really mattered.
To its detractors, the SEC becomes
complacent during fat years. To its
defenders, it becomes underfunded.
Congress decided not to add a new
position in the SEC between 1995 and
1998 when the markets were exploding
with activity, says Seligman. It [Congress] may have been more responsible
than any other agency for weakening
the SEC at time when it might have
MARCH-APRIL 2004
prevented a great deal of fraud.

When scandal breaks, embarrassment and finger pointing ensue, and
everyone questions why the exchange
in charge was lax in disciplining its
members. After the debacle, the SRO
proposes minor rule modifications,
often at the SECs insistence, but then
essentially leaves the exchanges functions and membership intact.
W A L L ST R E E T
ROGUES GALLERY
1929 Albert Wiggin, CEO of Chase
National Bank, makes millions
shorting shares of his own
company.
1932 Utility giant Commonwealth
Edison declares bankruptcy.
1971 Robert Vesco embezzles
US$224 million from Investors
Overseas Services Corp.
1975 US SEC censures accounting
firm Peat Marwick Mitchell for
giving clean reviews to five
companies that soon fail.
1980 Silver prices tumble from
US$50 to US$10 an ounce
after Hunt Brothers corner
the market.
1986 The SEC fines Wall Streets
Ivan Boesky US$100 million
for insider trading.
1987 Over US$8 billion worth of
real estate limited partnerships
packaged by Prudential-Bache
collapse.
1989 The US government seizes
Charles Keatings insolvent
Lincoln Savings & Loan
Association.
1990 Michael Milken pleads guilty
to six counts of securities
fraud and pays more than
US$1 billion in fines.
1998 Hedge fund Long Term Capital
Management requires a
US$3.6 billion rescue.
2002 WorldCom inflates profits by
US$7 billion between January
2001 and March 2002.
Sometimes an ambitious outsider

attempts to instigate reform. Late last
year, New York State Attorney General
Elliot Spitzer, along with SEC Chairman
William Donaldson, CFA, announced
a broad US$1.4 billion settlement
between regulators and 10 of the largest
Wall Street firms.
The efficacy of the punishment is
debatable, since only money is involved:
Nobody has to admit wrongdoing, no
CEO loses his job, and nobody goes to
jail. Its all window dressing, says
Singer. If you have a chance of making
a million dollars and the fine is $100,
firms will error on the side of making
money. Its basic cost-benefit analysis.
To be sure, Draconian punishment
is the exception, not the rule. The
only major case when anyone has ever
been closed down was in 1990 when
Drexel, Burnham was effectively shut
down by the SEC, says Geisst. The
fine was so big it drove them out of
business.
Possible Solutions
One criticism of the United States current regulatory structure concerns the
ability of a private stock market to
effectively regulate itself. Given recent
history, the criticism is warranted; both
the NASDAQ/NASD and the NYSE have
proven to be poor self-regulators.
One possible solution to the current structure is to merge the various
SROs into one national SRO. You
could set up one regulatory organization composed of representatives for
public investors, registered persons,
and broker-dealers to privately regulate
the market before you go to the SEC or
the states, says Singer. The major
advantages of this scheme are the cost
savings realized from economies of
scale and better coordination of regulatory chores.
Laissez-faire offers another possible
solution. In theory, the major exchanges
have a business incentive to foster
investor confidence. If Congress were
to abolish SROs, this incentive would
remain. The various trading markets
would then compete on price and on
quality of service. Without the SRO
crutch, an exchange would have to either
CFA
MAGAZINE
gain the expertise necessary to regulate

its trading business or close its doors.
But this approach has its critics as
well. If you allow a pure free-market
competition trading system, we will get
to monopoly trading very quickly,
warns Seligman. We almost destroyed
the regional exchanges in the 1930s
when the NYSE wanted to adopt a rule
to prevent any NYSE member from
trading on any other exchange of a listed stock on the NYSE.
Electronic communications networks (ECNs) provide another alternative by abrogating the interests of the
middleman. Instead of having individuals enter trades through brokerage
firms, and instead of having a broker
only able to work with one firm, you
could allow individuals to trade directly, which is basically what an ECN is,
says Singer.
Most financial market experts
agree that if wholesale regulatory
improvement is not implemented, little
can be done to repel the next wave of
fraud and scandal. Fact is, history has
repeated itself every decade for the past
70 years despite regulators best intentions: At the end of a boom cycle, optimism reigns and pressure to keep the
good times rolling a little longer grows.
This imperative cascades up and down
the corporate pyramid. After the
inevitable meltdown, media and
investors importune for more regulation. Unfortunately, the damage has
already been done.
Stephen Brown, CFA, is a financial writer
based in Brighton, Colo., USA.
Effect of Regulation FD on Asymmetric Information
Financial Analysts Journal, March/April 2004
(aimrpubs.org)
Why Ethics Codes Dont Work
Financial Analysts Journal, Nov./Dec. 2003
(aimrpubs.org)
Corporate Governance as an Investment Risk
Factor
100 Years of Wall Street
By Charles R. Geisst (McGraw-Hill, 2000)
MARCH-APRIL 2004
53
100
90
70
60
50
40
Standards
K E Y P O I N TS
IN PRACTICE
Shareholder engagement is growing in

the UK, driven by regulatory initiatives
and shareholder self-interest.
30
20
10
0
The Corporate Governance Evolution

Shareholder engagement grows in the UK
BY MARK HARRISON, CFA
54
fter a series of bitter confrontations between shareholders

and corporate boards in the
United Kingdom, the 2004
proxy season promises a lively test of
the countrys evolving system of corporate governance. For the first time, UK
companies had to put their remuneration
reports to a shareholder vote in 2003,
says Colin Melvin, director of Corporate Governance at Hermes Investment
Management, in London, England.
GlaxoSmithKline PLC, one of the
countrys largest companies, saw its
remuneration report voted down by
shareholders registering their dissent at
the level of executive pay. What happened after the GlaxoSmithKline event
was positive, says Melvin, as many
more companies are now consulting
with shareholders.
Investors are experiencing increasing pressures to take a keen interest in
corporate governance. Shareholder
engagement is growing in the UK,
although I wouldnt say it is working as
smoothly as it might yet, says Ken
Ayers, chairman of the National Association of Pension Funds (NAPF) Investment Council. What we are trying to
achieve is the development of a smooth
running system of responsible share
ownership. There will be periods when
shareholders overreach themselves as
well as periods when management is
overeager to restrict powers of their
shareholders. The NAPF has launched
a voting advisory service jointly with
Institutional Shareholder Services (ISS)
and hopes to encourage US shareholders
to vote their UK proxies more efficiently.
Government initiatives have
heightened discussion, but the UK system is guided by best practice rather
than rules, and shareholders cannot be
forced to intervene. When the direction a management takes conflicts with

the fiduciary responsibilities of share
ownership, that is the point at which
investors should intervene, adds Ayers.
We need to recognize that we have an
obligation to watch a company and if a
mistake happens, then we have to act,
says Karina Litvack, director, head of
Governance and SRI, at ISIS Asset Management in London, England.
The best interventions are ongoing rather than once a year, says Litvack. They involve a productive discussion and a continuous dialogue.
Rather than laying down a set of rules,
the UKs Combined Code involves a
comply or explain approach and enunciates broader principles. It is intended
to stimulate a focus on the underlying
principles of corporate governance. Sarbanes-Oxley in the US is so prescriptive
that there is a real risk of slipping into
a box-ticking approach, says Litvack.
In-House Specialists Trigger Dialogue
In traditional terms, it is probably true

that the average fund manager is just
too overworked to deal with all the
paperwork and the complexity of corporate governance issues, says Ayers.
What we are seeing is the development
of corporate governance specialists
within fund management organizations
who are not involved with the day-today dealing and portfolio management.
A number of UK investment firms
have established corporate governance
departments staffed with specialists.
Managing a fund is a lot of work. The
structure that works for us is a team
approach with a number of corporate
governance specialists from investment
or investment banking backgrounds,
says Litvack. But a corporate governance team cannot work in isolation.
We are constantly hopping the fence.
CFA
MAGAZINE
The Combined Code now recommends

a 50/50 split between executives and
non-executives on UK boards.
Executive remuneration is now subject
to greater transparency and a shareholder vote at meetings.
AIMR has established a task force on
Global Corporate Governance to help
members navigate the issues.
At Hermes, which boasts a team of

40 corporate governance specialists,
Melvin points to a spectrum of interest
by investment houses, which depends
on the nature of the client base. Houses with public pension fund clients,
charities, universities, and those investing for the long term will be under
more pressure to do something about
corporate governance. Very active fund
managers and retail funds may feel
under little pressure, says Melvin.
Many firms, unable to justify the
cost of hiring scarce corporate governance specialists have instead turned to
outsourcing and subcontracted the
process. For certain types of investment houses, we think that outsourcing
may be a legitimate approach, says
Ayers. But it would need to be done
carefully and be integrated with the
investment process.
Fiduciary Duty Cannot Be
Subcontracted Out
We believe that those who manage

client money have a responsibility to
vote proxies as part of their fiduciary
duty, and we believe that proxy votes
have an economic value, says Jonathan
Boersma, CFA, vice president, Standards
of Practice, at AIMR in Charlottesville,
Va., USA. The fiduciary duty cannot be
outsourced. While some firms may find
the need to subcontract out the proxy
voting function, the fiduciary duty ultimately resides with the investment
manager, so outsourcing this function
must be done with caution.
MARCH-APRIL 2004
AIMR has established a task force

on Global Corporate Governance,
which comprises 15 members representing 12 different countries to reflect
the global nature of the issues. The
AIMR task force is looking to address
three different areas, says John Rogers,
chief executive of the UK Society of
Investment Professionals (UKSIP) and a
UK member of the task force. First,
what investment professionals should
be thinking about before they invest in
a company; second, what investors
should consider when their clients are
shareholders; and finally, what we can
expect from a good board of directors.
Starting with the OECD Principles
of Corporate Governance, the task force
is aiming to equip members with tools
to use in analyzing companies and to
provide a statement of what good corporate governance should look like. It
is also examining issues such as voting
proxies of shares on loan or in index
funds. In an index strategy, you cannot
vote with your feet, so our perspective
is that you have a duty to vote the
stock, says Boersma.
US Model Is Not the Only One
It is not as simple as just moving the

rest of the world to a US standard,
says Litvack. Why move to a standard
when it has proved to be flawed? In
having such a preponderance of nonexecutives on US boards, they can
become ineffectual and the creature of
over-powerful chairman/CEO figures.
In the UK, boards are a more healthy
mix of executives and non-executives,
and there is the luxury of easy access to
a senior independent director by the
shareholders, whereas in the US, this is
often actively discouraged.
The new Combined Code requires
the largest 350 companies to have at
least half the board, excluding the chairman, be independent of the company.
For the first time, it also lays down criteria to define the independence of nonexecutives. On a typical US board, you
are getting your executive team message
from the CEO/chairman and finance
director alone, says Rogers at the
UKSIP. A UK board has a hands-on
management function and is probably
U K C O R P O R AT E G O V E R N A N C E T I M E L I N E
1990-91: Collapses of Robert Maxwells Mirror Group Newspapers PLC and Asil
Nadirs Polly Peck PLC.
1992: The Cadbury Code outlined the principle of separation of chairman and
chief executive and at least three independent, non-executive directors.
1995: The Greenbury Committee suggested stronger links between boardroom pay and company performance.
1998: First version of Combined Code brought together Cadbury Code,
Greenbury, and Hampel Committees.
2001: Myners Review of Institutional Investment in the UK.
2002: Directors Remuneration Report requires a remuneration report to be
disclosed and voted at shareholder meetings. Took effect in 2003.
2003: Higgs Review on the role and effectiveness of non-executive directors.
2003: New Combined Code on Corporate Governance.
more clued up as to what is actually

happening within the company.
In the UK, the Combined Code
recommends a 50/50 balance between
executives and non-executives, says
Melvin. In our view, it is also inappropriate for non-executive directors to be
compensated in share options. We
think a straight cash fee or equivalent
in shares is in the interest of the companys owners.
Ayers at the NAPF agrees: We feel
that non-executive remuneration
should discourage short-term behavior
that might result from holding share
options whose benefits are triggered at
particular moments.
Long-Term Incentives Remain
Center Stage
The rejection of the remuneration report

vote at GlaxoSmithKline raised a range
of issues on remuneration disclosure. In
particular, the termination payments to
Jean-Paul Garnier, CEO of GlaxoSmithKline, were estimated by PIRC, a research
consultancy, as worth up to US$35 million including share-based payments.
PIRC and other corporate governance agencies attempt to quantify
stock-based remuneration in the context
of total remuneration, allowing clients
to make judgements on the basis of
fuller information.
The real strength of the UK system is in the consultation that was inte-
CFA
MAGAZINE
gral in the Higgs Review and the comply or explain mechanism in that
Review and in the Combined Code,
says Melvin. By encouraging a dialogue
between corporations, investors, and
government, all parties are edging
toward a workable solution that everyone can live with.
You start by agreeing to rules that
are going to apply, says Ayers. Then,
when something triggers a breach, you
have to start the more subjective process
of negotiating and raising objections to
get a dialogue going. This may result
in a situation where the company or
the shareholder modifies its approach
and there is a meeting of minds in the
middle.
Mark Harrison, CFA, is an investment
officer of Merseyside Pension Fund and is
based in Liverpool, England.
Investor Protection and Corporate Governance
Abstracted in The CFA Digest, May 2001
(aimrpubs.org)
Measuring Governance Risk
Ethics Under the Carpet
Abstracted in The CFA Digest, Fall 2000
(aimrpubs.org)
The Hermes Principles
www.hermes.co.uk
NAPF 2004 Corporate Governance Policy
www.napf.co.uk
MARCH-APRIL 2004
55
Point
AGREE
Counterpoint
DISAGREE
To argue that derivatives should only be

Restraining the use of derivative strategies
used for risk reduction purposes requires
only to risk reduction deprives investment
a full definition of risk. Financial risk
managers of the flexibility and advantages
(volatility, VAR, etc.) is an important part
that come with the strategies. It underof the story, but by no means the full
mines investment managers efforts to
story. Credit risk, counterparty risk,
produce the best results for their clients.
model risk, and operational risk should
Besides hedging, derivative strategies
Marsland
Yau
also be considered.
can be used with the existing portfolio to
Lets start with financial risk. Finanenhance return or produce an altered
cial risk measurement is now a basic feature of any portfolio
risk-return tradeoff. They do not have to increase risk to a
managers due-diligence process; without it disgruntled clients
level that exceeds what investment managers intend to hold.
can be expected to quickly turn to the legal system for reparaFor example, the use of derivatives in international investing
tions. Risk management is the obvious next step and aids a
provides a low-cost method of managing country exposure.
more intelligent portfolio construction process. But risk is not
The costs of trading stocks internationally are much higher
a bad thing per se without it there
than the costs of trading futures. Thus, if
would be little point in a securities indusexposure in international stock markets is
AGREE OR DISAGREE
try the point is to regard risk as a predesirable, doing it with derivatives takes
Derivative strategies
cious commodity to be spent deliberately,
advantages of the liquidity and operapreferably through some sort of risk
tional efficiencies in the derivatives marshould be used by
budgeting process. As a result, we are
kets. Exposure in the derivatives market
investment managers
increasingly less interested in single measis used as a proxy for exposure in the
ures of portfolio risk and more interested
cash market.
only to lower risk
in the distribution of possible returns.
Other examples include using futures
exposures.
Derivatives are an excellent tool in
to equitize cash, to track a benchmark,
the quest to re-shape this distribution and
and to implement tactical asset allocation.
to systematically manage expected risk
In these applications, risk exposures that
and return. Buying a put option on a basket of risky securities
would have been otherwise taken in the cash markets are
might be one example of this; collectively the portfolio of
replaced with those in the derivative markets. Derivative
securities will be much less risky (thanks to correlation), and
strategies just make existing investment strategies more effithe portfolio option will be cheaper than the sum of options
cient and/or less costly without increasing their risk exposure.
on each stock. This will have the desired effect of reshaping
More importantly, many alternative investment strategies
the portfolios return distribution, and it will lower risk.
use futures and options as their primary investment vehicle.
This might also be an interesting strategy for a hedge
For example, relative-value strategies such as fixed-income
fund. But why use capital to purchase a portfolio and then
arbitrage and derivatives arbitrage are made possible by the
buy protection when you can purchase the same distribution
built-in leverage, low transaction cost, and operational effiof returns in a single derivative with no capital outlay? Of
ciency provided by derivatives.
course this might be considered to raise risk. But compare it
Critics of derivatives often suggest limiting the use of
with the alternative option-replicating trading strategy and
derivatives in the name of preventing derivatives abuse, huge
sizeable leverage you would need to do it. The institution
losses, excessive leverage, and the collapse of world financial
you approach for the leverage would incur credit/counterparsystems. They believe derivative strategies per se have caused
ty risk you would pay for this in the interest rate spread.
financial fiascoes in the past, although this has been proven
Your option replication model incurs model risk, and, given
wrong in post-mortem studies. In fact, the culprits behind
that these sorts of strategies typically require numerous
these fiascoes were found to be a few individuals who had run
rebalances, this would incur you operational risk.
amok in organizations with inadequate monitoring systems.
So from a total risk perspective, derivatives should only
What we need to do is to ensure that users are knowlbe used to lower risk in the context of the distribution of
edgeable and educated in derivative strategies, and are conscireturns the investment manager is seeking; otherwise,
entious about their proper use.
nobody would buy them.
Jot Yau, PhD, CFA, is an associate professor of finance at Seattle
John Marsland, CFA, is head of portfolio and risk advisory at
University, in Seattle, Wash., USA, and a co-founder of Strategic
Commerzbank Securities in London, England, UK.
Options Investment Advisors Ltd. in Hong Kong.
The views expressed herein are those of the individual authors and do not necessarily represent the opinions of their employers.
56
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CFA Magazine March-April

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AIMRs Member Magazine for

AIMRs Member Magazine for

BY TED ARONSON, CFA

The story of risk

Should derivative strategies be

Outside the Box

BY JOHN MARSLAND, CFA, AND JOT YAU, PHD, CFA

BY SUSAN TRAMMELL, CFA

Robert Engle on measuring

Nothing ventured, nothing gained.

Upcoming AIMR and society events.

14 AIMR expands GIPS standards

16 IPC seeks comment on updated

50 Private Client Corner

Putting risk measurement in context.

Explaining risk to private clients.

BY CYNTHIA HARRINGTON, CFA

The rewards of managing

Can regulatory reform change

BY STEPHEN BROWN, CFA

AIMR, member, and society news.

QFII rules open Chinese markets

Shareholder engagement grows

BY MARK HARRISON, CFA

17 Australia set to legislate new auditor

18 Europe remains divided on adoption

20 NYSE at center of controversy

22 Wise Persons Committee supports

AIMRs Member Magazine for

AIMR PRESIDENT & CEO

DIRECTOR OF DESIGN & PRODUCTION

Tom Bowman, CFA

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MAGAZINE / MARCH-APRIL 2004

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VOL. 15, NO. 2

More than 75 percent

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I agree completely with the concept of a name change [for

I disagree with Tom Bowmans support of changing AIMRs

formats, as well as limiting its use as a noun. Given this, its

MAGAZINE / MARCH-APRIL 2004

any years ago, in the middle of a staff meeting, a

First, what is the balance between the consequences of

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Evolution of the Private

Internet and Media

Global Population Developments and Implications

EUROPE, MIDDLE EAST, & AFRICA

Enhancing Phone Skills

Speaker: Dr. Edgar Loew

18 March Broad-Based Employee

The Failing Wall Street

29 March Behavior of Institutional

Co. Presentation: Bank of

International Trust and

18 March Speaker: Dr. Lee Thomas

The New World of Pension