#3: Risk Appetite
What Is Risk Appetite?
The amount of risk you take to achieve your strategy.
Why Is It Important?
By preparing for eventualities and ensuring they are consistent and incorporated into your strategy, creates a strategy that is achievable over a wider range of economic conditions and events than it would be otherwise. It will signal to investors, and the market, that you know what you are doing and make clear judgements on the riskiness of returns. In principle this should mean the information discount on your cost of capital is lower. But it is not a certainty.
It also gives a mechanism for the members of your firm to judge whether a trade or enterprise fits into your framework and you have the willingness to enter into it.
How to Set Risk Appetite
First decide on your risk capacity. This is the maximum amount of risk you could take. It is set by the expected longevity horizon of your firm.
Next set your risk appetite. It is set by setting how risky and volatile you want your earnings to be, within your risk capacity. It is not a static choice. The choice may have many dimensions to it. There will be constraints on this choice too (you may be bound by regulation, geographic location and legal issues as well has historic factors).
Let me give some examples. The first is a hedge fund that decides it wants an average life of 5 years. Its strategy is to sell puts on the S&P and share any profits with its investors. It sets the out-of-the-moneyness of the puts using the longer dated volatility of the S&P index, given the funds expectation of a firm ending draw. A one-in-five year fall (as measured at the inception of the strategy) in the S&P gives a draw of AUM which will threaten the survivability and likely cause a wind down. The amount and strike of these options will vary with varying market conditions (and the method used to determine the size and likelihood of the draw as a scenario). The actual instantaneous expected average life will also depend on the history of put buying, and the past market volatilities versus the current expect market volatility. Here the fund is looking to set a simple risk capacity and use it all in one type of risk. Note that the outcome is not simple.
A more practical example is for a bank. First they need to set their riskiness (think of this as their credit rating); this choice will not be independent of their strategy. The likelihood is the expected average life for the bank will be greater in their analysis than the targeted rating suggests. (There are more causes of loses than we imagine or prepare for). By measuring this risk appetite, both for the component businesses and the whole bank in both short term volatility and unexpected scenario stresses, the bank can get an idea of its current riskiness. Then by changing its risk stance to the outcomes of these tests, either increase or decrease its risk to earnings volatility or survivability. This may not exactly be the way it is phrased in committees, but this is the underlying idea. Again this is not easy at all. There will be many variables and dimensions in a banks risk profile. Not all of them will be easily controllable. The error in the estimation of the appetite will be large. The metrics used may not be sensitive to the risks you should be caring about, at some periods of time. Some of these risks may be missed or considered less risky than your actual experience. This is not easy to overcome. It is best to use a selection of complimentary metrics. These may need to be dynamic and there will always be risks they are not sensitive to. Thus risk control is dependent on experience and innovation in thought about risk in many dimensions.
Once you have set the risk appetite. You have to ask the question of whether it is compatible with the strategy? Does your strategy require more risk to be taken to generate income that you can take? Is the risk diversified enough? Will the firm have a strong enough capital base to be active in the markets and raise capital at a cost that can be borne by the strategy?
If they are not compatible, then strategy and parts of risk appetite may need to be varied to create a compatible set. This rotation between appetite and strategy must continue till you have a position you feel is consistent and explicable. The trap most will fall into here is to edge up ‘riskless revenue’ and edge down costs and capital usage if the outcome doesn’t meet return thresholds. These are risks too and should affect operational risk appetite.
Though it may not come to the perfect conclusion, this method should lead to a reasonably completable strategy and one where risks to are mainly understood.
How to Control to Your Risk Appetite
The aggregate metrics and high level targets must be interpreted to limits for major businesses, and thus downwards to individual units. These limits should be taken seriously. They should be monitored and adjusted only based on real policy, information or strategy change. The pushing down of appetite to specific limits will occur across scales of materiality. As an example consider a major bank: they will need risks with losses of say $200m to be set at the highest level. Businesses of the bank may be controlling for losses in the $50m level. Trading desks perhaps to $10m, and traders to $1m. The types of risk measures for each of these risks varies. You need to connect the domains of the risks together. The highest may be set by capital tests, the next by related stress tests, the smallest by the components of a stress test quoted as a limit on a risk characteristic. The risk metrics have differing domains (related to scale) of usage and you have to knit them together to give a consistent set. The above may be repeated for liquidity measures and concentration measures.
How to Test Risk Appetite
It is important to consider whether you have got your risk appetite right over set periods. Hence testing actual outcomes to the expectations you have predicted is important. Banks do this in detail for statistical measures – such as VaR or credit default rates. Testing gives you a sense if risks are missing when they are close to expectations; or if a major event happens, whether your scenarios are diverse and severe enough.
Once tested any new information must be incorporated into your metrics and hence your appetite.
What Next?
A lot in the above has been taken for granted. For instance risk metrics and how to create them; scenarios and stress testing approaches; how to measure risks and how to rough out how poorly you have measured them. The response of your firm to external events and the effects of those events on markets are likely not to be very predictable at all. There are many follow-ons in this space to comment on. But the key point is this is not easy. Any risk appetite will not be perfect, but trying to create one, using it dynamically and always thinking on missing dimensions will get you a long way forward in reducing unforeseen outcomes for your firm.
I am not going to go further into the details in my next instalment, because the next piece on Risk Management will deal with Convexity, and why this matters.
Lewis O'Donald
4th November 2023
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