MODULE III
RISK IDENTIFICATION AND CONTROL
Portfolio
Policy and
procedures
Security
Reporting
choice
Cash flow Risk Strategy
analysis analysis analysis
The identification and measurement of risk is one of the key building blocks for a solid investment
foundation. The process of investing involves all kinds of risk. Risk, in its many forms, is the only thing
that you get paid for in investments. You can not avoid it; but you can manage it.
Risk comes to the investor in many different forms. Risk is present in potential defaults of issuers, it is
present in market movements when prices drop, it is present in collateral which is pledged to you but not
owned by you. It is involved in every settlement of every transaction. That is why the investor needs to
learn about all the various types of risk and to decide what level of risk the entity can tolerant. Risk
tolerance depends on many factors.
Risk tolerance is dependent upon such disparate factors as cash flow, staff resources, or political realities.
Cash flow analysis tells the investor when and how much money is projected to be available during any
given time period. That cash flow determines what risks are realistic as far as maximum maturities on
securities and weighted average maturity on the entire portfolio. Establishing a weighted average maturity
also helps to set limits and also create an appropriate benchmark for the portfolio. The detail of
information on cash flow determines exactly how much will be kept liquid and whether or not the investor
can reduce some of that the liquidity and extend maturities to a higher level of yield and income. The cash
flow is critical to the identification of acceptable risks; “extension” risks can only be considered which do
not impact the cash flow requirements.
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Staff resources also determine risk tolerance levels. Even with a healthy cash flow that indicates that some
funds in a large portfolio could be extended to longer maturities or shows a potential use of mortgage
backed securities; if funds are not available for information systems to obtain good market information and
investment accounting or the staff is not trained, then the risks may not be worth the earnings.
Political realities also affect the risk tolerance levels of a government. Often a governing board feels that
leaving money in a bank keeps the funds local and supports local enterprises. This argument, though not
totally accurate, may limit or prohibit effective use of the markets regardless of cash flows or staff
capabilities.
By understanding the extent and effect of various risks and the controls which can be put in place to protect
your portfolio and your entity it is possible to structure an investment program which is safe, liquid and
produces some incremental yield at reasonable market levels.
Types of Risk
There are eight primary types of risk that the governmental investor will encounter regarding securities on a
regular basis. Those risks are:
Credit risk
Liquidity risk
Market risk
Volatility risk
Collateral risk
Extension risk
Reinvestment risk
Event risk
There are other types of risk which involve the settlement of securities, transaction errors, and portfolio
structure.
Credit Risk
Credit risk is the potential that the issuer of a particular security or a borrower may default on his obligation
therefore leaving the security worthless or difficult to liquidate. It also includes the risk that a payment
may not be made on the sale of a negotiable instrument (often known as overnight delivery risk).
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In governmental finance, credit risk is generally minimal because statutory requirements speak to the credit
quality of the authorized investments and restrict investments to high credit quality securities for safety.
United States Treasury obligations represent the highest credit quality in the world. Obligations of the US
Government agencies and instrumentalities also have the implicit (not explicit) credit backing of the US
government which means all of these would be backed by the taxing ability of the federal government. For
practical purposes all these obligations are considered AAA-rated.
Where specific inherent credit quality guarantees are not present, most states and local governmental
entities have imposed additional third party ratings systems to check and monitor credit quality. Securities
where credit rating are critical are commercial paper, bankers acceptances, certificates of deposit (if not
collateralized), and corporate notes. Ratings are also often required on money market mutual funds.
(GASB1 40, for example, requires disclosure of funds that are not AAA-rated.)
Firms such as Fitch Investors’ Service, Moody’s Investors’ Service, and Standard & Poor’s rate the
commercial paper used by many entities as well as the banks guaranteeing investments such as bankers
acceptances and asset backed securities. These firms are reviewing the company’s financial situation and
balance sheet continuously to support their ratings decisions. Most securities are rated by more than one
rating agency and since different firms have differing strengths and skills it is always better to have dual
ratings on a security.
There are several points to remember if required ratings are written into an investment policy. If securities
or their issuer should lose the required rating while held by the portfolio, a provision should be made for
what actions should be taken to further limit risk. Normally a committee review of the situation is required
so that the entire situation can be evaluated. Selling into a panic is never a good idea.
If the investment policy restricts securities to the highest ratings level (for example A-1/P-1 on commercial
paper) and the term of the security has been restricted (for example to 90 days), then the policy might well
allow that the security be held to maturity. This recognizes a market reality. If the credit is dropping on a
security or issuer for some reason, the yield on their securities will rise to entice investors who are not
adverse to taking risk to purchase the securities.
If reasonable provisions have been made in the policy to restrict risk by exposure, maturity and rating it is
unlikely that the security or corporation will be in default and unable to pay its obligation on short term
securities. Monitoring the situation and reporting it accurately to the governing board is a prudent
investment strategy.
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The Government Accounting Standards Board statements.
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To manage the exposure of a portfolio invested in securities with inherent credit risk, the investment policy
can control risk in three ways: (1) by requiring a sufficiently high credit rating, (2) limiting exposure to the
issuer by percentage, and (3) by limiting the maximum maturity of the security thereby shortening the
period of time in which the portfolio might be exposed to possible credit risk. The investment policy may
limit the use of commercial paper for example by defining it as shown below.
Commercial paper rated A1/P1 or equivalent by two nationally recognized rating agencies and
with a maximum maturity of 90 days. No more than 10% of the portfolio may be invested in any
one issuer.
Local government investment pools (LGIP) are also often rated. This rating is not directed entirely at
credit risk but also at liquidity risk. As investment pools become more numerous and vary in investment
parameters, the ratings on pools increasingly look at the pool’s investment policy, the management
capability of the pool, the structure of the portfolio, and liquidity controls. Rating agencies have recently
added additional rating categories (such as volatility ratings) to encompass all the types of pools and
address their volatility risks. These should not be confused with credit ratings.
Credit risk for banks issuing certificates of deposit or holding municipal demand deposits can be especially
troublesome to public entities because of the potential for loss of principal as well as interruption of service
and loss of liquidity. Since certificates of deposit are often long term, the investor has to be assured that the
bank is financially solid.
There are a number of ratios used to monitor the credit worthiness of banks. Like the rating agencies for a
security issuer's credit, there are nationally recognized firms that analyze a bank’s creditworthiness and
stability based usually on a set formula of financial ratios. Use of a bank rating firm makes ratings
independent and assures a complete analysis. Firms such as Thompson Financial's Highline, Prudent Man,
and LACE allow governments to make meaningful decisions on bank credit. Bank ratings should be
monitored whenever public funds are on deposit. A requirement that the bank supply its rating or a copy of
its quarterly Call Report should be established by the public entity to assure that credit ratings are not
deteriorating over time. Any change in the rating (or the bank's debt rating) should be required to be
reported to the public entity as well.
Credit risk is compounded on a longer term security. The longer maturity exposes the investor over a
longer time period. Even credit that was initially excellent can erode from any number of reasons. A firm
that was financially solid can issue securities rated AAA or A1/P1 and over time find itself with serious
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financial weaknesses. If the investor recognizes this potential a combination of term limitations (maximum
maturities) and ratings can limit credit risk.
How then do we manage credit risk?
1) Utilize high credit quality securities such as US government obligations and rated securities.
2) Limit the maximum maturity on credit sensitive securities. (Shorter is safer.)
3) Limit exposure to credit sensitive securities by restricting the percent allowed in a portfolio.
4) Monitor the ratings on securities held in the portfolio especially if inherent credit risk is
present.
5) Require dual ratings on commercial paper and banks.
6) Utilize rating services for monitoring complex credit standings of banks.
7) Understand what the ratings mean.
Liquidity Risk
Perhaps the greatest risk that is faced by governmental investors is liquidity risk. Liquidity risk is defined
as the risk that monies needed to fund operations, projects or payments may not be available when needed.
For governments it means that bills or payrolls may not be paid. It can result in vendor difficulties and
delays in projects and potential problems on debt ratings if debt schedules are not met on a timely basis.
To correct a liquidity problem on the portfolio, the investor normally has to sell a security. The security
selected for liquidation may or may not be at a profit or unrealized gain position and therefore exposes the
investor to a principal loss. The use of a reverse repo with a security (lending a security) can be used to
raise short term cash but this should only be used or relied upon in sophisticated and active portfolios with
several options and a wide variety of securities from which to choose.
As with other types of risk, to build a portfolio that can withstand liquidity risk the investor has to (1) use
securities for which they will be able to find buyers in the market should the need arise and (2) structure
the portfolio to provide liquidity naturally. It is the combination of these two factors that reduce liquidity
risk. The key to knowing how liquid a portfolio must be is cash flow analysis which will identify cash
needs.
Choosing Securities for Liquidity
A liquid asset is one which can be easily converted to cash and there are several factors which make a
security more or less liquid. Liquidity is enhanced with high credit quality (because investors always want
high quality). Liquidity also comes from using short term securities.
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The normal or positive yield curve has lower rates at the short end and higher rates at the longer maturities.
It is called the normal curve because the curve will be shaped in this manner the majority of the time. It
reflects all investors’ highest priorities including credit risk, inflation risk and event risk. The curve’s
shape is a reflection of value as well as the risk we are taking, i.e., the investor will not demand higher rates
in the short end because he is not taking much time risk (the investment is short).
We know that as interest rates rise, prices fall. As rates fall, prices rise. Viewed in this light, the short end
of the yield curve is very “expensive” (low rates and high prices). This is called the curve’s liquidity
premium which means the investor is willing to pay extra for enhanced liquidity. The investor can actually
pay more than par (i.e. pay a premium) for the right to be liquid. Since this is an accepted practice with a
positive yield curve it is clear to see that all investors placing new funds into the market are willing to pay
up for liquidity because liquidity is that important to them.
Liquidity is important because no investor knows where the market is headed or all the demands that will
be placed on their portfolio. The government investor who has bills to pay wants funds available for
planned and unplanned expenditures and emergencies. On a trading basis, even the most bullish investor
who is “sure” that rates are going down (prices up), wants to have some cash available just in case rates rise
for reinvestment at higher rates. The bearish investor on the other hand, believing that rates will increase
and prices drop, always wants to have cash available to put to work when yields do rise.
The three factors that influence the liquidity of any security are: the length of the security (maturity date),
the quality of the security (creditworthiness), and its marketability (its liquidity in the marketplace).
Security Maturity
Normally, the shorter a security’s maturity the greater the liquidity. Shorter securities will obviously
mature sooner, giving the investor the cash that may be needed. These shorter securities are also more
liquid because, as we know from the shape of the normal yield curve, more investors are willing to pay up
for owning them.
Security Quality
The credit quality of a security makes a huge difference to its liquidity. Governmental operating portfolios,
like many other isk adverse investors need high quality. Therefore there is a great demand for high quality
securities and that high demand makes them liquid. Some securities provide a more liquid market than
others. Highly liquid means that there are always buyers for the security. The new investor has to
remember however that a liquid market does not guarantee against a principal loss. A liquid market simply
means that the security can be sold.
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For many governmental investors, US Treasury Bills represent the most liquid and safe security and many
feel that investing in bills guarantee against principal loss. However, the guarantee on US Treasury Bills or
Notes is simply that they will pay interest on time and principal at maturity. If you have to sell a Bill or
Note before maturity, you face market risk which could result in a possible loss or gain. Like any security
you buy, you should anticipate that it can be held to maturity.
Different securities represent different levels of liquidity. Only US Treasuries and a few agencies of the
US Government (like GNMA) have the US Government's explicit guarantee as credit support.
Commercial paper is a short security by nature (a maximum of 270 days) but it not as highly liquid as a US
Government guaranteed security because the ability of corporate issuers of this type of paper to pay is
dependent on their business’ condition and or the credit support of a bank credit line they purchased. .
They may or may not have cash available. Other US agencies and Government Sponsored Enterprises
(GSE’s) that issue short term discount notes and debentures represent only slightly less liquidity than their
counterparts issued by the US Treasury. The quality of these securities is very high – second only to
treasuries, but, agencies are sold through syndicates of broker/dealers. No broker/dealer is required to buy
back agencies or instrumentalities but will usually do so at current market values.
Security Issue Size
Another factor which affects the liquidity is issue size. Issue size directly affects the liquidity of any type
security. The US Treasury issues regularly at scheduled auctions. The auctions are large and investors
know exactly how many of that particular issue are to be sold. This size and regularity increases liquidity.
US agencies, instrumentalities and other securities are not always issued in large auction forums. Agency
paper for example is often sold in small issues. If these issues are tailored to particular investors with
specific investment needs or reflect a view of the market which changes quickly afterwards (such as step-
up bond) finding a buyer might be difficult in different conditions. Such restrictions and conditions limit
liquidity and increase liquidity risk.
Liquidity Risk is measured in:
- the maturity of the security
- the credit quality of the security’s issuer
- the size of the security’s issuance
One measure of a Security’s liquidity is the security’s price spread (difference in yield over a
comparable US Treasury)
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How then do we manage liquidity risk on securities?
1. Purchase short term securities.
2. Purchase securities with high credit quality.
3. Purchase securities from larger issues and auctions.
Structuring a Portfolio to Reduce Liquidity Risk
There are a number of basic factors which can reduce or manage liquidity risk in a portfolio. A large
percentage of the liquidity risk in a portfolio can be managed by choosing the high quality short-term
securities as discussed above. For the portfolio as a whole, liquidity risk is reduced in much the same way.
Every portfolio must be based on the objectives of the entity for which it is invested and the cash flow it is
constructed to serve. Therefore the best means of protecting a portfolio from liquidity risk is to base the
portfolio decisions on cash flow needs.
The safest and most conservative process in building a portfolio against liquidity risk is to identify every
expected liability through the cash flow analysis process and purchase a security to match those liabilities.
This structure is fundamentally a buy and hold process and allows the investor to disregard liquidity risk
because every liability is covered. However, even in a perfectly matched portfolio some liquidity risk
remains because of unexpected liabilities that arise over time.
Liquidity risk will always exist for the investor. We can manage it however through careful attention to the
securities purchased and structuring the portfolio to match as many anticipated liabilities and needs as is
possible.
Market and Volatility Risks
Market risk and volatility risk approach the investor hand in hand. The primary way to counter market and
volatility risk is to understand what causes them.
Market risk is the risk that the market price will move against the investor and the price (value) of
your securities will decrease. This price action results in unrealized losses on a portfolio
and, if an unexpected liability requires a holding to be sold, can ultimately result in a
realized loss - a loss of principal. For an investor who needs to sell a security before
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maturity an increase in rates (and a corresponding drop in prices) may mean a capital
loss. Market risk is common to all securities and can not be totally overcome by
diversification. When markets move it produces widespread changes in value and is
referred to as systemic risk.
Volatility risk is a relative risk. Volatility risk is the risk that a change in market price will affect
the price of one security to a larger degree than another. Volatility can be the
characteristic of a single security or an entire market sector or market.
Certain attributes contribute to volatility. The investor has to identify these factors in order to manage
volatility and market risk. We have to first return to the yield curve to look at volatility.
Volatility is directly affected by time because over the time an investment is held many conditions can
change and risks can materially grow or diminish. If an investor invests in the six month or one year area
of the curve, the amount of change that can occur is often limited.
However, if that investor invests in a security that will not mature for thirty years, tax laws can change,
economic conditions will change, portfolio requirements may change and cash flows will change. But, the
investor also has to worry about the conditions affecting the market. Mathematically it requires a larger
change in price for a longer security to affect the same change in rates as a short security.
For example:
2-yr T-Note 5 5/8 % priced at 102 yields 4.69 %
priced at 100 yields 5.69 %
A 2 point change in price is required to change the yield 1.0 %
30-yr T-Note 5 3/8 % priced at 110 yields 4.69 %
priced at 96 yields 5.69 %
A 14 point change in price is required to change the yield 1.0 %.
In addition, longer maturity investors have a natural tendency to react to events by moving funds quickly in
and out of the market to protect their investments. This action, performed more aggressively as greater
risks are perceived or projected, can move prices even more violently. This price movement creates
volatility. Volatility will always be greater in longer securities.
Volatility Risk in Securities
Besides the maturity of securities, volatility is affected by the security’s structure. The same principals that
affect the whole market are reflected in individual securities. Securities with embedded options, such as a
call feature, can either exaggerate market changes and therefore add to volatility or undermine the
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underlying security’s ability to have price appreciation as the option (the date the security can be called)
becomes the overwhelming consideration in determining when a security will be redeemed.
Securities with embedded options have puts and call options as part of their payment structure.
A Call Option gives the issuer the right to redeem a security prior to its stated maturity at a pre-
disclosed price on a pre-disclosed date or dates.
A Put Option gives the bond holder the right to have an issuer redeem a security prior to its stated
maturity at a pre-disclosed price on a pre-disclosed date or dates.
A callable security is more likely to be called if rates decrease. The possibility of a general rate change will
cause more (or less) risk in the callable security and therefore the volatility in price. The embedded option
adds overall risk to the security because it may or may not be exercised (used). Some examples of
embedded option securities in the bond market include:
Callable bonds: Securities for which the issuer has the right to call back at a specified time
enabling the bonds to be reissued at a lower interest rate.
Floaters: Securities whose interest rates move in direct (or indirect) relationship to certain
indexes.
Market risk is systemic. The investor can not avoid market risk. However, market risk does vary slightly
by sectors and security structure.
How do we manage volatility and market risk?
1. Purchase shorter term securities and maintain a shorter average portfolio maturity
2. Diversify the portfolio to spread risk among market sectors
3. Purchase high quality securities where perceived risk is minimized
4. Minimize exposure to securities with embedded options such as callables..
Collateral Risk
Collateral risk is a prevalent risks faced by all public investors. Collateral risk involves the loss of value or
loss of control on collateral pledged to the entity. Both must be addressed to control collateral risk. In
many states where individual collateral is pledged to the entity for bank time and demand deposits,
collateral issues require constant monitoring and assurance. In states where collateral is pooled by the state
the collateral risks on bank deposits are lowered although not eliminated.
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Collateral risk is also faced in repurchase agreements or collateralized guaranteed investment contracts
(GICs) however collateral in these instances are not pledged but “owned” by the public entity so the
situation can be addressed more directly. The collateral risk addressed here deals with collateral pledged to
a public entity, usually for bank time and demand deposits.
Ownership Issues in Collateral Risk
The ownership/control issue is critical. Who owns and controls this collateral? How do we prove the
pledge? We must identify the location of the collateral and who has control of the security. The evidence
of ownership in a time or demand deposit situation is perfected with an original safekeeping receipt.
Collateral should be held by an independent third party to the transaction and the safekeeping receipt
must be issued from that third party. The safekeeping receipt must clearly show on its face that this
collateral is “Pledged to the [governmental entity name].” Many banks no longer issue individual
safekeeping receipts for collateral, but, computer generated lists must still contain the same information:
name of the pledgor, full description of the security(s) pledged, name of the pledgee, and clear indication
that this security is pledged.
In order to assure that the safekeeping agent (custodian) performs as an independent agent it is reasonable
to require a written contract between the public entity, the entity pledging the collateral, and the
safekeeping institution. The safekeeping institution will normally be paid by - and therefore work for – the
pledging institution (the bank) – not the governmental entity. A written contract can clearly identify all the
rules and responsibilities of each party including valuation, substitution, and release of collateral.
The FDIC is governed by the Financial Institutions Resource and Recovery Enforcement Act (FIRREA)
when closing or reorganizing a bank. The conditions of FIRREA are clear and the public entity must have
a collateral agreement executed under FIRREA to assure the safety of their collateralized funds. FIRREA
has four conditions to be met:
1. the collateral agreement must be in writing
2. the agreement must be approved by resolution of the Bank Board or Bank Loan
Committee
3. the agreement must be in the official records of the bank (which is accomplished by
the resolution above)
4. changes in specified collateral will require a new agreement
The last condition requires that you not list specific pledged collateral in the agreement. Simply state that
all collateral pledged will come under the provisions of the agreement.
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Some of the elements required in a collateral agreement would include:
Listing of acceptable collateral
Disallowance of garnishment of public funds
Designation of an independent third party as safekeeping agent
(outside of depository bank’s holding company)
Margin requirements for all types of collateral (102%)
Designation of responsibility for pricing collateral
Schedule for pricing collateral
Reporting requirements
Issuance of original safekeeping receipts directly from custodian
Remedy for market value adjustments to collateral
First and prior lien establishment by public entity
Right of substitution of collateral with consent of the public entity
Availability of collateral for review and audit
Remedies for non-performance by any party to the agreement
Default provisions
Signatures of all parties to the agreement
A critical issue is the pricing of the collateral to assure that the government has enough market value to
cover the deposits. Pricing should not be done by the counter-party in the transaction.
Ownership Issues for Entity Owned Securities - Safekeeping Risk
Securities owned by a public entity must also be held by a custodian independent of the
party from which you bought the security. For example, if a city buys a T-Bill from a
broker that broker should not hold the security. It must be transferred into the custodian on
a delivery versus payment (DVP) basis. This process alone assures ownership and control.
Valuation Issues in Collateral Risk
Collateral risk also occurs in valuing the collateral. This process uses the current market price to determine
if the market value is sufficient to cover deposits. This risk is managed by requiring a margin. A margin
(for collateral) is the amount by which the value of the collateral exceeds the value of the deposits or
transaction.
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An industry standard for most collateral is 102%. To secure a $1 million deposit, collateral with a value of
$1,020,000 would be required. The margin protects the depositor from market price fluctuations. If
collateral is of a longer and therefore more volatile nature the entity may want a higher margin to exceed
possible volatility. If collateral requires a pricing which includes a subjective call by the analyst – such as
mortgage backed securities – then the margin might also be higher than 102%. The investor may want to
avoid such problems by simply excluding certain more volatile securities (such as mortgage backed
securities) from the authorized collateral list. However it should be remembered that the bank owns many
such instruments and restrictions may also increase collateral cost and reduce the interest rate the bank pays
on the deposit.
A parallel control in valuation is the frequency of pricing. If collateral is priced only once a month then
margin should be set higher to anticipate price changes over the long period. If collateral is pledged daily
potential fluctuations can be minimized so margins can be set at the 102%. At a minimum, pricing should
be done at least weekly.
If margin limits are reached (up or down) the investor (if values fall), or the pledging entity (if prices rise),
makes a margin call. This is simply a readjustment or reassignment of the collateral (adding or releasing
collateral). Written agreements should make provision for these calls and how they are accomplished. All
parties need to know what is being called and why and how the adjustment will be made.
Since pricing is so critical in managing collateral risk, it is important that the pricing be done by an
independent party (for example the custodian). This is a standard provision in repurchase agreements but
not in bank depository situations because of the cost. If there is difficulty in requiring independent pricing,
the governmental entity should restrict collateral to securities that they can price themselves. A standard
requirement is to limit collateral to securities able to be priced in the Wall Street Journal.
Security Issues in Collateral Risk
The security of the pledged collateral primarily involves where the collateral itself is held. As mentioned
above, the public investor needs an independent agent holding the collateral.
A summary of Collateral Controls
- Delivery versus Payment settlement - Types of collateral pledged
- Independent Third party safekeeping - Timely and accurate reporting
- Original safekeeping receipts - Written contracts
- Margins - Third party pricing
- Bank Board approval of contract - Record in Bank's official records
- Controlled substitutions
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Reinvestment Risk
Reinvestment risk is the risk that cash flows of a security will have to be reinvested at a lower rate than the
prevailing rates. This situation can significantly affect yield.
Reinvestment risk is most often experienced by public investors in callable securities (securities which
have a call provision). If interest rates fall during the life of the security a callable security may be called
away. The issuer would refinance the debt at a lower interest rate (as municipalities often do with their
own bonds). If a bond is called because rates fell, the investor must now reinvest at these lower rates also.
The investor who loads a portfolio with callable securities in a decreasing rate environment because they
offer more yield is incurring significant reinvestment risk. If rates fall, a large portion of the portfolio
securities could be called and that same large percentage of the portfolio must be reinvested at lower rates.
The benefit of the additional yield on the front end (at time of purchase) must be balanced by the risk being
taken.
Another area where we encounter reinvestment risk is mortgage backed securities (MBS). As interest rates
fall, home owners look to refinance their homes at the lower interest rates. As they pay-off mortgages and
purchase new ones, the original mortgage backed securities are pre-paid faster than expected. Now the
owner of the MBS must reinvest at lower rates. On such long securities this prepayment risk can be
significant. The investor may have purchased a security believing he had a 6% coupon for twenty years
and with falling rates found himself in cash and reinvesting at 3%!
Managing reinvestment risk requires attention to the diversification in the portfolio. The callable securities
are not to be avoided but managed. To manage reinvestment risk the investor must diversify the portfolio
and refrain from concentrating too much of the funds in securities which could be called.
Extension Risk
Extension risk is basically the opposite of reinvestment risk. As rates rise for example, a security's maturity
may extend unexpectedly. Extension risk occurs most often in mortgage backed securities (MBS). It can
occur if the investor buys a callable note on the expectation that it will be called and it is not called because
rates rise.
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Mortgage backed securities are derived from home mortgages and pay down as people pay their mortgages.
If rates have been dropping and people are paying off mortgages, analysts may anticipate that the securities
will continue to pay off at this same rate for an extended period of time creating a relatively short security.
The investor who buys such a security expecting it to pay off in 2-3 years could be unhappily surprised if
rates quickly rise. The increasing rates would stop any home refinancings and result in home owners who
are happy to keep their mortgages for a much longer term. The investor then has a security which may take
up to 10 years or more to pay off. This situation is amplified significantly in mortgage derivatives. The
mathematical formulas controlling such securities can easily compound the rate effect.
Managing extension risk requires a good understanding of the forces driving the payments into the security.
MBS securities will always contain extension risk. Most public investors with short term needs should
avoid the risks incurred in mortgage backed securities.
Overall Risk Control
In this general review of risk, there have been several controls which reoccur regularly and allow the
investor to manage risks. Remembering that risk can not be avoided we have to put the controls in place to
manage it. The table below shows which controls manage which risks.
Overall the investor is best served by (1) matching cash flow requirements, (2) requiring high credit
quality, and (3) staying short term to avoid liquidity, volatility and market risk. This does not advocate
staying totally liquid. It shows instead that risk can be taken along with normal precautions.
All risk can be reduced by asking questions before a purchase and understanding fully the security and how
it is supposed to react to changing market conditions. Knowledge of the securities and the market is a
valuable tool for all investors.
Type of Risk Tools to Manage that Risk
Credit Risk -requiring high credit quality
Liquidity Risk -requiring high credit quality
-diversification to limit exposure
-using short term securities
-using liquid market securities
Market Risk -using short term securities
-requiring high credit quality
-diversification to limit exposure
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Volatility Risk -using short term securities
-diversification to limit exposure
Reinvestment Risk -diversification to limit exposure
-avoiding over-investment in callables and MBS securities
Extension Risk -avoiding over-investment in MBS securities
-avoiding over-investment in callable securities on assumption
they WILL be called.
Collateral Risk -using independent safekeeping agent
-safekeeping receipts
-delivery versus payment settlement
-adequate margin requirements
-written agreements
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