Risk Management for Pensions, Endowments, and Foundations › download › 0007 › 7791 › 59 ›...

SUSAN M. MANGIERO

John Wiley & Sons, Inc.

Risk Management forPensions, Endowments,

and Foundations

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and Foundations

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Founded in 1807, John Wiley & Sons is the oldest independent publishingcompany in the United States. With offices in North America, Europe, Aus-tralia, and Asia. Wiley is globally committed to developing and marketingprint and electronic products and services for our customers’ professionaland personal knowledge and understanding.

The Wiley Finance series contains books written specifically for financeand investment professionals as well as sophisticated individual investorsand their financial advisors. Book topics range from portfolio managementto e-commerce, risk management, financial engineering, valuation, financialinstrument analysis, as well as much more.

For a list of available titles, visit our web site at www.WileyFinance.com.

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SUSAN M. MANGIERO

John Wiley & Sons, Inc.


and Foundations

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Disclaimer: Nothing in this book is intended to serve as investment advice or to per-suade, induce, or encourage the reader to invest or not invest in any stock, bond, fund,derivative, or any other investment—financial or otherwise. The reader is advised thatlaws, regulations, and rules are subject to significant change and modification on littleor no notice; therefore, the reader should consult with an appropriate advisor beforerelying on the applicability of any law, regulation, or rule referred to in this book. Thereader is likewise urged to seek his or her own investment advice from a qualified finan-cial advisor. The author and the publisher specifically disclaim any and all liability forany suits, actions, or proceedings arising out of or related to the text, substance, and/orsubject matter of this book.

Copyright © 2005 by John Wiley & Sons, Inc. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New JerseyPublished simultaneously in Canada

No part of this publication may be reproduced, stored in a retrieval system, or transmit-ted in any form or by any means, electronic, mechanical, photocopying, recording, scan-ning, or otherwise, except as permitted under Section 107 or 108 of the 1976 UnitedStates Copyright Act, without either the prior written permission of the Publisher, orauthorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-646-8600, or on the web at www.copyright.com. Requests to the Publisher forpermission should be addressed to the Permissions Department, John Wiley & Sons,Inc., 111 River Street, Hoboken, NJ 07030, 201-748-6011, fax 201-748-6008.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used theirbest efforts in preparing this book, they make no representations or warranties withrespect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. Nowarranty may be created or extended by sales representatives or written sales materials.The advice and strategies contained herein may not be suitable for your situation. Youshould consult with a professional where appropriate. Neither the publisher nor authorshall be liable for any loss of profit or any other commercial damages, including but notlimited to special, incidental, consequential, or other damages.

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ISBN: 0-471-23485-0

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

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www.wiley.com

Dedication

I want to thank my husband, George, who combines intellectwith humor and makes every new day a delightful adventure.To Bridget, Alan, and Melissa: know how much I appreciate

your words of wisdom and witty repartee.

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vii

Acknowledgments

Iwould like to thank attorney Kathleen Ziga for her review of the chapterson regulation and corporate governance. Her insightful comments reflecther experience as partner of Dechert LLP, specializing in the area of employeebenefits. I owe a special thanks to the editors at John Wiley & Sons whoprovided guidance and advice.

Moreover, I want to express my appreciation of the many people whogenerously gave me their time and knowledge during the research phase ofthe book. Though some people preferred to speak anonymously, their assis-tance was nevertheless a big help.

On a personal note, my family and friends remind me everyday of mygood fortune.

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ix

Contents

PREFACE xi

LIST OF ABBREVIATIONS xv

PART ONEOperating Environment 1

CHAPTER 1Why Focus on Risk Management? 3

CHAPTER 2Corporate Governance and Risk Management 13

CHAPTER 3Legal and Regulatory Considerations 26

CHAPTER 4State of Reporting about Institutional Investors 45

PART TWOToolbox 57

CHAPTER 5Basic Concepts 59

CHAPTER 6Financial Futures 76

CHAPTER 7Financial Options 93

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x CONTENTS

CHAPTER 8Swaps 120

CHAPTER 9Risk Is a Four-Letter Word 142

PART THREEPUTTING IT ALL TOGETHER 167

CHAPTER 10Getting Started 169

CHAPTER 11Risk Management: Fine-Tuning 201

PART FOURTHE FUTURE 221

CHAPTER 12Looking Ahead 223

APPENDIX 225

NOTES 241

INDEX 259

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xi

Preface

Just as the twig is bent the tree’s inclined.

—Alexander Pope

TWO GIANTS MEET

Financial markets are undergoing massive changes, not the least of which isthe role played by institutional investors, a group that includes endow-ments, foundations, and pension funds. The facts speak for themselves.Institutional assets worldwide now exceed $13 trillion.1 About half of everydollar of U.S. corporate equity is in the hands of nonhousehold investorsand their ownership of bonds is similarly impressive.2 What, how, andwhen they trade can dramatically influence market prices and volume. Notsurprisingly, business managers, policy makers, and individual market par-ticipants pay attention when institutions speak.

A second giant, the mushrooming interest rate derivatives market, nowexceeds $123.90 trillion.3 Add in other types of derivatives and total mar-ket size is impossible to overlook. Taken together, the use of derivativeinstruments by endowments, foundations, and pensions has the potential toroil markets if they are improperly used. In some situations, derivatives arebeing used directly to manage risk, transform cash flows, synthesize finan-cial positions, or enhance returns. In other cases, institutions expose them-selves indirectly by investing in leveraged funds or securities with embeddedderivatives.

Besides their sheer size, endowments, foundations, and pension fundsplay a vital role in the lives of individuals who depend on commitmentsmade by employers or grant-making institutions. Absent good financialhabits, endowments, foundations, and pension funds may find themselvesin the unfortunate position of being unable to keep promises. This meansthat others pick up the tab—taxpayers, shareholders, students on scholar-ship, community groups, and often the fund beneficiaries themselves. Withso much at stake, ignoring if and how these investing giants manage risk isfoolhardy and makes little sense.

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ABOUT THIS BOOK

Fine books have been written about derivatives, but they often intimidateunless the reader has some understanding of finance, especially when theinformation is presented with lots of equations and in an overly technicalmanner. This book provides intuitive and straightforward informationabout risk management for persons involved with or affected by endow-ment, foundation, or pension fund investment decision making and per-formance assessment. That defines a wide audience of readers.

• Plan sponsors, trustees, and anyone with a fiduciary responsibility. Inan era of increased concern about corporate governance, there is a com-pelling need to demonstrate the due diligence that leads to an informeddecision. This includes senior executives and board members who areresponsible for policy creation and approval, but who lack the expert-ise to tackle risk management issues at an excessively detailed level.

• Regulators and auditors. Compliance evaluation is complex. A no-nonsense guide to derivatives and risk management issues helps gate-keepers know what questions to ask and why.

• Consultants and investment managers. Knowing what clients need toproperly diversify or meet other investment goals is a cornerstone ofcustomer relationship building. Financial salespeople, consultants, andmoney managers can do a lot for institutional investors when they arecomfortable enough to compare the impact of derivative use with alter-natives that do not employ leverage.

• Analysts, employees, and investors. Understanding an organization’sfinancial well-being requires knowing how derivatives can potentiallyimpact earnings, cash flow, and capital structure. This is especially crit-ical in the current era of myriad bankruptcies and material loss ofshareholder wealth.

• Investor relations specialists and fund-raisers. Pension plan performancecan affect the bottom line in non-trivial ways. To the extent that deriv-ative usage affects pension plan results, persons who interface with WallStreet need to understand their influence on earnings. Fundraisers mustlikewise be able to answer donors’ questions about investment perform-ance and related spending ability.

• Financial journalists. Reporting about companies or nonprofit organi-zations that use derivatives is difficult without a rudimentary knowl-edge about how and why they are used.

• Students and jobseekers. Individuals seeking to work for or with anendowment, foundation, or pension fund that employs derivatives canimprove their chances for career development by understanding finan-cial risk management basics.

xii PREFACE

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PREFACE xiii

HOW THIS BOOK IS STRUCTURED

This book is organized into four parts. Part One provides a corporate gov-ernance rationale for risk management education and describes why a tax-exempt investor might consider using derivative instruments. Part Twoexamines the basics of risk, futures, options, and swaps, including case stud-ies specific to endowments, foundations, and pensions. Part Three addressesthe risk management process from start to finish, with special emphasis onits dynamic nature. Part Four ties together earlier parts of the book withcomments about the current operating environment that is changing, even asthis book goes to press.

Part One lays the foundation for risk management from a leadershipperspective. Chapter 1 furnishes compelling reasons to support risk man-agement education apropos to endowments, foundations, and pensionfunds. Chapter 2 provides an overview of corporate governance issues thatsupports a close relationship between risk management and investment pol-icy making. Chapter 3 addresses the legal and regulatory landscape from afiduciary perspective. Chapter 4 describes reporting requirements, alongwith requisite information for proper risk management.

Part Two presents building block concepts about risk and the threemajor derivative instrument groups—futures, options, and swaps. Chapter 5introduces financial concepts that are critical to investing and therefore torisk management. Chapter 6 looks at financial futures. Chapter 7 explainsoptions, and Chapter 8 talks about swaps. Chapter 9 discusses risks asso-ciated with derivative instrument use.

Part Three looks at various elements of the risk management process.Understanding basics about derivative instruments is important but repre-sents only one part of the overall risk management process. Chapter 10introduces the risk management process, where to start, the role of the ChiefRisk Officer, and the importance of technology. Chapter 11 addresses dif-ferent ways to measure risk and the significance of monitoring positions overtime, including a discussion of stress testing and risk budgeting.

Part Four includes Chapter 12, which looks ahead at the risk manage-ment challenges for endowments, foundations, and pension funds.

WHY THIS BOOK

Few books about derivatives have been written exclusively for institutionalinvestors. Books that rely on a solid knowledge of mathematics add to read-ers’ anxiety about a topic that is already viewed by many as arcane andcomplex. Factor in the seemingly infinite amount of information about thetopic and reading about derivatives quickly takes on the appeal of having a

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tooth pulled. Avoiding the topic is the wrong answer. Fiduciaries need toknow enough about derivatives and risk management to justify either theiruse or prohibition. They have little time or inclination to tackle a book thatis long on formulas and short on intuition. Examples, checklists, and end-of-chapter summaries in this book seek to simplify the learning process.

This book is written as a gentle introduction to assist individuals at thetop who are responsible for a host of investment and risk managementissues—(1) whether to use derivatives, (2) how to use them, (3) how much touse, (4) who can trade, and (5) what safeguards to implement to detect mis-use. Unlike the detail a trader needs to know before executing a trade, a man-agerial decision maker must look at the big picture. In addition to laying outrisk management essentials, this book focuses on the broader aspects of riskmanagement as they relate to endowments, foundations, and pension funds.

BOOK HIGHLIGHTS

The challenge is to create a useful reference guide that (1) informs withoutoverwhelming, (2) describes key concepts in an easy-to-understand manner,and (3) can be read in a short period of time. The reader should come awaywith a basic understanding of the following concepts:

• General description of derivative instruments• Various benefits owing to derivative instrument use• Basic features of futures, options, and swaps• Comparison of different derivative instruments• Different types of risks related to derivative instruments• Indirect exposure to derivatives from various investment strategies• Common derivative strategies used by endowments, foundations, and

pensions• Risk measurement• Risk management considerations for institutional investors

And much more.

No book can possibly provide a complete overview of the risk man-agement topic, and this work is no different. The book should be a spring-board for further action. This could mean holding in-depth interviews withexternal money managers, taking an internal assessment of current policiesand procedures, or making a commitment to training in the areas of invest-ing and risk management. Whatever happens, any action is one of manyrequired steps in implementing an effective risk management program orimproving an existing system.

xiv PREFACE

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xv

List of Abbreviations

Abbreviation Description

ABS Asset-Backed SecurityAICPA American Institute of Certified Public AccountantsAIMR Association for Investment Management and Research*

ASPA American Society of Pension ActuariesBIS Bank for International SettlementsCBOT Chicago Board of TradeCFTC Commodity Futures Trading CommissionCME Chicago Mercantile ExchangeCOSO Committee of Sponsoring Organizations of the

Treadway CommissionDB Defined BenefitDC Defined ContributionD&O Directors and OfficersDOL U.S. Department of LaborEBSA Employee Benefits Security AdministrationERISA Employee Retirement Income Security ActFASB Financial Accounting Standards BoardGFOA Government Finance Officers AssociationHLI Highly Leveraged InstitutionHLIWG Highly Leveraged Institutions Working GroupIAS International Accounting Standards Board®

ICC Independent Consultants CooperativeIOSCO International Organization of Securities CommissionsIRS Internal Revenue ServiceISDA International Swaps and Derivatives Association, Inc.LIBOR London Interbank Offer RateMBS Mortgage-Backed SecurityMPT Modern Portfolio TheoryMOSERS Missouri State Employees’ Retirement SystemNACUBO National Association of College and University Business OfficersNCCUSL National Conference of Commissioners on Uniform State LawsNYMEX New York Mercantile ExchangeOCC Office of the Comptroller of the CurrencyOECD Organization for Economic Co-operation and Development

*Renamed the CFA (Chartered Financial Analyst®) Institute as of mid 2004.

(continued)

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xvi LIST OF ABBREVIATIONS

Abbreviation Description

OTC Over-the-CounterPBGC Pension Benefit Guaranty CorporationPSLRA Private Securities Litigation Reform ActPWBA Pension and Welfare Benefits AdministrationRFP Request for ProposalSEC U.S. Securities and Exchange CommissionSPAN® Standard Portfolio Analysis of RiskUPIA Uniform Principal and Income Act of 1997VaR Value at Risk

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PART

OneOperating Environment

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3

CHAPTER 1Why Focus on Risk

Management?

There is nothing more frightful than ignorance in action.

—Johann Wolfgang von Goethe

FIDUCIARY EDUCATION—THE BIG PICTURE

A fiduciary is paid to make intelligent decisions about other people’s money,something that is difficult to do without full information. Fiduciary respon-sibility is more than common sense. Volatile market conditions, plungingasset values, and an ever-growing variety of investment choices are heavy-duty challenges for the estimated 3 million persons in the United States withfiduciary responsibility. “The overwhelming majority of these investmentdecision makers want to do the right thing, but lack the education andtraining on the practices that constitute a prudent investment process.”1

As shown in Exhibit 1.1, decisions made by those in power have a dra-matic effect on a number of constituencies. One flawed choice sets off adomino effect, potentially drawing the sponsor into litigation, using up pre-cious resources along the way. In some cases, taxpayers may be required tomake up the loss, and all the while, beneficiaries feel the pinch. Effects mayvary. Fewer scholarships are granted or a community center has to shutdown or retirement is postponed until it is more affordable.

Current events tell the tale well. Poor managerial decisions that lead tobankruptcy are particularly hard for employees with a 401(k) concentra-tion in company stock, especially if unemployment follows. Even thoughindividuals determine asset allocation with these self-directed plans, man-agement determines the possible choices, and sometimes the choices are justtoo limited to permit effective diversification.2 The renewed focus on 401(k)plan choices is only one of many recent reminders that sponsor vigilance iscritical, even when investment decision making is shifted to individuals.3


EXHIBIT 1.1 Fiduciary Decision-Making Matters

HIDDEN RISKS

As if fiduciary education was not already serious business, add derivativesto the mix and the challenge looms large. Like any financial tool, derivativeinstruments are a double-edged sword. Used properly, they can transforma financial exposure in ways otherwise not available to the investor ordeemed too expensive without them. Used incorrectly, they can wreakhavoc, causing monetary loss, missed opportunities, and legal damage. Theproblem is that derivatives-induced leverage may go unnoticed until toolate, especially if no one knows it exists. As shown in Exhibit 1.2, a fundcan easily be exposed to derivatives-related risk without an investor explic-itly buying or selling a derivative instrument.

Three common examples are hedge funds, embedded derivatives, and useof outside managers. Hedge funds, a popular choice with many institutionalinvestors, often employ derivative instruments. This choice may be good orbad but at the very least, their effects on portfolio risk and return should be

4 OPERATING ENVIRONMENT

EXHIBIT 1.2 Direct and Indirect Sources of Derivative Exposure

Direct Use of Indirect Use ofDerivatives Derivatives

Employ futures Allocate money to hedge funds that use derivative instruments

Use options Allocate money to private equity funds that use derivative instruments

Execute swaps Hire external money managers that use derivativesEnter into combination Invest directly in securities with embedded

of derivative instruments derivative-like features. Assume liabilities with embedded derivative-like

features Execute vendor contracts with embedded derivative-

like features

Bad FiduciaryInvestment-Related

Decision

ShareholderExposure to

Litigation Costs

Existing and PotentialBeneficiary

Loss

Tax PayerSubsidization


considered. Convertible bonds and other complex securities include derivative-like features that alter the way they behave as market conditions change.Money managers, selected directly or by outside consultants, can use deriv-atives and the pension, endowment, or foundation investors are completelyin the dark unless they ask the right questions and are given complete infor-mation. Risks may be lurking out of view but present a danger nevertheless.

Hedge Funds

Potential for higher returns and diversification benefits has attracted manynew entrants to the $500 billion global hedge fund market.4 Surprisingly,there is no legal definition of a hedge fund though most people agree thatthe term refers to a pool of money that is largely unregulated. A few defi-nitions are shown in Exhibit 1.3. The name itself says little about the fund’sinvestment strategy and, as shown in Exhibit 1.4, the style can range con-siderably. Funds that are highly leveraged in nature are recommended onlyfor more sophisticated investors and are restricted to certain conditions. Ac-cording to Mark R. Szycher, Director of Research & Chief Risk Officer ofWeston Capital Management, some hedge funds “initiate positions usingderivatives. Others use protected puts or write covered calls, etc. In general,fixed income and direction strategies such as global macro/managed futuresuse lots, equity managers use fewer.”5

Hedge fund investors include tax-exempt organizations, such as en-dowments and foundations.6 Until recently, pension funds had taken tohedge funds in smaller numbers, due in large part to opaque reporting thatmakes it difficult to evaluate a fund’s inherent risk.7 Anemic returns fromtraditional asset classes, the prospect of comparatively better returns, and

Why Focus on Risk Management? 5

EXHIBIT 1.3 Selected Definitions of a Hedge Fund

Definition

A hedge fund is a private investment limited partnership that invests in a variety of securities.a

A fund, usually used by wealthy individuals and institutions, which is allowed to use aggressive strategies that are unavailable to mutual funds, including sellingshort, leverage, program trading, swaps, arbitrage, and derivatives. Since they are restricted by law to less than 100 investors, the minimum investment is typically $1 million. The general partner usually receives performance-based compensation.b

aSource: Hedge Fund Center. Copyright © 2001, Fund-Investors, LLC. Reproducedwith permission. All rights reserved.bSource: InvestorWords.com. Copyright © 2002, InvestorGuide.com. Reproducedwith permission. All rights reserved.


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less volatility has prompted some pension funds to take a fresh look athedge funds, “something they may not have been comfortable with even afew months ago.”8 Study after study indicates continued institutional in-vestor interest in the hedge fund market with no decline in sight.9 As thingsstand right now, this translates into an estimated 7 percent of total hedgefund assets from investments made by endowments and foundations and 9percent from retirement funds.10

So what’s the big deal? The answer is leverage, leverage, and moreleverage. Fiduciaries who fail the hedge fund I.Q. test may find themselvesin hot water, trying to explain away losses if a strategy sours. It’s easy toforget that a financial position that goes way up has the potential to fallprecipitously. In his speech to the Public Funds Symposium, Securities andExchange Commission (SEC) director Paul Roye urged caution, notingthat

The funds are relatively unregulated, which allows the managers to usederivatives or debt to gear up returns and to be more secretive. Highdebt and secrecy have become parts of the hedge fund culture. Manyhedge fund managers make money because they are privy to informa-tion others do not have. Demands for regular disclosure and trans-parency from investors can hinder this process—if your competitorknows what you are up to, he might get a leg up on you. As a result, itis harder for hedge fund investors to know how their funds are beingmanaged, much less exert control over the manager. Managers canchange investment strategies and their investors would never know.Moreover, it is more difficult for hedge fund investors to vote with theirfeet. Many hedge funds only allow investors to cash in their holdingson a few days a year.11

On the plus side, some hedge funds are opening their books to moreclients and making a point to thoroughly disclose their use of derivativesand related risk control policies. After all, the low transaction costs, ease ofmarket entry, and relative liquidity are compelling reasons that favor use ofsome of the more common derivative instruments.12 Moreover, using deriv-atives to take offsetting positions in bonds, commodities, currencies, orstocks is certainly different from using them to speculate.

Investing in hedge funds is not a question of right versus wrong butrather that investors are weighing potential risks against expected returns,a task that is virtually impossible without knowing whether and how ahedge fund employs derivatives and manages risk. At the very least, thehedge fund should disclose data about the type and amount of derivativesused, if any, their purpose, and the fund’s ability to liquidate positions inshort order.



Securities with Embedded Derivatives

The value of a compound security, sometimes called a complex security,also depends on factors that drive the value of the derivative instrument.These may or may not be the same factors that determine the value of theunderlying host stock or bond. Ignoring the more complicated structure ofa complex security makes no sense because the derivative cannot bestripped out and sold separately.

There are many kinds of compound securities. A mortgage-backed se-curity (MBS) is one example. It can be thought of as a straight bond pairedwith an option on the underlying assets. Specifically, the MBS bond takesthe prepayment option associated with the underlying mortgagee into ac-count. The key is to accurately value the derivative-like feature embeddedwithin the security.

Ownership by pensions, endowments, and foundations merits discus-sion for several reasons. First, as shown in Exhibit 1.5, two types of com-plex securities—asset-backed and mortgage-backed bonds—represent largemarkets. Second, relaxed rules invite pension plan participation. As of Au-gust 23, 2000, employee benefit plans covered by the Employee RetirementIncome Security Act (ERISA) can now choose from an expanded list of per-mitted asset-backed and mortgage-backed securities, including bonds with“eligible interest rate swap” features.13 Third and very importantly, therisk-return trade-off of these bonds differs from the attributes of morestraightforward structures.

Similar to investments in leveraged hedge funds, derivative-like featuresof complex securities, liabilities, or other financial arrangements expose an


EXHIBIT 1.5 Bond Market Size (Billions of Dollars)

Year Mortgage-Related Asset-Backed

1991 1,636.9 129.91992 1,937.0 163.71993 2,144.7 199.91994 2,251.6 257.31995 2,352.1 316.31996 2,486.1 404.41997 2,680.2 535.81998 2,955.2 731.51999 3,334.2 900.82000 3,564.7 1,071.82001 4,125.5 1,281.1

Source: The Bond Market Association.


investor to a broader, but more subtle, mix of risk factors. Later chapters inthis book will look at these issues in greater detail.

Consultants and External Money Managers

According to the Pension Fund Consultant Survey 2001, “47.1% of sur-veyed plan sponsors, with assets over $100 million, use the services of pen-sion fund consultants.”14 Endowments and government entities report evenhigher numbers. As shown in Exhibit 1.6, a whopping 78.7 percent of largepublic and government sponsors use consultants for a variety of investment-related services, including but not limited to crafting official investment poli-cies, recommending how to allocate assets, and selecting money managersand/or evaluating their performance. Having expert help can prove invalu-able, particularly for organizations with limited staff or expertise. The flip-side is a cost in terms of information-gathering and oversight.

Fiduciaries must ask intelligent questions about the use of derivativesby outsiders, especially if a large chunk of the investment work is con-tracted out via consultants or direct hiring of external money managers.Everyone should be very clear about what constitutes a proper usage of de-rivatives or whether their use is even logical. The pension, endowment, orfoundation plan should create policy guidelines that explicitly list permittedinstruments, applications, limits, and reporting frequency.

One example is the “Statement of Derivatives Investment Policy forExternal Money Managers,” posted on the web site of the California Pub-lic Employees’ Retirement System. The document lays out the rules forpermitted and banned derivative strategies along with a requirement thatexternal money managers “prepare, maintain, and periodically review a


EXHIBIT 1.6 Excerpts from “Pension Fund Consultant Survey 2001: ConsultantUse among Plan Sponsors—2001”

Type of Number of Sponsors Number Using Percent Using Sponsor Over $100M Consultants Consultants

Public/government 478 376 78.7%Endowments 358 247 69.0%Hospitals 268 131 48.9%Unions/Taft-Hartley 618 289 46.8%Corporate/ERISA 2,333 980 42.0%Foundations 536 138 25.7%Total 4,591 2,161 47.1%

Source: Nelson Information’s 2001 Survey of the pension, endowment, and foun-dation investment consulting industry. Copyright © 2001, Nelson Information, aThomson Financial company. Reproduced with permission. All rights reserved.


written derivatives policy.” Major components of the prescribed policy areshown in Exhibit 1.7 and reflect an effort to exchange information betweenexternal managers and the pension plan sponsor.

In the absence of an established communications policy or question-naire, the request for proposal (RFP) is a good place to include questionsabout derivative instruments, notably how their usage is likely to affect per-formance outcome and what metrics are used to validate their contribution.Some of these can be quite long, but length is not the issue. No one canafford to buy the services of an outsider without a proper vetting. Play the


EXHIBIT 1.7 Excerpts from “Statement of Derivatives Investment Policy for External Managers”

Policy Components

1. Specifies the philosophy and prescribed use of derivatives for client accounts;2. Establishes limits to derivative exposure within a client account expressed in

terms of a percentage of notional amount of derivatives exposure as a percentof market value;

3. Establishes a standard of care concerning the following areas:a. Back office and systems capabilities,b. Internal audit and review of derivatives use,c. Separation of responsibilities,d. Senior management supervision,e. The required expertise of those permitted to engage in the use

of derivatives, andf. The authority of those permitted to use derivatives.

4. Establishes and describes the following criteria:a. The accounting and valuation procedures in the use of derivatives,b. The counter-party exposure credit limit policy,c. The value-at-risk analysis regarding the impact to a client’s portfolio caused

by the use of derivatives,d. Reconciliation procedures with the client’s master custodian bank,e. Reporting requirements to clients, andf. The frequency of the policy review and the names of individuals conducting

the review.5. Establishes and describes the monitoring procedures for the following issues:

a. Policy implementation, andb. Risk exposures

6. Describes the compensation of traders, portfolio managers, and other individuals involved in the use of derivatives to avoid inappropriate, fraudulent, or non-compliant behavior.

7. Specifies the periodic review of the written derivatives policy.

Source: California Public Employee’s Retirement System website. Copyright © 1996,CalPERS. Reproduced with permission. All rights reserved.


role of a financial detective and employ the RFP to ferret out the facts aboutrisk management policies of the external manager(s).

RISK MANAGEMENT AND DERIVATIVES

The discussion so far has used the terms derivatives and risk managementwithout much explanation. When it comes to headlines, derivatives tend tobe a key focus, but the reality is that risk management encompasses abroader array of concerns. What is risk management? That’s the “$64,000question”—one that begs a more fundamental question: What is risk in itsmost basic sense? Simply put, risk relates to uncertainty. No one has a lockon the future. Bad things can happen.

In the case of pensions, endowments, and foundations, the risk that re-ally matters is the possibility that projected funds will be unavailable forwhatever reason. Managing risk is the process of containing any negativesurprises. Put another way, risk management represents the policies andcontrols put in place to ensure—to the extent possible—that beneficiarieswill get what they are promised. Where do derivatives fit in? Futures, op-tions, swaps, and combinations of this trio are tools that, if properly used,can minimize risk. Derivative usage is just one part of the dynamic riskmanagement process that repeats itself over and over again. As shown inExhibit 1.8, identifying risks is a natural starting point, followed by tech-niques to control them. This process of risk identification and control mustbe reviewed on a regular basis and revised as needed.


EXHIBIT 1.8 Risk Management Cycle

IdentifyRisks

Reviewand

Revise

ControlRisk


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