Product classifications of financial products
Part 3 of the series risks of investment products.
Introduction
In the first two posts of this series, volatility and Value at Risk (VaR) were presented as indicators of risk for the market risk of financial instruments. In this post, we will, on the one hand, examine the other two main risk factors of investment products, credit risk and liquidity risk. On the other hand, we will look at the Product Risk Classification, known as PRC, which is used within the wealth management of many financial institutes to assess risks, to inform about risks and to compare the risks of different investment products.
Credit risk as a risk factor
In the present case, credit risk is mainly understood as counterparty risk. Besides the classical credit risk – e.g. from money market transactions – this also covers default risks, that arise from derivative positions or through performing financial transactions. A quantification of this risk can be made through the Credit Spread. The Credit Spread expresses the market participants’ estimate of the inherent default and credit risk of the debtor, issuer or counterparty of the investment. In general, the Credit Spread is added to the risk-free interest rate curve. Therefore, we calculate the Credit Spread using the market price of the instrument and determine that unknown premium to the risk-free interest rate curve for discounting, so that the calculated value matches the market value of the product. This premium is referred to as Implied Credit Spread.
Liquidity risk as risk factor
In the context of private investment, liquidity risk refers to the risk of (not) being able to exchange a basic value quickly for something (e.g. liquidity) without suffering massive markdowns at a marketplace. A good measurement for the liquidity risk is the Bid-Ask Spread. Basically, one distinguishes between Bid-price and Ask-price. The Bid-price is the highest price that a potential buyer is willing to pay, and the Ask-price is the lowest price at which a potential seller is willing to sell. The difference between Ask-price and Bid-price is termed Bid-Ask Spread. A small Bid-Ask-Spread usually shows a low liquidity risk.
PRC as an aggregate risk indicator of an investment product
Why use Product Risk Classification in the first place?
Well, this helps to compare financial instruments over various investment categories. The necessity of this comparability arises from the different regulation requirements, that are already in place across Europe or will be put into place in near future. For instance, the European Markets in Financial Instruments Directive (MiFID II) and the Swiss law for financial services (‘Finanzdienstleistungsgesetz’) (FIDLEG) give greater priority to informing and protecting investors.
Particularly to provide transparent information about financial instruments and their risks for the customer, a product risk classification allowing to compare risks between different product types and investment classes, is essential.
For this reason, in the Directive (EU) 1286/2014 the regulator issued clear directions to disclose the risk of Packaged Retail and Insurance-based Investment Products (PRIIP) using key information documents for specific investment products on the European Market. These regulations, however, refer to a conclusively defined group of investment products. We would like to point out, that the subsequently presented PRC method can by no means replace the requirements of the regulator for the so-called PRIIP. We would rather consider the PRC as a universal product risk classification that enables a comparison of risks across all product types and investment categories and that can complement the risk classification of the PRIIP regulation.
Methods for the product risk classification
Different methods for the product risk classification exist. The majority of these, however, do not take the central risk factors of investment products into account. These were already examined in this and the previous article and are subsequently listed:
- Market risk
- Credit risk
- Liquidity risk
How the risk factors are included in the product risk classification, whether qualitative or quantitative approaches are taken into account and how the risks factors are weighted when estimating the aggregate risk of the investment product, differs among the providers.
In what follows, we would therefore like to present the methods of UnRiskOmega AG. Considering the partially high costs for market, reference and qualitative data, we opted for a purely quantitative modelling.
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PRC methodology
UnRiskOmega’s PRC model is based on a categorisation of an arbitrary investment product with the possibility for the client to determine the bandwidth (e.g. 1-5 or 1-7). The individual risks flow into the calculation of the PRC as follows:
Market risk
The market risk is based on the annualised volatility and the liquidity adjusted Value at Risk (LVaR) of the investment product. The volatility is the main drive and the market risk can be corrected upwards by means of the LVaR.
The volatility is calculated on a monthly basis. The time series takes a 5-year history as a basis, from which the returns are determined with the help of a Moving Window approach. The VaR is determined historically – the 1-year VaR is used.
To be able to account for illiquid or structured instruments of a time series, these instruments are assessed using a market to model approach. For this, an assessment using the underlying risk factors / product data (Yield Curves , Credit Spreads, Coupon Dates, …) is made. In this process various numerical methods such as QMC are used.
From the market risk indicator and the market increment the market PRC is formed. This is used to determine the PRC on product level.
Credit risk
The credit risk for investment product is calculated using interest rate components. The Implied Credit Spread, which is calculated from the difference between the Fair Value and the traded price, serves as an indicator.
The credit risk indicator is defined as credit-PRC, which is also used to determine the PRC on product level.
Liquidity risk
The liquidity risk is determined by the difference between the Bid and Ask price (Liquidity Spread) and flows into the VaR, and therefore also into the market risk, as Liquidity Adjustment Factor.
PRC as aggregate risk indicator of the investment product
The PRC is presented as aggregated risk indicator on the basis of the underlying risk indicators. By default, the PRC is defined as the Maximum of the market risk indicator (including liquidity risk) and the credit risk indicator.
Management of data and fallback logic
It is evident from the above-described PRC methodology that to determine the PRC different amounts of market and reference data are needed. Particularly to assess complex investment products, such as structured products, and to be able to carry out accurate risk assessments, additional information about the investment product itself (duration, barriers) must be available besides the time series of the underlying. For the time series (as already mentioned above) data of the past 5 years is required.
In individual cases, there is not enough (e.g. too short time series) or no data at all (e.g. OTC product) available and therefore a calculation according to the above described method is not possible. In these cases, the PRC methodology provides different fallback logics. To achieve a complete coverage for a product universe, investment products with insufficient available data can be approximated or substituted via the fallback logic.
Conclusion
The PRC is particularly suitable in wealth management to explain the risks of different investment products to the client in a simple and understandable way. It includes the main risk factors of an investment product. In the form that is offered by UnRiskOmega the PRC can be calculated for all types of investment products due to the purely quantitative method and the intelligent fallback logic.
The PRC in a nutshell:
- An easily understandable, transparent risk indicator to compare financial risks of different investment products.
- A risk indicator that refers to the risk of any individual financial instrument without considering portfolio aspects.
- A risk indicator that can support financial service provider to comply with the regulation requirements (FIDLEG, MiFID II) (<<considering all risk aspects in the advice process>>).
The PRC is not:
- A risk indicator of the portfolio and can therefore not substitute a thorough risk assessment of an investment portfolio.
- An accurate risk measure for the detailed control of asset allocation, but rather serves the comparability of investment products of different asset classes.
- A replacement for all key risk figures, such as volatility and VaR, which should be used for a precise analysis.
