Portfolio Risk Management and Performance Measurement
Core concepts
Risk management quantifies exposure and tests resilience. Candidates need variance and standard deviation, beta, tracking error, value at risk (parametric, historical, Monte Carlo), stress testing, and scenario analysis. VaR is a loss threshold at a confidence level over a horizon - not a maximum loss. Stress tests ask what happens under specified adverse scenarios, complementing VaR's probabilistic view.
Performance measurement covers return calculation (time-weighted versus money-weighted), benchmarking, and risk-adjusted metrics. The time-weighted return removes the effect of cash flows and suits manager evaluation; the money-weighted return reflects the investor's actual experience. Metrics include Sharpe (total risk), Treynor (systematic risk), Jensen's alpha, and the information ratio (active return per unit of tracking error). Attribution explains excess return sources.
Traps
- Treating VaR as a worst-case loss; it says nothing about the tail beyond the threshold.
- Using Sharpe when the portfolio is a component of a larger diversified fund (Treynor or information ratio may fit better).
- Comparing money-weighted returns across managers with different cash-flow timing.
- Ignoring that leverage and derivatives change effective exposure.
Worked example
A portfolio returned 11% with volatility 15%; the risk-free rate is 3%. Sharpe = (11% − 3%) / 15% = 0.53. If its beta is 0.9 and the market returned 9%, Jensen's alpha = 11% − [3% + 0.9 × (9% − 3%)] = 11% − 8.4% = 2.6%.
Rule of thumb: match the risk measure to the question - total risk for standalone portfolios, systematic risk for components - and pair VaR with stress testing.