The Role of Risk Management Louise Watkins, Risk and Quantitative Analysis MUTIS Finance Conference, November 2014

For professional clients / qualified investors only BlackRock’s business is INVESTING

For professional clients / qualified investors only

5 Who does BlackRock work with?

6 What is “ ” Risk?

Risk depends on perspective 7

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Understanding, Constructing and Delivering a Diversified Portfolio 9 UnderstandConstructAnalyseTailor

Risky assets and the Capital Asset Pricing Model (CAPM): We can determine an asset’s expected return once we know:  The risk free rate  The return on the market  The asset’s systematic risk or beta (sensitivity to the market) The ‘Risk-Free Rate of Return’: The rate of return that can be expected with certainty ‘The Market’:The portfolio in which each security is weighted in proportion to its market value Positive Beta:Return of an asset moves in the same direction of the market Negative Beta:Return of as asset moves in the opposite direction of market Refresher Risky Assets: Establishing a Stock-Specific Return 10 E(R) = Rf + β(E(Rm) – Rf) Refresher : The ‘Risk-Free Rate of Return’: The rate of return that can be expected with certainty. ‘The Market’: The portfolio in which each security is weighted in proportion to its market value Positive Beta: Return of an asset moves in the same direction of the market Negative Beta: Return of as asset moves in the opposite direction of market

CAPM expected returns example A stock has a beta of 1.2, the expected return on the market is 8%, and the risk free rate in 2%. What is the stock’s expected return? 11 In equilibrium, the expected return and the required return in the market are equal E(r) = Risk free rate 2% Beta Market Risk premium (8% - 2%) = 9.2%

Understanding, Constructing and Delivering a Diversified Portfolio 12 UnderstandConstructAnalyseTailor

Risk in Construction: Modern Portfolio Theory 13 Harry Markowitz Who is “ ” This?

Grouping Individual Assets into Portfolios The riskiness (standard deviation) of a portfolio that is made of different risky assets is a function of three different factors: The standard deviation of a two-asset portfolio may be measured: 14 Individual Asset Risk The standard deviation of the Individual assets that make up the portfolio Asset Weights The relative weights of the Assets in the portfolio Interaction Between Assets The degree of co-movement (covariance) of returns of the Assets making up the portfolio For professional clients / qualified investors only

Correlation = 1 Diversification reduces correlation 15 Expected return Total risk σ Equity Portfolio Debt Portfolio Correlation = -1 0 Correlation = 0.3 For professional clients / qualified investors only

Understanding, Constructing and Delivering a Diversified Portfolio 16 UnderstandConstructAnalyseTailor For professional clients / qualified investors only

17 The Factor Model Approach U.K. Country Risk for a global fund manager Energy Large Cap Common Factors Specific Oil Spill EUR/GBP Currency Risk for a French investor High Yield Common factors Asset return Exposure (or Sensitivity or Factor Loading) of asset to factor M Return of factor M Asset specific (or idiosyncratic) return r i = e i,1  f 1 + e i,2  f 2 + …… + e i,M  f M + r i,Specific

Understanding, Constructing and Delivering a Diversified Portfolio 18 UnderstandConstructAnalyseTailor For professional clients / qualified investors only

19 Grinold & Kahn, in “Active Portfolio Management”, McGraw Hill, 2000 A manager with great information and bad portfolio design can snatch defeat from the jaws of victory “ ” For professional clients / qualified investors only

Lessons of Portfolio design 20 The alphas are valuable…...the risk model makes them more valuable For professional clients / qualified investors only

How easy is it to forecast risk & return? Which of the following stocks would you mostly likely invest in? 21 For professional clients / qualified investors only

Which of the following do you think is easiest to forecast? 22 Expected volatilities Expected correlations Expected returns ??? For professional clients / qualified investors only

Forecastability Correlation is the easiest to predict 23 Return is x10 harder to forecast than volatility BUT Based of 20 years of observation, many portfolio managers behave as if this is the case: Source? Source: BlackRock. Data at April 2013 Forecastability For professional clients / qualified investors only

Three basic principles of Portfolio Design Deliberate Diversified Scaled Only take rewarded risk 24 For professional clients / qualified investors only

The first step in the risk management process is to acknowledge the reality of risk. Denial is a common tactic that substitutes deliberate ignorance for thoughtful planning Managing risk 25 Charles Tremper, Risk Management Author “ ” For professional clients / qualified investors only Risk Management IS NOT avoiding risk. Risk Management IS understanding risk and planning for it.