Not Only Risk Optimization Tool [Instrument Score Card]

Portfolio Manager's Wish:-

        Every portfolio manager wishes to construct optimum portfolios that are less risky, profitable & with less investment. This is going to be a uphill task, In this post we have demonstrated Portfolio Risk Optimization processes & tools.


Optimize Portfolio Risk How to? Tools Used

Portfolio Manager can optimize[Reduce Risk, Improve Returns] portfolio by doing:-

               1) Conscious allocation of economic capital.
               2) Trade off risk and return.

Some of the tools available are ComponentVar , MarginalVar, IncrementalVar, and other VaRs for that matter. But one drawback of VaR is it is a single number focusing on risk only and even worse it is is not even a coherent risk measure.

Optimize Portfolio Risk How to? Instrument ScoreCard[Not Very New!!!]
                When trying to optimize a portfolio, by either including or excluding an instrument portfolio manager can make use of below table for taking an informed decision. This table can be used as a framework for arriving at a score for given instruments(taking into consideration trends,risks,exposures,funding,...etc).

Given multiple instruments, manager can derive the score for those instruments and then choose the one with high score[Usage explained after the table].

	Category	SubCategory	Effect	Weightage
	Funding
		Available Capital	+	w1
		Interest Rates	#	w2
		Transaction Cost	-	w3
	Protection
		Protection Cost	-	w4
		Hedging Cost	-	w5
		Hedging Benefits	+	w6
	Trend
		Seasonality Trend	#	w7
		Market Trend	#	w8
	Exposure
		Soverign Exposure	#	w9
		Counterparty Exposure	#	w10
	Organization Goal
		Alignment	+	w11
	Situation
		Demand for Instrument	+	w12
		Demand for Sector	+	w13
		Predicted Future Demand for Instrument	+	w12
		Predicted Future Demand for Sector	+	w13
	Strength
		WorstCaseScenarioPerformance	+	w14
		BestCaseScenarioPerformance	+	:
		AvgCaseScenarioPerformance	+	:
		NormalCaseScnearioPerformance	+	wi
Usage:-

       1) Assign Weights to each factor with restriction of (w1+...+wi=1).
            [Note:- This is extensible framework,i.e. you can have as many factors as you want ]
            [Guidelines:- Don't have so many, then it will be maintenance nightmare].

       2) Calculate Instrument Score by
                 Effect * Weightage * Instrument's Score
             [Note:- Keep Instruments Score on a scale 1 to 5 for each factor]
     
       3) Rank the instruments using the score into categories[HighlyRequired,Required, NotRequired].
             [Note:- This is extensible framework,i.e you can have as many categories as you want.]
             [Guidelines:- Don't have so many, then it will be maintenance nightmare].

       4) Make investment decisions using the investment Category.
             [eg:- If an instrument is in NotRequired Category, then see whether it is going to become less                       worthy for sure, then buy a Put Option :)]

Conclusion:-

Using the Instrument Score Card Approach we can get holistic view of an instrument's impact on the portfolio rather than focusing only on Risk. But can we improve on this still, yes i think so. Watch out this space for new insights into this.

Thanks & Regards,
Srinivasan