FRM Handbook Ch 29: Portfolio Risk Management
Book: Financial Risk Manager Handbook Plus Test Bank
Author: Philippe Jorion
ISBN: 978-0-470-90401-5
Chapter 29 shifts from bank regulation to the investor’s problem. You take risk because you expect a return. The real question is how to balance the two across a whole portfolio. That sounds like Markowitz from Chapter 1, but Jorion updates it for how institutional money actually works today.
Risk budgeting from the top down
Risk budgeting starts with a total portfolio risk target. The CIO decides how much volatility (or VaR) the fund can tolerate. That budget gets split across asset classes, strategies, and managers.
This is a top-down process. You do not let each manager run independent risk and hope it adds up. You allocate risk the way you allocate capital. A manager consuming 40% of the firm’s risk budget should justify that with expected return.
The steps look like:
- Set total portfolio risk target.
- Allocate across asset classes based on expected return per unit of risk.
- Allocate within asset classes to individual managers or strategies.
- Monitor contributions and rebalance when drift occurs.
Buy side vs sell side
Jorion draws a useful contrast:
Sell side (banks, broker-dealers) uses high leverage, short horizons, active trading in liquid markets. Think proprietary desks.
Buy side (pension funds, endowments, mutual funds) uses little leverage, longer horizons, and can hold less liquid assets. Hedge funds sit in between with more leverage and more flexibility.
The risk tools overlap (VaR, stress tests, factor models) but the philosophy differs. A bank desk cares about daily P&L and regulatory capital. A pension fund cares about funding liabilities over decades.
Performance evaluation in three steps
1. Return measurement
Cash flows complicate return calculation. The industry standard is the time-weighted rate of return (TWRR). Value the portfolio before each cash flow, compute sub-period returns, and compound them. This isolates manager skill from the timing of investor deposits and withdrawals.
2. Risk adjustment
Raw returns are misleading. A manager who earned 20% with 30% volatility did not necessarily outperform one who earned 12% with 8% volatility.
Common metrics:
- Sharpe ratio: Excess return per unit of total volatility.
- Information ratio: Active return per unit of tracking error (for benchmarked managers).
- Treynor ratio: Excess return per unit of systematic risk (beta).
- M-squared: Return adjusted to match benchmark volatility.
The first question is always: absolute risk or relative risk? A pension fund with liability matching cares about relative risk against its benchmark. A hedge fund investor may care about absolute drawdowns.
3. Attribution
Performance attribution decomposes returns into allocation effects (did you pick the right asset classes?) and selection effects (did you pick the right securities within classes?). Risk attribution does the same for risk contributions.
Portfolio construction and constraints
Real portfolios face constraints that textbook optimization ignores:
- Liquidity requirements
- Regulatory limits (for insurance companies and banks)
- ESG mandates
- Concentration limits
- Currency hedging policies
Jorion shows how to incorporate these into the optimization. The unconstrained efficient frontier is a starting point, not the answer.
Risk monitoring
Ongoing monitoring tracks:
- Actual vs budgeted risk contributions
- Style drift (is the manager doing what they promised?)
- Correlation changes (diversification benefits shrink in crises)
- Tail risk measures beyond volatility (skewness, kurtosis, drawdown)
What stuck with me
Risk budgeting is the investor version of RAROC. Both put a price on risk and force trade-offs. The difference is the time horizon and the absence of regulatory capital charges.
The performance evaluation section is practical. TWRR, Sharpe, information ratio: these are the metrics you see in every fund fact sheet. Jorion explains why each exists and what it misses.
Previous: FRM Handbook Ch 28: The Basel Accord (Market Risk Charge and Conclusions)
Next: FRM Handbook Ch 30: Hedge Fund Risk Management (Hedge Fund Industry and Market Risks)