Why re-invent the wheel...then spend a fortune building and maintaining it? Independent valuation services can give you the sophisticated advice you need.

By Miriam Bensman

Earlier this year Russell Flynn decided that he had to get a better handle on the risks in Chrysler Corp.'s increasingly complex pension funds. International securities, for example, now comprise some 15 percent of the total portfolio; as director of pension fund investment, Flynn wanted to quantify the fund's net currency exposure.

But Flynn didn't go the route - familiar to many banks - of building a vast new risk management system. He didn't even buy one from the host of new software vendors. Instead, he decided to rent a service from Bankers Trust.

Flynn is part of a new outsourcing boom in the risk management business. Trading disasters have awakened pension funds, corporate and municipal treasurers, regional banks and money managers to the need for more systematic and objective valuation and risk measurement - as earlier disasters had awakened major dealers.

But unlike the biggest dealers, few end-users and midsize financial institutions are willing to pour huge sums into developing or buying systems - or to hire the manpower to run and upgrade them. Some are therefore choosing to rent software and expertise from a host of new service bureaus springing up like mushrooms.

"My prediction is the service bureau phenomenon will grow," says Ken Cunningham, managing director at Gnosis, Inc., a risk management training and consulting firm in Chicago. "It fills the need. For anybody who has gone past the stage of being comfortable with one-off valuations or spreadsheets, and who isn't at the stage where it can justify a big system, I think the service bureau alternative makes a lot of sense."

After all, service bureaus aren't unique in the financial realm. Under pressure to cut staff, corporate America increasingly outsources receivables management to places like Dun & Bradstreet. And smaller hedge funds often outsource their operations and accounting functions to independent trade support services.

The risk managers for hire vary widely in scope. Some simply provide periodic valuations of individual securities or portfolios; some also provide more comprehensive risk analysis or take on the task of mapping complex securities into a risk system. The providers also vary widely. Regulators, senior managers, rating agencies and pension fund trustees have all cried for more independent valuations of derivatives positions, and several different types of industry players have jumped into the service game.

Accounting firms: Price Waterhouse, the accounting and risk consulting giant, in January opened a Risk Information Services Center (RISC) in Chicago to provide big dealers and end-users with independent valuations of their derivatives portfolios. Although other accounting firms provide valuations as part of their audit practice, Price is the first to set up a separate unit that offers ongoing valuations as a separate product.

Dealers: Bankers Trust has started offering the bank's much-vaunted Risk-Adjusted Return on Capital (RAROC) system to pension funds and corporations through the bank's risk management services area. Some other derivatives dealers - most notably Goldman Sachs - also make their internal risk management systems available to favored clients on a more limited basis.

Software providers: Many vendors will load customers' portfolios into their system for an additional fee. BARRA, which has been converting its World Markets Model into a true VAR system, is considering turning it from a pure software product to a software/consulting product.

Money managers: TSA Capital Management, the Los Angeles-based quantitative money manager, a year ago began providing periodic valuations of structured notes portfolios to pension fund clients. Ferrell Capital Management, a Greenwich, Conn.-based fund of funds, provides weekly value-at-risk reports to pension funds and banks with broad securities portfolios.

Consultants: Independent consultants such as Emcor Risk Management Consulting have started valuing derivatives positions for corporations that don't think they need Emcor's advice - but want valuations independent of their dealers. Capital Market Risk Advisors, Gifford Fong Associates and a host of smaller independent consultants offer portfolio valuations in emergency situations, such as Orange County's.

Futures exchanges: The Chicago Mercantile Exchange and the Chicago Board of Trade are each developing collateral management services as part of new swaps collateral depositaries they plan to start next year. As part of their services, they're likely to offer simple - and inexpensive - valuation services to end-users that do not need to post collateral or to dealers that require an independent valuation for regulatory capital purposes.

Here's a look at four of the new service providers.

TSA Capital Management

TSA, a quantitative money manager that actively trades futures and options, turned consultant in October 1994 when a pension fund concerned about its portfolio of structured notes hired it to provide a valuation and shortly thereafter unofficially provided advice to Orange County. The Los Angeles-based firm now provides four major pension funds with periodic valuations of structured notes portfolios. "We do a mark-to-market monthly, quarterly, annually or when the need arises," says David Depew, executive vice president at TSA. In addition, if asked, TSA advises clients on how to make a proposed transaction more attractive. For example, if the client thinks the implied forward curve indicates a future spot rate that's too high, TSA might advise asking for swap reset dates in arrears.

TSA uses Theoretics software to value complex instruments. Clients could, of course, buy and update the system and expertise themselves, Depew notes. At $25,000 a year, the cost of Theoretics software is often not the issue. More likely, the question is whether it makes sense to hire someone at a six-figure salary and have them spend three months learning the ropes. "It's hard to say which is more efficient," says DePew. "If you have a big enough portfolio it may make sense to buy it."

Valuations tend to run 2-5 basis points of notional value of a particular deal, depending on the complexity. Valuing a $10 million exotic structure, such as a resetting range note with a binary American option, might cost $5,000. That's a lot of money, Depew notes, but, "if the bid/offer spreads on these deals are 40 basis points, getting the valuation can pay for itself."

Clients that seek regular monthly marks, however, usually put TSA on retainer, which is much less expensive because TSA then has to model each note just once; subsequent valuations are simpler. There are economies of scale for larger portfolios, too, since a portfolio of 100 securities usually includes only five or six different types.

Price Waterhouse

Price Waterhouse's new Risk Information Services Center in Chicago is designed to be a virtual middle office that monitors, values and analyzes derivatives positions and portfolios. The firm has been hired by smaller regional corporations, municipalities, pension funds and mutual funds to augment in-house capabilities. It's also used by derivatives dealers who monitor their own valuations but need to demonstrate an independent valuation of their in-house marks to regulators and rating agencies; special purpose triple-A subsidiaries such as Salomon's Swapco or Merrill's MLDP use it to meet rating agency requirements for independent valuation. Last summer, RISC also helped Price's consulting service quantify the Wisconsin Investment Board's derivatives losses.

Ed Buchanan, managing director at RISC, says that although many clients could purchase and run relatively simple software on their own, they may not have the capability to enter it properly. "We gather data - transaction data, market data, curve data and volatility data - from various sources within an institution and adapt it to the requirements of our applications," Buchanan says. "Then we calculate the values and provide an analysis of the difference between our values and those the client showed." Entering all the data is complex, because even on simple transactions the volume of detail required is large, with many moving parts.

"Preservation of data integrity is key," adds Buchanan's partner, Chris Phillips. "When there's a large volume of data, it is transferred by electronic means such as tape or the Internet, but still has to be remapped into our data model." Mapping the data in essence means understanding it in the format provided by the client and interpreting it for the RISC's model. It's both a computer language problem and a problem in representation of transactions.

RISC uses customized software from Infinity, Theoretics and a number of smaller applications on SUN/UNIX workstations and PCs. At this time it can handle portfolios of listed futures and options as well as simple and exotic OTC products, but not CMOs.

Pricing is driven by the annual volume and complexity of transactions. A typical provider's portfolio of 20,000 transactions, 80 percent vanilla and 20 percent exotic, might cost about $250,000 a year. That could be 5,000 transactions valued quarterly, or 20,000 valued annually.

Ferrell Capital Management

Andrew Donaldson, treasury director at the European Bank for Reconstruction and Development (EBRD), is no babe in the woods when it comes to risk management. Last year he began developing a value-at-risk system for the bank's nearly $6 billion in internally managed funds. But Donaldson wanted a second set of eyes to monitor the risk of a $400 million global bond program run by six external managers. Its custodians were unable to provide the sophisticated risk analysis needed, so Donaldson convinced Ferrell Capital Management to do it for the bank.

For Ferrell, the move to consulting was a logical step. The firm manages a group of hedge funds and commodity trading advisors for institutional clients, subjecting its traders to the kind of tight risk controls used by big dealer banks for in-house traders. "The only difference between this and our asset management work is in the latter we construct, monitor and rebalance a portfolio of managers," says Virginia Parker, managing director at Ferrell. "With the consulting work, we're given a portfolio of managers and we monitor it and advise on problem spots."

"We're not a software house, and we're not a consulting firm that sets up your software and risk management procedures and wishes you luck," adds S. Waite Rawls, a former executive vice president of The Chicago Corp. who authored the management control section of the Group of Thirty's Derivatives Practices and Principles Report - and joined Ferrell in June. "We stick around at the end of the consulting to provide ongoing advice and service."

Every week the EBRD's external managers electronically send Ferrell a list of all positions in their portfolios; Ferrell measures the value-at-risk by country, duration bucket, and manager, noting any major changes from the prior week. Then, it analyzes the key drivers in the portfolio to identify concentrations of risk. "We want to understand the risk of each manager and the correlated risks," Donaldson notes. "If we don't like all that French exposure, we can hedge it out without telling the managers how to run their portfolios."

This summer, Ferrell acquired a second client, a large U.S. pension fund that wanted risk analysis of its global equity and fixed-income portfolios, which aren't hedged for currency risk. To the client's surprise, Ferrell found that much of its risk came from short-term rates in Germany, even though the fund didn't have any outright positions in short-term Euromark. What it did have was positions in many European equity markets, and the currencies in those markets were highly correlated to the Deutsche mark. That "really opened their eyes," Parker says. "It's surprising to a lot of investors to see how much less diversification they get than they thought from international investing, because the European markets are so highly correlated to each other."

"What they give back is a robust correlation matrix and the careful identification of key drivers of portfolio value," observes one risk management consultant. For stress testing, Ferrell tests for the impact of a major move in those key drivers. "Monte Carlo analysis tests for everything, including highly unlikely, or nearly inconceivable, combinations of events - such as what might happen if the long bond rates for major industrial countries drop to 2 percent while the price of oil triples to $50 a barrel," Parker explains. "We try just to stress test for the kinds of things that could happen."

Rawls concedes that the system has its limits. It looks at most components of market risk, and is particularly good at yield curve, spread risk and duration risk in fixed income. "If you have a lot of high-tech mortgages, there are better systems than ours," he adds. (The EBRD, in fact, doesn't use Ferrell to monitor its $270 million short-duration mortgage program.) "The truly weird structures don't lend themselves to price volatility analysis, which is the foundation of what we do."

Ferrell's fee depends on the complexity of the portfolio and the instruments, and the frequency of report generation. Typically, the annual fee for a traditional, multicurrency global equity and fixed-income portfolio would be at least $250,000.

Bankers Trust

With RAROC 20/20, Bankers Trust harnesses for customers two of its key strengths: its custody expertise and the value-at-risk methodology it developed to measure and manage its own huge trading book. The combination is perhaps the most comprehensive risk management service available at this time. "This is a high-end system geared to large, sophisticated global investors," says Charles Kiley, managing director and head of risk management services. "It started when pension funds woke up in the 1990s to the fact that the financial instruments managers were buying had risks they couldn't comprehend - and their managers didn't under stand either."

Chrysler signed up to use the system because it wanted to start paying closer attention to the risk side of the risk/return equation, says Russell Flynn, Chrysler's director of pension fund investments. While Chrysler had long looked at standard deviations to measure the effectiveness of a manager or portfolio strategy, it wanted to get more information on the types of risks it was taking and how they change over time. It also wanted to quantify those risks with a hard number. "We get a report that tells us, based on Monte Carlo simulations, what the capital at risk is for the total portfolio, by asset class and by manager," Flynn says. "They stage the data for us and run it through their software. And we pay them a fee - just as we pay them fees for performance reporting and custody."

RAROC 20/20 analyzes the portfolio by risk type (equity, interest rate, currency or commodity), security type (options, stocks, futures, convertible bonds) and by manager or account. The valuations are based on the volatility and correlation data that BT devised for its own trading desks. That data is run through BT's high-powered Monte Carlo simulator to generate reports on paper or on Windows-based software that the client can use to stress test the portfolio for bigger market moves.

Different Deviations

In a departure from most systems currently available, the valuations are based on a one standard deviation move for a one-year holding period. JP Morgan's RiskMetrics, by contrast, provides data for one- and 90-day holding periods. It's partly a question of whether you measure in feet or inches. When RAROC 20/20 says that the value-at-risk for a portfolio is 20 percent, it is saying the portfolio might lose 20 percent of its value in one year in 100. By contrast, if a system running RiskMetrics says the value-at-risk for the portfolio is 20 percent, it is saying that in one day in 100, or one quarter in 100, the portfolio might lose 20 percent of its value. A 20 percent VAR under RiskMetrics is far riskier than under RAROC 20/20.

The different scale of measurement is designed to fit the perspective of the investor. "The one-day or 90-day holding period is appropriate for short-term traders who need to see small fluctuations," explains Kelsey Biggers, managing director and project manager for RAROC 20/20. "The longer holding period smoothes out much of the volatility, and says, implicitly, that you are only interested in a true disaster, not daily fluctuations. Pension funds are typically long-term investors that see the world in a five-year time horizon, and can ride a loss for a year."

The service comes with a significant degree of customization. Not all clients want to break down their portfolios into standard risk categories. For example, a pension fund that had 20 percent of its portfolio in company stock quite properly didn't want to lump such a major component of its risk in with other US equities - it wanted it to be a separate line on the matrix.

Data Scrubbers

Perhaps most important, from a practical point of view, is that BT - like Price Waterhouse's RISC - handles much of the data entry and mapping functions that bedevil most would-be risk managers. The bank collects data from the client's trustee, decomposes it into various risk elements and marks it to market, before doing anything else. "It's only by coincidence if the electronic feed we receive is clean," notes Biggers. "We always need to scrub it. That's a big value added that the software vendor misses."

Kiley notes that a sophisticated custody client in Europe with its own risk management system told him he couldn't enter his derivatives into the system because neither his own staff nor the software vendor could break them down properly. BT ended up using its decomposition package to feed the derivatives into the client's risk management system.

For exchange-traded instruments, Kiley explains, if you have the CUSIP number, you can get the security description. But for instruments that aren't exchange-traded, there's no standard security description, so you have to break the security down into its component cash flows - which is easy to say and hard to do, particularly with complex derivatives such as multifactor options. "We can handle that," he says, "because we have people that are expert in reverse engineering these instruments, so we can stage them and run them in our system."

This kind of expertise does not come cheap. For a $10 billion pension fund with 50 fund managers, a fairly typical asset allocation mix, and about 80 percent of its positions exchange traded, monthly valuations would cost about $200,000 and $300,000 a year. BT might charge a much bigger fund twice that amount for quarterly valuations. Since its launch this spring, two pension fund clients have subscribed to the system.

A foreign energy concern, meanwhile, purchased a site license, which allows it to take the software back to the office and run it as often it wants. A site license fee is around $1 million, plus separate fees for consulting and for integration with accounting or the legacy system. For site licenses, BT is targeting major regional banks and oil companies who would use this for their basic corporate risk system.