Market risk can be defined as the risk that the value of an investment declines due to a change in external factors. These risk factors vary according to the nature of the investment; however, for short-term investments, market risk tends to cover the risk of a decrease in value arising from changes in interest rates. Other risk factors, such as exposure to equities, commodities and/or foreign exchange (FX), are generally not considered for short-term investments, due to their high volatility. In addition to these factors, banks must consider the capital requirements which arise, adding a further level of complexity to market risk management.
When banks – or any other investor – make any short-term investment, their appetite for a potential loss of value is sharply reduced, if not nil. While this does not necessarily imply hedging away all market risk when investing short-term cash balances, it does require careful risk management. Money market funds (MMFs) provide a viable investment solution for short-term cash balances, via risk management practices that allow the investor to limit exposure to market risk, yet still obtain competitive money market returns.
The likely period that an investment can be held will influence the investor’s choice of instrument. Short-term cash balances generally fluctuate, and treasurers often have limited certainty of whether, and for how long, that balance will remain available. Investments that are made for a limited time period should be subject to a minimal exposure to market – or any other – risk. This is due to the fact that the short period for which they are held provides limited potential for risk mitigation. MMFs respond to these criteria, given that their objective is to provide security and liquidity, whilst having limited potential exposure to market risk.
Medium- and longer-term cash balances can be invested in instruments which have greater susceptibility to risks, including any changes in value due to market risk exposure. This follows on directly from a longer investment horizon, which allows for a greater time period within which any risk may be managed and properly mitigated. In these instances, the potentially higher exposure to market risk is offset against the greater propensity for an increased return to be achieved – the classic risk/reward conundrum.
When investing cash balances, it is therefore fundamental to choose an instrument, and thus the method of (market) risk management, based on the horizon over which the investment is being made. The potential risks, and possible rewards (i.e. return), will then follow suit.
Managing Risk in a MMF
MMFs provide a viable means of managing short-term cash balances. To achieve the fund’s objectives of security and liquidity, the MMF manager will construct the fund’s portfolio in such a way to limit and control exposure to market risk.
Concretely, market risk in MMFs is frequently managed by limiting the exposure of the fund to longer-dated, as well as floating rate, instruments. IMMFA MMFs are subject to a maximum weighted average maturity (WAM) of 60 days. The WAM is calculated using the next interest reset date of any floating rate instruments, and is a measure of the susceptibility of a MMF to movements in interest rates. The higher the WAM, the greater the impact of a change in interest rates on the value of the fund.
The WAM of a fund reflects the view of the fund manager on short- and medium-term interest rates. Where the fund manager considers that interest rates are likely to increase, he may reduce the overall duration of the portfolio, allowing the fund to quickly react to any rises in interest rates. Where a fund has a longer WAM, the manager will either consider markets to be stable, or that interest rates are likely to fall. In these instances, a longer WAM will allow the fund to benefit from the higher yields payable on longer dated assets.
The WAM limit provides an effective mitigant to market risk. A MMF can withstand significant movements in interest rates without there being a material impact upon the value of a share in the fund. For example, if a MMF has a WAM of 60 days and experiences no net redemptions, it should be able to absorb a 300 basis point interest rate rise in one day and still maintain a constant net asset value of 1.00. Even with redemptions of 30% of assets in a given day, a MMF should maintain its constant value despite a 200 basis point interest rate rise. Most funds operate with a WAM in the region of 30-40 days, meaning that they should withstand even higher movements in interest rates on a single day without experiencing any impact upon the value of a share.
The Benefits of MMFs
This restriction on the maximum WAM limits the amount of market risk within a money market fund. In addition, IMMFA funds are managed to limit exposure to credit and liquidity risks. These funds maintain a triple-A rating, obliging them to only purchase high quality investments. The assets held are short-term, with nothing longer than 397 days permissible. These assets are held to maturity, and the regular maturing of these short-dated assets provides the funds with a continual supply of liquidity. This ‘natural liquidity’ is supplemented by minimum amounts of overnight and one week assets, which can be called upon to meet redemption requests should the need arise.
These MMFs also provide the benefit of diversification. A MMF will purchase a number of assets in order to meet the stringent diversification parameters of the Undertakings for Collective Investments in Transferable Securities (UCITS) Directive and the requirements of the rating agencies. Any risk is spread across the portfolio, limiting the impact that a single asset could have upon the overall portfolio. The combination of market, credit and liquidity risk management, together with the benefits of diversification, provides a product which should consistently deliver security of capital and same-day liquidity.
For banks, investing in a MMF will however give rise to a capital requirement. Under the standardised approach to credit risk, the risk weighting is 20% – the same as when investment is placed in a bank deposit. The consistency in the risk weighting between a MMF and a bank deposit reflects the similarity in their risk profiles. If the investment by the bank is recorded under the trading book, the standardised approach would implement a 32% risk weighting. For both the banking and trading books, the more advanced approaches will result in a materially lower capital requirement, where look-through to the underlying assets results in a more prudent measurement of the risk. It has been estimated that the risk weighting under an internal ratings-based approach to credit risk could be in the region of 6%.1
MMFs regularly publish key data – including the WAM – allowing investors to monitor the relative susceptibility of the fund to movements in interest rates. The data also allows investors to compare and contrast the variety of MMFs available, as well as monitor the volatility of the WAM.
Funds can adopt a variety of strategies to manage the liquidity needs of their investors. These may include either a laddered approach (where the fund has an even spread of asset maturities), or a barbell approach (where large amounts of both short- and long-term assets are held, effectively limiting the amount of medium-term assets held). If a fund using a barbell approach is required to meet large volumes of redemption requests, the short-term assets will most likely be sold to meet those redemptions. This could result in a spike in the WAM of the fund, as the remaining assets will primarily be long-term. A barbell approach may therefore mask the true market risk within the fund. Investors should therefore monitor the WAM of a fund to gain a view on its volatility, as well as the liquidity breakdown to understand the maturity profile of the fund’s assets.
Other disclosures provided by IMMFA MMFs give an indication of credit risk (the weighted average life) and liquidity risk (the percentage held in overnight and one-week securities). This combination of key summary data allows an investor to identify those funds which most closely mirror their risk appetite and objectives.
The horizon over which an investment is being made will influence how much risk the investor is prepared to accept. When that horizon is short, there should be limited risk of capital loss, whether through exposure to market risk or another risk, such as credit or liquidity risk. MMFs provide a risk-mitigating solution for short-term cash management, enabling treasurers to manage their market risk exposure and still obtain competitive money market returns. MMFs are equally suitable for banks as with any other investor. The capital requirements applicable to investment in a MMF are minimal, especially where the bank investor uses one of the advanced approaches to market or credit risk management. Such a low-risk investment and a minimal capital requirement make these funds attractive to banks when seeking an investment solution for short-term cash balances.
1 European Money Market Funds and Basel II, Fitch Ratings (October 2007).
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