Note 20

Risks

Refer to the heading Risk Management on pages 30-31 for a more detailed description.

Business risks

Below is a description of AP4’s principal risks, which consist of financial and operational risks.

Operational risks

Operational risks are the "risk of loss resulting from inadequate or failed processes, people and systems or from external events". The definition includes legal risks. Examples of operational risks can be conscious or unconscious mismanagement, which may be caused by substandard
procedures or instructions, inadequate systems, insufficient control and audit, as well as by criminal actions or external events.

Operational risks within AP4 should be managed through an established, and common to all funds, process and methodology. There should be key controls for all significant risks, which as far as possible reduce the likelihood of risks materializing, or that mitigate the consequences when adverse events do occur. In the valuation of risks, existing key controls should be verified to ensure they have the desired functionality and effectiveness.

As part of risk management, regarding operational risks, it is especially important to evaluate change processes and effects on the business.
Operational risks are specifically evaluated in connection with the implementation of new products, systems and organizational changes.

To minimize operational risks, a clear division of responsibilities and authorities should be documented in writing. Existing processes and procedures should ensure sound internal control and should be documented by way of relevant instructions.

All AP4 units and / or groups that are responsible for daily operations should meet the requirements for sound internal control and should allocate sufficient resources to this aim. This takes into account, among others, verification of compliance of all rules that apply to AP4; including the responsibility of each individual within AP4's organization to fulfil their duties in line with the objectives and operational plans, including within the framework of external and internal constraints.

The Performance & Risk Control (ARK) unit is responsible for risk
management in order to support and coordinate operational risk
management throughout the fund. This means that at a minimum the ARK unit monitors that common methods of risk management, with respect to operational risks, have been complied with for all mapped processes within the fund. The corresponding applies to identified material change processes such as for the implementation of new products, systems and organizational changes

AP4's Legal Counsel unit is responsible for legal risk aspects of contracts and similar.

Financial risks

The financial risks, which are primarily comprised of market, credit and liquidity risk, are monitored and controlled by an independent Performance and Risk Control department that reports directly to the CEO and Board. Management’s goal is to only take positions that are expected to generate good returns within established risk mandates. Therefore, the main risks the Fund is exposed to consist of transparent financial risks that are predominantly market risks with good opportunities for risk premiums to be forecasted.

Market risks

Market risk is the risk that the value of an instrument is adversely affected due to fluctuations in share prices, currency rates or interest rates. Since AP4’s holdings consists predominately of listed instruments with daily pricing on liquid markets, opportunities are good to regularly
measure and report on market risk through both forecasted and
realized risk amounts. The Fund aims to maintain a high proportion of listed equities and fixed income instruments.

Share price risk

Share price risk refers to the expected variation in the market value of shares. Share price risk is managed through diversification across
regions, countries and sectors.

Interest rate risk

Only fixed-income assets are included in the measurement of interest rate risk relating to expected variation in the market value of the Fund’s fixed income assets caused by nominal interest rate movements in bond markets. AP4 manages interest rate risk by diversifying across different regions and yield curves, as well as by limiting the deviation in duration between the Tactical and Strategic management.

Currency risk

Currency risk refers to the expected variations in exchange rates on assets denominated in foreign currencies. Currency risk arises in connection with investments denominated in foreign currencies. The law on Public Pension Funds limits the total currency risk exposure of the Fund to a maximum of 40 percentage points. AP4’s investment policy determines final currency risk exposure for each major currency in the normal portfolio.

Risk in investment assets

One method to calculate financial risk is the Value at Risk (VaR) metric. Value at Risk is defined as the maximum loss that can occur with a given probability and a given time horizon. The table below applies an analytical factor model for a time horizon of 10 days and a confidence level of 95 %.

Management horizon VaR, ex-ante, holding-period, 10 days Contribution volatility % 12 month portfolio VaR, ex-antem holdingperiod, 1 day ²
2016-12-31      
Equities  7 225  8,00  2 152
Fixed income  -151  -0,17  -66
Currency  -22  -0,02  71
Total Normal portfolio  7 053  7,81  2 157
Strategic Management¹  486  0,54  -80
Tactical Management  154  0,17  -6
Total investment assets  7 685  8,51  2 071
       
2015-12-31      
Equities 6 568 7,83 2 119
Fixed income -100 -0,12 -31
Currency 4 0,00 319
Total Normal portfolio 6 471 7,71 2 407
Strategic Management¹ 572 0,68 -66
Tactical Management 71 0,08 -10
Total investment assets 7 116 8,48 2 330

The risk measure Value at Risk (VaR) is used for the calculation of financial risks. Value at Risk is defined as the maximum loss that can occur with a given probability over a given period. The table above uses a 10-day period and 95 percent confidence level, unless otherwise mentioned.

Foreign Exchange exposure

AP4 hedges all holdings of foreign fixed income assets and part of its foreign equity shareholdings using currency derivatives. AP4's currency risk exposure at year-end was 26.9 (27.0) percent. The table below shows the Fund's currency exposure.

2016-12-31 USD EUR GBP JPY Other Total
Shares and participations  85 809  18 042  8 076  10 330  10 717  132 974
Bonds and other fixed income securities  44 680  16 287  9 978  0  0  70 945
Derivate instruments, excl. Currency derivatives  -825  -3 700  0  0  0  -4 525
Other receivables and liabilities, net  1 180  481  421  90  393  2 566
Currency derivatives  -74 523  -20 652  -8 586  - 3 338  -5 007  -112 106
Foreign Exchange exposure, net  56 321  10 458  9 889  7 082  6 104  89 854
             
2015-12-31 USD     EUR      GBP  JPY   Other Total
Shares and participations 72 237 19 600 8 504 9 474 9 223 119 038
Bonds and other fixed income securities 41 870 15 376 11 305 0 0 68 551
Derivate instruments, excl. Currency derivatives -845 -272 0 0 0 -1 117
Other receivables and liabilities, net 959 917 422 183 559 3 040
Currency derivatives -60 832 -20 140 -11 168 -3 574 -9 949 -105 664
Foreign Exchange exposure, net 53 389  15 481  9 063  6 083  -168  83 849 

Credit risks

Credit risk refers to the risk that an issuer or counterparty cannot fulfill its payment obligations. Credit exposure refers to the value that is exposed to credit risk through agreements with counterparties or issuers, that is, credit exposures include both issuer and counterparty exposure. The total credit risk is limited by the selection of the interest rate index in the Normal portfolio and limits per rating category.

Credit risk per pool of issuers or issuer are restricted by limits which include both issuer and counterparty risk.

The CEO approves all counterparties with which the Fund can do business (in both standard and non-standard instruments). Further, when trading in OTC derivatives ISDA and CSA must be included with all larger counterparties.

2016-12-31   Non-standard derivatives Non-standard derivatives  
Rating category Bond, exposure² Fair value² Collateral/security Residual risk
AAA¹  81 707      
AA  16 513  -110  307  196
A  6 096  -1 387  1 576  189
BBB  2 934  -107  110  4
Lacks rating³  747      
Total credit risk exposure  107 997  -1 604  1 993  389
         
2015-12-31   Non-standard derivatives Non-standard derivatives  
Rating category Bond, exposure² Fair value² Collateral/security Residual risk
AAA 50 199 4    
AA 40 054 318 -375 -56
A 5 143 739 -863 -124
BBB 8 260 175 -186 -11
Lacks rating³ 3 773      
Total credit risk exposure 107 428 1 236 -1 424 -192

Liquidity risk includes both liquidity risks relating to cash flow and liquidity risks in financial instruments.

Liquidity risk in a financial instrument consists of the risk that the instrument cannot be sold or can only be sold at a significantly lower price than the publicly quoted price.

A large proportion of AP4’s securities are lendable at short notice. Any losses on currency futures and stock index futures may, however, be of significant amounts and daily estimates of liquidity in SEK and currencies must be calculated.

The Fund’s liquidity risk of financial instruments is limited by the Fund’s investment universe and the choice of reference indices for fixed income securities and listed equities. Illiquid financial instruments primarily arise in the form of assets in unlisted companies and real estate. OTC derivatives and credit instruments may from time to time also become illiquid and/or show significant differences between the bid and ask prices.

Liquidity risk can also be high if large net payments are needed given the Fund has a payment obligation to the Swedish Pensions Authority. It is then necessary to keep a large proportion of liquid assets. The Fund currently makes monthly payments to the Pensions Authority, which are relatively small in relation to existing capital.

Further, the Law on National Pension Funds limits liquidity risk given at least 30 percent of the Fund’s total market value must be invested in debt instruments with low credit and liquidity risk.

The Board’s rules limit liquidity risks through specific guidelines for
investments in interest-bearing assets and through careful monitoring of cash balances. AP4 invests a large proportion of the portfolio in listed shares and government bonds with good liquidity. Overall liquidity risk in AP4 is considered to be low.

The table below presents a summary of the Fund’s liquidity risk according to maturity. Bonds and interest-bearing instruments are recognized at fair value, including accrued interest.

Maturity profile

2016-12-31            
Term < 1 yr. 1 < 3 yr. 3 < 5 yr. 5 < 10 yr. > 10 yr. Total
Nominal government  1 415  7 113  16 555  19 074  10 643  54 800
Nominal corporate  2 753  22 421  17 851  8 068  2 103  53 196
Total  4 168  29 534  34 406  27 142  12 746  107 997
             
2015-12-31            
Term < 1 yr. 1 < 3 yr. 3 < 5 yr. 5 < 10 yr. > 10 yr. Total
Nominal government 634 3 434 12 537 26 852 9 847 53 304
Nominal corporate 4 042 11 703 28 256 8 066 2 058 54 124
Total 4 676 15 137 40 793 34 918 11 904 107 428

 

All liabilities have a maturity of less than one year except for a few currency options and credit derivatives (so-called credit default swaps), see Note 11.
The aggregate market value of these contracts is limited and they have therefore been omitted from the above table.

Managing derivatives

The Fund uses derivatives in most management mandates. Derivatives have several different uses and purposes where the most important are the following:

  • Hedging the Fund's foreign investments, for which derivatives are the only alternative.
  • Making index management more efficient, where derivatives are used to minimize transaction costs and simplify administration.
  • Making active management more efficient, where derivatives are used not only to minimize transaction costs and simplify administration but also to enable positions to be taken that cannot be generated using other instruments (short positions, volatility positions, and more).
  • Regulating the Strategic portfolio’s risk with the help of strategic derivative positions.

The use of derivatives is limited in terms of the nominal underlying values as well as market risk. All derivative positions and associated risks are subject to daily position and risk monitoring.

The CEO approves all counterparties with which AP4 may do business regarding both standard and non-standard instruments.

Furthermore, when trading in OTC derivatives, International Swaps and Derivatives Association Credit Support Annex (ISDA), and Credit Support Annex (CSA) must be included with all large counterparties. ISDA agreement relates to a standard agreement to regulate trading of derivatives between two counterparties. CSA agreements relate to an annex to an ISDA agreement.

CSA agreements regulate how collateral is posted as outstanding liabilities in the form of cash or securities.