Risk management
Financial risk-taking is part of the Fund's everyday operations and is necessary to conduct asset management. It should be possible to project risks before an investment is made and subsequently to control them. It is important to avoid risks that do not involve a possibility of returns, for example operational risks. The financial risks are monitored and controlled by an independent Performance and Risk Control unit that reports directly to the CEO and Board.
Each year, the Board of Directors adopts an investment policy, a credit policy and a risk management plan for the Fund's operations. The investment policy describes, for instance, the Fund's management orientation and goals in terms of return and risk. The credit policy stipulates rules and limitations regarding management of credit risk and credit risk exposure. The risk management plan clarifies the allocation of responsibility and authority for the investment operations. The risk management plan also describes the principal operational risks and how these risks shall be controlled and monitored. The principal risks are of a financial and operational nature.
Monotoring and measuring risk on a daily basis
Risk management has evolved and comprises measuring risk on a daily basis and monitoring the Fund's liquid assets. This gives the Fund access to forecasts of the aggregate risks in the Fund's investments, both in absolute numbers and relative to their benchmarks.
Risk forecasts can be broken down by management area, instrument, risk factor, etc. and serve as input data for the Fund's ongoing efforts to optimise its risk-taking. The Fund plans and analyses its strategic risk-taking with the help of stress tests and different scenarios.
Because of the financial instability that has affected parts of the global economy, liquidity and credit risks have risen, particularly among heavily indebted European governments and in the European banking sector. This has meant that counterparty exposure and the credit ratings of counterparties have been monitored to a greater extent.
Financial risks
Financial risks, which mainly include market, credit and liquidity risks, are followed up and controlled in an independent Performance and Risk Control unit, which reports directly to the CEO and Board.
The task of this unit is to ensure that the Fund's operations comply with legislated investment rules, the investment and credit policies and the risk management plan. This includes careful measurement and analysis as well as daily reporting of return and risk, in absolute terms and in relation to benchmarks. The unit is divided into a compliance function and a risk analysis function. The compliance function is responsible for complying to rules with monitoring and control of, for instance, credit risk and liquidity risk. The risk analysis function is responsible for analysis, control and reporting of chiefly market risks.
There is also a legal unit that is responsible for following up on legal aspects relating to risk in agreements and such. This includes follow-up and monitoring of employees' securities transactions.
Operational risks
To manage operational risks, the head of each AP4 unit takes responsibility for identifying, limiting, and controlling their units' operational risks in accordance with the risk management plan. The compliance function is responsible for monitoring the operational risks in the investment operations, and ensuring compliance with regulations relating to these risks. Operational risks are specifically evaluated in connection with the implementation of new products, and system and organisational changes.
In accordance with the risk management plan, and with the purpose of minimising operational risks and ensuring quality internal control, there is a clear allocation of responsibility and authority documented in written instructions. Procedures and routines are regularly reviewed to assess whether the documentation is up to date and to identify weak points in transaction chains or other procedures. What is known as the duality principle is consistently applied.
Financial risks
Market risks
Market risk is the risk of the value of an instrument changing due to variations in share prices, foreign exchange rates or market rates.
The asset management's market risks are defined partly as risk in relation to the benchmark (active risk in the short and medium turn), and partly in absolute terms as a contribution to total actual portfolio risk. The risks are broken down into different investment horizons and analysed with the help of risk contribution based on the investment procedure of each mandate. Stress tests and scenario analyses are also used. Foreign exchange, fixed income, and equity risks in active management are managed by means including limitation of active risk, duration, and permissible deviations from index weights.
Foreign exchange exposure
The Fund hedges all of its holdings of foreign fixed income assets and parts of its foreign shareholdings using foreign exchange derivatives. At year-end, the Fund's foreign currency exposure was 25.7% (19.8). The following table shows the Fund's foreign exchange exposure.
Credit risks
Credit risk consists of the risk of individual counterparties being unable to fulfil their commitments to the Fund. AP4 has established individual counterparty limits to manage credit risks. The limits are continually monitored. Credit risk is also limited by a rule that permits investment only in securities with a rating of BBB or better. The following table summarises the Fund's credit exposure broken down by credit rating.
Liquidity risks
Liquidity risk consists of the risk that a financial instrument cannot be sold or can only be sold at a significantly lower price than the publicly quoted price. The risk is limited by special rules for investment in fixed income assets and by careful monitoring of cash balances. The Fund invests a large proportion of the portfolio in listed equities and government bonds with good liquidity.
Managing derivatives
The Fund uses derivatives in most of its management mandates. Derivatives have several areas of usage and purposes, the most important being:
- Hedging the Fund's foreign investments, for which derivatives are the only alternative.
- Making index management more efficient, where derivatives are used to minimise transaction costs and simplify administration.
- Making active management more efficient, where derivatives are used not only to minimise 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.