ALFI UCITS IV implementation project – KID Q&A Document

Keeping the strike constant whilst taking a time-decreasing maturity along the five years needed to complete thedata for an SRRI calculation would produce meaningless, artificially material results (due to time-value of theoption plus "moneyness" effects)Alternatively, repricing could be done assuming constant maturity. The question of the dynamic strike adjustment is leftto the discretion of the investment companies or management companies, since a range of possibilities exist.Q. How can a practitioner ensure that the SRRI captures the leverage of long/short funds (e.g., 130/30) in theevent that the computation is made on the basis of a representative portfolio model, target asset mix orbenchmark?A. The computation may be based on the price of every security in the portfolio for each interval in the required timeseries. It may equally well be based on the net exposure of the relevant benchmark multiplied by the relevant leverageratio. It is important that the computation captures the leverage and does not simply present the net exposure.Q. CESR/10-673, Box 5, Para 3 says, "the volatility … shall be deemed to be consistent with the risk limit of theUCITS if this is itself a risk target for the fund." What does this comparison mean?A. It means that if a fund is managed with respect to a volatility target then the target may be considered to be a risklimit for the fund.We think that the explanatory text on page 11 of CESR/10-673 provides an insight to CESR's thinking. It speaks about"a predetermined risk limit (generally expressed in terms of volatility or VaR measures)." This indicates that risk limitsmay be expressed in other terms. In summary:(1) If the risk limit is expressed as volatility, use it in the calculation.(2) If the risk limit is expressed as a VaR, derive the volatility according to CESR's advice and use it in thecalculation.(3) If the risk limit is specified neither as volatility nor as VaR, estimate the volatility using an appropriatetechnique.Q. Can you give an insight into what might be an appropriate technique to estimate volatility in the event thatthe fund's risk limit is specified neither as volatility nor as VaR?A. There is no definitive technique, no unified model with which to do this but we would approach it in the followingway:(1) Given reasonable hypotheses, estimate the distribution of returns that adequately specify the expected riskof the fund.(2) Use statistical and probabilistic tools to estimate the fund's volatility. This is an heuristic exercise, whichrequires specialised investment modelling skills and which is dependent on the specific design of the fund andthe risk analyst's judgement, just as CESR's technique for deriving volatility from VaR (page 11, CESR/10-673)does.Q. If an absolute return fund or a total return fund calculates its SRRI with respect to a volatility or VaR limit,does that limit become a binding limit which should be treated as a formal investment restriction, the breachof which must be reported to the regulator and which may require rectification and shareholdercompensation?A. Risk limits may be required by regulation and should be used consistently with the relevant regulation but that doesnot make them an investment restriction in the sense of one imposed by Chapter VII of the UCITS Directive or in thesense of a restriction adopted in the fund's prospectus. Management companies are required to construct models andin doing so they must make choices as to the design of the model and the data that are processed through it but we donot think that those choices and associated internal limits – even though they may be back-tested – should be treatedas investment restrictions. However, we note that CSSF Circular 11/512, Part III.2 and CSSF Regulation 10-04, Art45(2)(f) says, "management companies shall put in place appropriate procedures so as to take rapid remedial action,in the best interests of unit-holders, in case of breaches of the limits."Q. If we can only know what a structured fund's payoff will be when the NAV is first struck, how can weestimate the SRRI in the weeks or months preceding the launch?A. We think that the practitioner should simulate the SRRI for various plausible scenarios and, comparing the results,select the SRRI that best represents the fund's risk.ALFI KID Q&A, Issue 1314, 11 April25 September 2012 Page 44