Financial Risk Management – Assessing the Asset allocation Approach
Firm investment involves the allocation of resources to generate an expected return. Some firms are able to survive and prosper even with the loss of specific assets, whereas others cannot endure the same. Theory suggests that over-all asset allocation results in under-performance. Conversely, some financial managers believe that firm investments are primarily designed to generate positive long-term returns. As such, they strive to minimize the occurrence of misvaluation-induced losses.
Over-all allocation is a function of costs and the expectation of future returns. However, there are different ways of achieving this objective. One approach is through the use of an effective framework, which is able to make precise assumptions and estimate historical performance. Another approach is to perform a random sampling over time, which allows for the capture of the effects of misvaluation on risk-return curves. Yet another approach is to adopt techniques that allow only the identification of the value of firm investments based on current and past misvaluations, irrespective of the nature of the underlying securities.
Asset allocation strategy is often adopted by firms to achieve cost-to-income (CUV) ratio objectives. The goal of this strategy is to allocate assets to offset losses and to maintain a constant level of income over time. In order to achieve a good level of CUV, firms must reduce the probability of unexpected losses, which are typically the result of mispricing of assets or a lack of diversification. In addition, it is important that the distribution of assets is not simply made on the basis of current tangible assets or on the basis of future expected returns.
When a firm makes the decision to implement an effective asset allocation policy, it must first identify the inputs that will be used to measure the results of its policy. These include the present value of expected cash flows, the historical volatility of prices, the expected frequency of dividends, and the correlation between stocks and bonds. Other important factors that need to be considered are the price of equity and profit margins. The evaluation of the possible modification of investment strategies should be conducted on a quarterly basis to ensure that there has been no substantial changes in the balance sheet since the last measurement.
Once the selection of the factors for the measurement of the firm’s asset allocation policy is made, the measures and formulas for implementation should be established. The evaluation of the selected methods needs to be based on realistic assumptions about the behavior of the underlying assets. The methods need to be tested for sensitivity to changes in interest rates and other factors. Once these are established, they can be gradually refined to create a more accurate depiction of potential risk.
Financial reporting requirements for asset allocation may vary from one jurisdiction to another. It is very important that allocating decisions are subject to review and analysis by individuals in the relevant fields. It is also important that decisions based on asset allocation are made in accordance with applicable laws and regulations. Finally, it is important that the appropriate accounting procedures are followed. All of these considerations are necessary in the determination of an effective and efficient asset allocation policy.
