A Risk- and Complexity-Rating Framework for Investment Products

Benedict S.K. Koh, Francis Koh, David Lee Kuo Chuen, Lim Kian Guan, David Ng and Phoon Kok Fai

Financial Analysts Journal, 2015, vol. 71, issue 6, 10-28

Abstract: Many investors who bought such investments as Lehman Brothers’ minibonds did not understand the products’ complicated features. This fact suggests that if the inherent risk and complexity of products’ structure are not clearly understood by investors, they will be unable to make informed decisions. Some practitioners have recently attempted to calibrate product complexity. The authors propose a framework for classifying investment product risk and complexity separately with a list of factors that contribute to these attributes. They demonstrate the framework’s simplicity and usefulness in helping investors make informed decisions, showing that it can be used to calibrate a variety of investment products.Investors often do not have a clear understanding of the complicated features embedded in complex investment products. In the aftermath of the 2008 global financial crisis, regulators have increasingly looked for various ways to provide such information, motivated by the need to enhance consumer protection. Although risk indicators are well developed and widely adopted, the financial industry as a whole does not have a common methodology to calibrate the complexity of investment products. In this article, we propose a simple, integrated framework to classify both the risk and the complexity of investment products. Risk is decomposed into six main factors: volatility, liquidity, credit rating, duration, leverage, and the degree of diversification. Product complexity is measured by five basic factors: the number of structural layers, the expansiveness of derivatives used, the availability and use of known valuation models, the number of scenarios determining return outcomes, and the transparency/ease of understanding. We simulated and stress tested the proposed framework with a range of weights for the chosen factors and found it to be technically robust. The framework can be used by industry players to enhance product transparency as well as to offer their clients suitable products, appropriately classified by risk and complexity.Editor’s note: This article was reviewed and accepted by Executive Editor Robert Litterman.

Date: 2015
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DOI: 10.2469/faj.v71.n6.2

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