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Securitized-Product Investment: Risk Management Perspectives*1

  • *1This is an English translation of the Japanese original released in February 2008.

March 19, 2008
Financial Systems and Bank Examination Department
Bank of Japan

Click on ron0803a.pdf to download the full text.

1. Introduction

The market for securitized products has expanded around the globe. Two factors in particular have supported this expansion: advances in financial engineering have enabled a wide range of products to be synthesized for the purpose of transforming and reselling the risks and returns on portfolios of underlying assets; and investors with various risk preferences have begun to invest and invest more actively according to their individual needs. In Japan, issuances of securitized products are on the rise,1 and are held primarily by financial institutions. Basically, these securitized products are being utilized by investors as an investment choice for effectively controlling the risk and return on an investment portfolio. They also could contribute to improving the efficiency of financial markets by providing economic entities requiring funds with a new means for fund-raising.

Because securitized products, as described above, transform the risks and returns on a portfolio of underlying assets and resell all or parts of them to investors, the products generally have a risk/return structure that is different from the portfolio of underlying assets on which they are based, and have a relatively complex product feature.

In addition, because most securitized products tend to be quite distinctive and their trading volumes on secondary markets are usually limited,2 it is not necessarily easy to measure their trading prices.

Therefore, given the nature of securitized products and their current trading circumstances, investors must accurately recognize the risks associated with securitized-product investments and will be required to have a considerable amount of expertise and ingenuity in order to appropriately identify and manage those risks.

Against this backdrop, the current instability in the markets triggered by the U.S. subprime mortgage problem reaffirms the importance of investors accurately recognizing and appropriately managing the various risks inherent in investments and financial products with complex risk profiles, particularly securitized products.

It is from this perspective that this paper presents an overview of the basic points to be considered when attempting to identify and manage the risks inherent in securitized-product investments and, as an aid to understanding, provides an introduction to several basic measures considered useful at this time.3 This paper is based on studies of the theory and practice of risk management for securitized products and on dialogues between the Bank of Japan's Financial Systems and Bank Examination Department and financial institutions and other market participants. Given the extremely wide variety of securitized products available, it is important that investors develop and improve their own risk management measures to suit the risk profiles of the products in which they invest.

It should go without saying that there are no definitive measures for identifying and managing risks, either for securitized products or for any other financial product. Indeed, at the current point in time, measures for identifying and managing risk are still under development in some areas. In addition, when investing in new forms of securitized products, there is the potential for exposure to new risks not found in conventional securitized products. For this reason, individual investors need to carefully monitor the conditions and developments in markets for securitized products, and must continually strive to devise ways to appropriately identify and manage securitized-product investment risks.

  1. Total issuance of securitized products in Japan has increased steadily from 5.3 trillion yen in FY 2004 to 8.2 trillion yen in FY 2005 and to 9.8 trillion yen in FY 2006 (figures through FY 2005 are from the Bank of Japan; figure for FY 2006 is from a study conducted by the Japan Securities Dealers Association).
  2. In some cases, there are securitized products that are actively traded on the market.
  3. There are many different types of securitized products and many different ways to categorize their risk monitoring and management methodologies. The purpose of this paper is not to provide an exhaustive overview.

Notice

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Risk Assessment Section, Financial Systems and Bank Examination Department, Bank of Japan
E-mail: post.fsbe65ra@boj.or.jp