Zyania Pillmon is a portfolio manager at Public Investment Authority (PIA), a sovereign wealth fund. Pillmon is meeting with risk analyst Mansour Mevi to discuss new investment opportunities. Mevi has recently joined the risk team at PIA and previously worked for an insurance company.
Pillmon and Mevi start the meeting by reviewing portfolio performance metrics. Mevi notices that the Direct Infrastructure asset class generated high returns on a risk-adjusted basis. Pillmon explains that attractive returns for this asset class are partially an effect of the smoothed nature of returns, which might result in overallocation to Direct Infrastructure while performing single-period mean–variance optimization.
Pillmon tells Mevi that last year, PIA decided to develop direct investing capability by assembling an in-house team specializing in infrastructure projects. The team is gaining experience with each new project, but the fund occasionally sources deals from external managers. Pillmon and Mevi are reviewing three prospective toll-road projects proposed by the infrastructure team. All three projects are located in Country NNN, where PIA has already executed four infrastructure projects over the last year. The revenues on all three potential projects would come from toll charges paid in local currency. NNN is currently experiencing a robust growth period. In the past, the Central Bank of NNN fought inflation very aggressively by hiking interest rates preemptively, pushing the country into recession a few times. The information about prospective projects is presented in Exhibit 1.
Exhibit 1.
Infrastructure Investment Opportunities
InvestmentFunding StructureInvestment TypePIA’s RoleProject AEquity: 70mIndirectLimited PartnerProject BEquity/Debt: 70m/20mDirectGeneral PartnerProject CEquity/Debt: 70m/50mDirectGeneral Partner
After analysing prospective investments, Mevi focuses on the fund’s risk measurement methods. Mevi notices that PIA’s risk management system calculates only short-term risk metrics, such as value at risk (VAR) and conditional value at risk (cVAR), but does not allow modeling future payouts or incorporating different rebalancing methods. Pillmon suggests that Mevi use Monte Carlo simulation, which could address some of the shortcomings of PIA’s risk management system. Mevi asks Pillmon the following:
“How does Monte Carlo simulation compare with PIA’s risk management system?”
Question
What type of risk is unique to Project B compared with Project A?
- Liability risk
- Liquidity risk
- Currency risk
Solution
Solution
A is correct. Project B has considerably higher liability risk compared with Project A. Project B is a direct investment, where PIA acts as a General Partner and would bear additional liability risk, whereas for Project A, PIA would act as a limited partner and therefore would not bear liability risk.
B is incorrect because Project A and Project B bear different liquidity risk levels, though Project A poses higher liquidity risk because of an investor acting as a limited partner.
C is incorrect because currency risk is present in all three projects because the revenues would be denominated in the local currency.
