Financial Risk Limits can help a Fund Manager/ Dealer/Trader and others who perform similar functions to manage Market, Credit, Asset Liquidity and Operational Risks in a more well planned and controlled manner.
Financial Risk Limits are of different types and can be applied in isolation or in the form of bundled groups.
Financial Risk Limits can be best described in Military Science Terms as Minefields, which prohibits and / or restricts pass through. Such Risk Limits inhibits a Money Manager’s ability to undertake excessive and / or irrational Financial Risks during trading hours.
For e.g. a Multi-Asset Class Fund Manager (dealing in both Debt and Equity Capital Markets) is running the risk of losing lots of money as prices of financial instruments change for the worst on any given trading day!
What kind of risk limit controls should an Investment Risk Manager assign to such a trading desk/s?
The following are a few examples of commonly used Risk Limits in Financial Markets :
- Stop Loss Limits ( to control the downside potential) and develop Risk Tolerance parameters during trading hours)
- Take Profit Limits ( to reduce the risk appetite to hold onto inventory unnecessarily for longer periods of time)
- Correlation Risk Limits (to control co-movement / joint movement risks)
- VaR – Value at Risk Limits ( to develop and control risk severity parameters and set standards for Loss Absorption). Normally Daily VaR Limits are used by fund managers to control the risk of their trading portfolios. A Fund Manager may set his VaR (VALUE AT RISK) Limits AT VaR, BEYOND VaR or Below VaR LEVELS !!!
- Event Risk Limit/s ( these trigger specific management action plan when a specific event takes place in the financial markets)
- Credit Exposure Limits ( to control nominal exposure risk)
- Product / Facility Risk Limits (to control risk on product wise and / or facility wise basis)
- Counter-party Exposure Risk Limits (quite similar to credit exposure limits, however they may also be described as FI Business Risk Limits) => They limit Funded & Non Funded Exposure to a particular counter-party in trading markets)
- Reputational Risk Limits ( these are used to control Operational Risks and other associated risk factors etc. ) They are normally used by FI’s to hedge against the operational possibility of dealing with a counterparty that has high risk profile and a poor business reputation!!
- Shariah Compliance Limits ( Are used by Islamic FI’s to maintain strict Sharia compliance and control Non Compliance Risk at all times) .
- Legal Risk Limits ( Again to control an Operational Risk Event that has purely Legal implications) Most of the Financial Institutions use these limits to cover their legal exposures. Relatively new concept!!!
- Quantitative Risk Metric Limits ( these are used to control “specific” Transactional and / or Financial Risks which may affect financial products in different ways) . For example a Mutual Fund Manager may structure various Quantitative Market Risk Limits such as: Option Delta Limits, Bond- Modified Duration Risk Limits, Govt. Treasury Bills PVBP – (Price Value Basis Points) Limits, Stock Beta & Tracking Error Risk Limits, Basis Risk Limits and may also derive higher order Greek Risk Controls for (Contingent Claims) e.g. Option Derivatives using Vega , Gamma, Theta , Rho, Kappa, Omega metrics and much much more.
- Currency Risk Limits ( to control exposure to any single and / or group of currencies)
- Short Sale Limits (to control Short selling activities)
- Hedging Limits ( reduce transactions costs by applying hedging activity controls)
- Arbitrage Risk Limits( to control Arbitrage seeking behavior of trader s/ fund managers beyond a certain level)
- Inventory Cost Averaging Limits ( to reduce unnecessary buying of assets at different prices to reduce overall average inventory/holding costs ) read Dollar Cost Averaging Methods used by the investors in stock markets.
I hope I have discussed all the basic Risk Limits in this blog!
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