The Required Rate of Return the Gordon ...
Given all the inputs to a dividend discount model (DDM) except the required... Read More
Effective management of risk is highly dependent on designing suitable constraints that can be used in market risk management. Measuring VaR to a confidence level as high as 99% and placing a loose limit can be less of a constraint than measuring it at a low level, such as 90%, but with a tight limit. However, too tight constraints may limit the pursuit of perceived opportunities. This, in turn, will shrink returns and reduce profitability. Too loose constraints, on the other hand, may lead to outsized losses. Consequently, this will threaten the viability of the underlying portfolio.
The following are the risk limits that may be imposed:
Risk budgeting involves the distribution of the risk of a portfolio among various asset classes that constitute a portfolio.
A bank might, for example, define its limit on VaR or the total economic capital and describe it as its risk appetite. The risk appetite may be allocated among the three key risk types, including the market, credit, and operational risks. In addition, risk appetite might be distributed among different business activities, units, and geographies. These limits are set based on the expected long-term profitability and shareholders’ expectations anchored upon the activities the bank is engaged in.
Given an ex-ante tracking error budget, a portfolio manager will aim at optimizing a portfolio’s exposures relative to a benchmark. They will do this to ensure that the strategies generating the most tracking error are the ones expected to generate the greatest reward.
A position limit is a ceiling on the number of derivative contracts any investor, trader, or group of traders may own. Position limits restrict investors from using derivatives to exercise excessive control over the market. They are usually set too high for individual traders and investors to reach. However, their presence prevents market prices from manipulation by traders or investors using derivatives. This, therefore, provides a level of stability in the financial industry.
A scenario limit is a maximum amount that is allowed for loss estimate in a particular scenario. Whenever a scenario limit is exceeded, corrective action must be taken in a portfolio. Scenarios can also be used to address VaR limitations. The limitations include the potential of changes in correlation or unpredicted extreme movements. A scenario analysis should be used hand in hand with related action steps. These action steps involve the development of a tolerance level for all possible scenarios. Higher tolerance is appropriate for potential loss under extreme scenarios. The risk manager should observe whether there is an increase in a portfolio’s sensitivity to the scenario or not.
A stop-loss limit is an indicator of the amount of a specified period’s market loss that a portfolio should not exceed. A limit is violated when a single-period market loss of a portfolio exceeds a stop-loss limit. In such an instance, the trader is required to either reduce the size of the portfolio or liquidate it completely. A significant limitation of stop-loss limits is that it is a retrospective risk measure. In particular, it indicates risk after the consequences of the risk have already been registered.
The stop-loss limit can be applied together with VaR constraints to minimize trending in the use of VaR. Trending occurs when a portfolio stays below its daily VaR limit but exceeds it in the long run. For instance, a portfolio having a ten-day, 5% VaR limit of $1 million, may be liquidated when its cumulative monthly loss is more than $3 million.
Question
Which of the following best describes a stop-loss limit?
- Allowing an ex-ante tracking error of up to 8% in each portfolio.
- Selling a position in a portfolio after suffering a loss of 8% of capital in one month.
- Setting a spot-month limit to 1000 contract units.
Solution
The correct answer is B.
A stop-loss limit is an indicator of the amount of a specified period’s market loss that a portfolio should not exceed. A limit is violated when a single-period market loss of a portfolio exceeds a stop-loss limit. The trader is, in such an instance, required to either reduce the size of the portfolio or liquidate it completely.
A is incorrect. This is an example of a risk budget.
C is incorrect. This is a position limit.
Reading 41: Measuring and Managing Market Risk
LOS 41 (j) Explain constraints used in managing market risks, including risk budgeting, position limits, scenario limits, and stop-loss limits.