The management of market risk is very difficult because the value of financial instruments traded in the markets changes very rapidly. It is possible for stocks or bonds to go from their full value to zero in just a couple of days. These instances have happened during various market crises such as the dot-com bubble, the Enron crisis, etc. Now, since the prices move so rapidly, decisions regarding whether to hold the positions or to sell them out also have to be taken rapidly.
Hence, companies do not have the time to deliberate whether or not to hold on to a position when the market is working and the trading is actually happening. As a result, in order to manage the market risk, they must have a predefined risk philosophy. This risk philosophy must be crystallized in the overall risk policy of the firm in the form of limits. It needs to be understood that market risk limits are different from credit risk limits.
In this article, we will have a closer look at the various types of market risk limits and how they impact the management of market risk in any firm.
- Position Limits: Organizations must decide in advance the maximum position that they are willing to take in the market. Some autonomy must be given to the traders. However, it is prudent to have limits on overall exposure which traders can make. The limit must take into account both gross as well as net positions. These limits must be decided by higher-level management and then must be cascaded to individual-level traders.
The traders must have visibility about how the trades they are making reflect against the overall limits imposed by the firm. Also, the limits must take into account the liquidity of the markets where the instruments are being traded. Markets with lower liquidity should also have a lower limit.
- VaR Limits: The management also has the option to not set absolute limits in dollars. Instead, they can use the value at risk (VaR) model number to set internal limits within the firm. The benefit of using VaR-based limits is that the same limit structure can be used for different trading departments within the organization. Later, the results can be compared to see which department is taking the maximum risk.
The problem with VaR based limits is that it is not intuitive for the traders. Traders are more comfortable talking in terms of traditional measures such as basis risk, spot risk, yield curve, etc. Many traders believe that VaR is an artificial construct and have a difficult time understanding how to interpret the results.
- Basis Risk Limits: Basis risk is the risk of finding an imperfect hedge. For instance, if a firm invests in a foreign currency bond, it can then buy derivatives to remove the impact of foreign currency transactions from the bond. However, there is a hidden assumption here.
The assumption is that changes in the currency will be reflected as changes in the value of the bond. Sometimes, this may not be true. This is called basis risk. Organizations tend to impose limits on basis risks as well. This is because if the basis risk is not completely matched, then there is always a possibility that the company may suffer some serious losses.
- Maturity Gap Limits: Maturity risk is that risk that arises from a change in the interest rate. Every company may have an income as well as expenses related to interest rates. These can change if the interest rate related to one benchmark resets but the other does not.
For instance, if interest receivable is from another country where the interest rates have been lowered whereas interest payable remains unchanged, there could be a financial loss. Organizations must make sure that they monitor the maturity gaps for financial instruments or groups of financial instruments. Also, limits must be imposed to ensure that excessive risk is not taken in this form.
- Option Limits: Options can often lead to excessive risk for the company. This is particularly true when the company is writing the options. For some time it may feel like the company is collecting free money in the form of premiums. However, huge losses can be incurred if the firm is not careful here. Many derivative products are quite complicated. Hence measuring and limiting such risks is also quite difficult.
How are Market Limits Set Up?
It is important to keep the trading team involved while setting the market limits. This is because the risk management team alone might end up setting limits that are overly conservative. The end result of this will be that the trading activity will be negatively impacted and the revenue earned by the firm might drop. The risk management team as well as the trading team need to be on the same page in order to set limits that actually help in reducing market risk without causing any other harm.
The fact of the matter is that in the absence of market risk limits, it will become impossible to control the behavior of large firms. Market risk limits are what helps multinational investment firms manage their trading desks across the world in a systematic and cohesive manner.
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