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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.
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.
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.
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.
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.
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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