Violator of Risk Limit

 

This may not be your corporate policy.  But you should be clear to all whether your risk limits are hard, soft or gigantic. 

A Hard risk limit is one where there just may be a rock and a snake for the violator.  Violations of limits are not expected to happen in a system with hard risk limits.  So maybe no one knows what the consequences are.  In systems with very hard limits, a system of “checkpoints” may develop that are actually soft limits that help managers to avoid coming too close to the hard limits.  These firms may have rules like “violations of limits must be reported to the board at the very next meeting”.  In addition, there may be a hard requirement to reverse or offset the actions that led to the violation within some short period of time, sometimes something like 72 hours. 

A Soft risk limit is very much the opposite.  Violation of a soft risk limit might most often result in raising the limit.  Or violations may simply be allowed to stand without any special notice or attempt to reverse.  A more diciplined soft limit system may track the number of violations and use the count of violations as an indication of potential issues. 

A Gigantic risk limit is very common.  There is no need to decide whether a Gigantic risk limit is hard or soft, because there is little chace that the firm will ever approach the limit.  Gigantic limits are often 200% or more than expected positions.  Commonly, Gigantic limits are are found in formal investment policies of firms or funds.  These are deliberately set so high that they will not get in the way of day to day operations of the investment managers, even if they want to make significant changes to the make-up of the fund.  Unfortunately, many firms have not yet realized that these policy limits are not useful risk limits.  But they do save money on snakes.

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2 Comments on “Violator of Risk Limit”

  1. riskviews Says:

    So that sounds like that vetting process for the annual reset was extremely important. I would imagine that there must have been at least quarterly reviews to see if the limit was being used or abused to take those re-allocation steps.

  2. riskczar Says:

    When I had risk oversight over the institutional trading desk for HSBC Securities in Toronto about ten years ago, limits were reset every year. We didn’t simply carry over last year’s limits, they had to be justified.

    I felt that if you didn’t break the current limit at least 2-3 times per year (or 1% of the trading days), they were too high. Alternatively, if limits are breached more often than that, then this is a flag to investigate the root causes for the too frequent breaches.

    There was only a finite amount of risk limits to distribute to the colonies and if mine were too high, they were allocated to a country that needed greater limits than me.


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