By Brett Sherman
A primer on basic risk management
Traders hate risk limits (sometimes called position limits), those pesky rules that restrict aggregate exposure to a single asset class or correlated classes of assets.
The point of risk limits is to make sure that no one trade - or series of related trades - can generate losses big enough to cripple, or even kill, a financial institution.
For instance, if an asset class - like mortgage backed securities suddenly "blows up" (a Talebism), a firm that actually enforces risk limits is may take some losses. However, because the size of its holdings is limited - there is no possibility that the blow up will cause catastrophic losses.
- Traders Hate Risk Limits!
When Wall Street trading desks believe they are onto a winning strategy, they like to build up big positions. Same with mostly unregulated hedge fund traders. Why? Because they are certain they won't lose (many traders, but not all of them, seem to have this kind of baseless overconfidence encoded in their DNA). And, since they can't lose, why not really max out the strategy to milk as much profit as possible?
Indeed, risk limits, when they are enforced, often do end up costing traders some upside. Sometimes rules that limit position size end up causing traders and their firms to leave a lot of profit on the table.
- To Exceed or Not to Exceed? That is the Question...
Most firms have procedures that allow traders to request permission exceed risk limits. From a risk managemet perspective, this is a bad idea.
- A very bad idea.
After all, the consequences of failing to enforce position limits (i.e., placing big bets) are always unknown at the time the trade is made. And the moment that the trade is made is also the moment the firm takes on the risk of holding oversized postions. In other words, nobody knows (and nobody can know) precisely when it might be disastrous to have excessive exposure to a particular assets or class of related assets.
- Moral of the story
Firms must strictly enforce risk limits. These limits exist because they keep firms alive. And being alive is always better than the alternative. Just ask the former public shareholders of Lehman Brothers and Bear Stearns (remember them?).