The difference between risk decisions, risk behaviours and risk preferences
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In a context where risk taking is authorized, risk limits are bounds placed on that risk taking.
Suppose a pension fund hires an outside investment manager to invest some of its assets in intermediate corporate bonds. The fund wants the manager to take risk on its behalf, but it has a specific form of risk in mind. It doesn’t want the manager investing in equities, precious metals, or cocoa futures. It communicates its intentions with contractually binding investment guidelines. These specify acceptable investments. They also place bounds on risk taking, such as requirements that:
the portfolio’s duration always be less than 7 years;
all bonds have a credit rating of BBB or better.
The first is an example of a market risk limit; the second of a credit risk limit.
A risk limit has three components:
a risk metric,
a risk measure that supports the risk metric, and
a bound—a value for the risk metric that is not to be breached.
At any point in time, a limit’s utilization is the actual amount of risk being taken, as quantified by the risk measure. Any instance where utilization breaches the risk limit is called a limit violation.
A bank’s corporate lending department is authorized to lend to a specific counterparty subject to a credit exposure limit of GBP 10MM. For this purpose, the bank measures credit exposure as the sum amount of outstanding loans and loan commitments to the counterparty. The lending department lends the counterparty GBP 8MM, causing its utilization of the limit to be GBP 8MM. Since the limit is GBP 10MM, the lending department has remaining authority to lend up to GBP 2MM to the counterparty.
A metals trading firm authorizes a trader to take gold price risk subject to a 2000 troy ounce delta limit. Using a specified measure of delta, his portfolio’s delta is calculated at 4:30 PM each trading day. Utilization is calculated as the absolute value of the portfolio’s delta.
1.5.1 Market Risk Limits
For monitoring market risk, many organizations segment portfolios in some manner. They may do so by trader and trading desk. Commodities trading firms may do so by delivery point and geographic region. A hierarchy of market risk limits is typically specified to parallel such segmentation, with each segment of the portfolio having its own limits. Limits generally increase in size as you move up the hierarchy—from traders to desks to the overall portfolio, or from individual delivery points to geographic regions to the overall portfolio.
Exhibit 1.1 illustrates how a hierarchy of market risk limits might be implemented for a trading unit. A risk metric is selected, and risk limits are specified based upon this. Each limit is depicted with a cylinder. The height of the cylinder corresponds to the size of the limit. The trading unit has three trading desks, each with its own limit. There are also limits for individual traders, but only those for trading desk A are shown. The extent to which each cylinder is shaded green corresponds to the utilization of that limit. Trader A3 is utilizing almost all his limit. Trader A4 is utilizing little of hers.
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- Technical risks are those events or issues associated with the scope definition, research and development (R&D), design, construction, and operation that could affect the actual level of performance vs. that specified in the project mission need and performance requirements documents. Examples of technical risks include new and changing technology and changing regulatory requirements.
- Schedule risk is the risk associated with the adequacy of the time allotted for the planning, R&D, facility design, construction, and startup operations.