Setting Clear Risk Mandates and Limits for Trading Desks
Summary
The document addresses how risk managers can respond when portfolio managers argue that tighter limits kept them from benefiting from rallies or rebounds. Its central recommendation is to agree with senior management on a clear mandate for each trader, including the risk measures and limits that will govern the desk. Once those are set, risk discussions can focus on whether a limit has been breached rather than on hindsight about market moves.
It contrasts VaR with other controls, including loss limits, net or gross exposure limits, and portfolio models that account for correlations. It also gives examples of desk-specific constraints, such as delta limits for options and limits on foreign exchange, rates, or dividend exposure. These are practical suggestions rather than empirical comparisons: the document does not establish which measure is best for every strategy or market. It emphasizes that risk controls depend on management agreement and consistent implementation, and argues that risk oversight cannot work effectively without senior support.
Key ideas
- Risk limits should be agreed with senior management and stated clearly for each trader.
- VaR alone may not capture the risks a desk needs to control.
- Loss, net exposure, gross exposure, and portfolio risk limits address different exposures.
- Desk mandates can specify constraints such as delta, foreign exchange, rates, or dividend risk.
- Consistent limits make risk discussions about mandate compliance rather than hindsight.
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Full text
# Risk and Reward in practice # Risk and Reward in practice My question is a bit philosophical. As a risk manager I often have to tell portfolio managers to reduce risk (e.g. due to VaR limits or exposure limits). Then usually the discussion arises that if they had had more exposure to risky assets they would have participated more in the rally or in the rebound after the crash. What I tell them is things like: If we knew when the crash ends and the rebound starts - if it starts at all - then we were rich and would not work here anymore. Furthermore a naive application of CAPM where more systematic risk leads to higher expected return is not true in all markets at all times (as e.g. Min VAR shows at least in a risk adjusted way). What do you tell risk takers in order to tame their risk appetite? Where do you reference to in order to underpin your opinion? A reference could be such as: In a recent paper Boudt et al. give clear indications to minimize risk in a bear market and diversify risk in normal/bull markets of risky assets. ## Answer by Matt Wolf (score 6, accepted) https://quant.stackexchange.com/a/9429 I am a risk taker and I can say with confidence that you will never convince those individuals, you cited in your question, that they incur too much risk, because there will always be certain traders who prefer lottery tickets over longevity with the same firm (running high risk books unfortunately in the current environment runs equal to a free option; blow up and one gets dismissed but almost instantaneously welcomed at another trading house). My advice is to simply make sure you have a clear mandate, numerically speaking. Sit down with upper management and agree on the risk limits for each trader and also agree which metric is to be used to assess such risk. VaR is a very flawed way to assess risk. A much better approach is to have strict loss limits and net exposure limits. Discuss with upper management what exact risks they want to be protected against. Some options trading houses, for example have strict delta exposure limits. Some equity desks mandate their traders to take no fx exposure or rates exposure nor dividend risk. Discuss whether Some equity desks have gross aggregate exposure limits, so even someone is 10bucks short stockA and long 10bucks of stockB that would amount to 20bucks gross exposure. Others run portfolio risk models, meaning they take correlation between assets into consideration. In any case make sure the mandate is crystal clear and the methodology, used, as well. Then you can go to the PM or trader and do not need to argue. Everyone is on the same page and a risk limit is breached or not, simple as that. Running a tight ship, risk management wise, is one of the most important things to run a stable business. If you do not get the support cited above then I would, as risk manager, consider changing job. If upper management does not care about risk and whether limits are violated or not then that is a big fat red flag in my book.
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