Risk Management Mistakes to Avoid Chapter XXIV

Risk Limits It is important that every company define in a clear and unambiguous way limits to the financial risks can be taken. Procedures should then be set up to ensure limits are adhered to. Ideally, overall risk limits are set at the board level.

Risk Limits It is important that companies monitor risk carefully when derivatives are used. Without close monitoring, it is impossible to know if a derivative trader has switched from being an arbitrageur or a hedger to being a speculator.

Difficult Situation It could be a tricky situation when an individual exceeds risk limits and makes a profit. It is tempting to ignore violations of risk limits when profit results; which in turn leads to a culture where risks are not taken seriously. The penalties for exceeding risk limits should be equal either when profit or loss results.

Do Not Assume You Can Outguess the Market Some traders may be better than others. But no one persists all the time. It shows that luck is obvious compared to skill. Thus, there is no reason to increase an individual’s risk limits as a result of previous good performance.

Do Not Underestimate the Benefits of Diversification Suppose there are 20 stocks, each of which has an expected return of 10% per annum and a standard deviation of return of 30%. The correlation between the returns from any of two of the stocks is 0.2.