Capital Loss & Stop loss limits

Stop loss limits act as a safety valve in case something starts to go wrong. Stop loss limits state that specified action must take place if the loss exceeds a threshold amount. Tight stop loss limits reduce the maximum possible loss and therefore reduce the capital required for the business. However, if the limits are too tight they reduce the trader’s ability to make a profit.

The first step in setting stop loss limits is to determine the appetite of the company regarding its risk tolerance. This translates to specifying the amount of capital that the company can afford to lose.

The following elements would need to be considered when determining the capital loss amount.

  • The expected rate of return that will be earned on the capital will the next twelve month period.
  • The rate of return that will be required to satisfy shareholders.

Here what we covered on Saturday at the Treasury Risk crash course at the Karachi Marriot (thank you Agnes for the notes). The one day Treasury Risk workshop in Dubai is now locked in on the 18th of March 2010 at the Dusit Thani in Dubai. You can download the nomination form here for the workshop.

First, to view trends from a much broader perspective, in general the practical as opposed to the quant/ data way to view distributions (effectiveness, behaviour, relationships). This is be one with the generator function (Nassim Taleb and Fooled by Randomness) or what we call the Nirvana effect.

Second, what is really happening when model price match market prices, especially in illiquid markets such as the one year FX swap space here in Karachi, Pakistan.

Third the difference between economic capital, regulatory capital and loss capital.

Fourth, linking Value at Risk limits to Stop loss limits and linking stop loss limits to book size and risk appetite.

Fourth, the second definition of Convexity, the fact that asset prices tend to rise by more and fall by less when interest rates change and the criteria for asset liability management and hence asset selection based on convexity (convexity of assets > convexity of liabilities).

Fifth, the allocation of portfolio assets by ALM criteria (duration and convexity)

Sixth, normally distributed actual returns are a reflection that a risk manager has not added value (similar to a coin toss) and that skewness is something to be viewed favorably, provided that it is skewed in the direction that meets existing risk return philosophy.