Basic Principles of Limit Setting

From the book “The Fundamentals of Risk Measurement” by Chris Marrison

• Ideally limits should be risk based, i.e. the measurement of limit utilization should be directly proportional to the amount of risk taken.
• Limits should be fungible at lower levels. The trader should be allowed to take risks to exploit the best opportunities available without being too tightly bound by complex limit system. Similarly a senior trader should be allowed to move limits from one subordinate desk to another.
• The limits should be aligned to the company’s competitive advantages.
• If a portfolio is to be managed within a given set of limits, it should not be possible for changes in another portfolio to cause the limits for the former portfolio to be broken.
• Both hard and soft limits need to be set. If the limit is hard then traders know that they will be disciplined or fired for violating the limit. If the limit is soft a violation simply leads to a conversation when the trader is advised to reduce the position.