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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.

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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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  • $\begingroup$ Thanks for your answer. I think I get the feeling that you want to transport: clear and supported limits that fit to the mandate. In fact we look at net/gross exposures (just as you described) and risk measures (VaR/ES taking into account all correlations) and stress tests (historial and discretionary). Loss limits are arguable in portfolio management because of the question of re-entry (when if at all and if you do not re-entry then what else do you do ;) $\endgroup$
    – Richi Wa
    Commented Nov 12, 2013 at 10:38
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    $\begingroup$ That last sentence scares me (and is probably the reason I have never entrusted a single dollar to buy-side funds in my life) ;-) $\endgroup$
    – Matt Wolf
    Commented Nov 12, 2013 at 10:55
  • $\begingroup$ Don't be scared ... this is rather my personal view. If you stop a strategy after you have lost a certain amount, then when do you re-entry? I don't mean an entry signal. Just starting the strategy again in the beginning of the the new period is mostly ad-hoc .. although that's what people do. The numbers look nice .. you never lost more than $x \%$ per period. But is there anything besides this fact optimal in this procedure? What I mean is that in portfolio mgmt an easy thing such as a loss limit is quite subtle. You could underperform the peers. In trading this is different I guess. $\endgroup$
    – Richi Wa
    Commented Nov 12, 2013 at 12:39
  • $\begingroup$ I would again disagree in that loss limits are subtle. Loss limits are there for a reason. After all, you are (your firm is) risking clients' funds, sometimes the funds of the fund owners. The only people or whole industry group that does not seem to understand the meaning of fiduciary duty is the buy-side mutual fund industry. For most of them it seems to be ok to beat the benchmark index but still lose 30 or 40 percent. This concept will never get into my head. A great long-only fund PM is supposed to be all in cash when the global economy starts to falter. $\endgroup$
    – Matt Wolf
    Commented Nov 12, 2013 at 14:48
  • $\begingroup$ I am not totally sure whether we disagree. I also don't like the concept of relative performance for a market fund. I was reather thinking of alpha or smart beta strategies. But also in your case of a market fund: it might take some time until you sell your stock and hold cash - so you have incurred losses. Then in the rebound your investors want to participate - but you are in cash. As long as we can not see the future we are in this dilemma. $\endgroup$
    – Richi Wa
    Commented Nov 12, 2013 at 14:57

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