Having a lessened exposure limit is a good way to reduce risk in trading. Depending on your risk tolerances, you can decide how you want to allocate your capital.
The capital allocation should change based on risk tolerances.
Having a good limit management system in place helps prevent unexpected volatility. It also helps make sure your capital allocation is in line with your risk tolerance.
The apt way to do this is to have a good understanding of what your risk tolerance is. This will allow you to determine what kind of investment strategy you should follow. A good way to learn about your tolerance is to do a risk-related survey or questionnaire. It can also be an apt idea to check out some historical returns of various asset classes.
In the investment world, the risk is measured in terms of downside risk. A portfolio that has lessened exposure to riskier assets has a lower percentage of risk borne. This means it is more likely to achieve its long-term goals.
The best way to do this is through a rebalancing strategy. This process will help restore the original allocations of your portfolio. Depending on your risk tolerance, you might be able to restore these allocations with little or no loss to capital. The downside to this approach is that it may not address prolonged changes in market conditions.
The most effective way to implement this strategy is to have a rebalanced asset allocation aligned with your target asset allocation. This will help minimize the upside growth potential and ensure you are not chasing market trends.
Measurement approach to managing counterparty risk
During the financial crisis, financial institutions had to step up their game when it came to measuring and managing counterparty credit risks. After the failure of Lehman Brothers, regulators were particularly concerned that the company’s default on its derivatives could have a systemic effect. They were also concerned that AIG would default on its CDS contracts and that this would ripple through the chain of counterparties.
Banks have responded to these concerns by improving the internal measurement of counterparty risk. They also have set limits on risk per counterparty. These limits are based on investment mandates. However, there are still gaps that banks have in their counterparty risk management.
The process of assessing counterparty risk requires a lot of stakeholders, such as risk management groups and business units. In addition, the opacity of a counterparty’s financial position makes assessing risk difficult. This is particularly true in the OTC market, where the value of the assets in a derivatives contract can swing negatively for both parties.
Measurement systems for counterparty credit risk must be internationally accepted and run on a robust system platform. The process of measuring exposure can be automated, especially for predeal limit checking. This can help limit the number of limit breaches.
Many leading banks have eliminated simplistic add-on methodologies and replaced them with more sophisticated ones, such as the Monte Carlo simulation. In addition, many have incorporated close-out netting into their processes.