By Brett Sherman
Traders hate risk limits (sometimes called position limits), those pesky rules that restrict aggregate exposure to a single asset class or correlated classes of assets.
The point of risk limits is to make sure that no one trade - or series of related trades - can generate losses big enough to cripple, or even kill, a financial institution.
For instance, if an asset class - like mortgage backed securities suddenly "blows up" (a Talebism), a firm that actually enforces risk limits is may take some losses. However, because the size of its holdings is limited - there is no possibility that the blow up will cause catastrophic losses.
-Traders Hate Risk Limits!
When Wall Street trading desks believe they are onto a winning strategy, they like to build up big positions. Why? Because they are certain they won't lose (many traders, but not all of them, seem to have this kind of baseless overconfidence encoded in their DNA). And, since they can't lose, why not really max out the strategy to milk as much profit as possible?
Indeed, risk limits, when they are enforced, often do end up costing traders some upside. Sometimes rules that limit position size end up causing traders and their firms to leave a lot of profit on the table.
-To Exceed or Not to Exceed? That is the Question...
Most firms have procedures that allow traders to request permission exceed risk limits. From a risk managemet perspective, this is a bad idea.
A very bad idea.
After all, the consequences of exceeding risk limits - whether such a move will be profitable or costly - are always unknown at the time of the decision to grant or deny a risk limit exception. In other words, nobody knows, and nobody can know, when having a whole lot of exposure to a particular class of assets will prove disastrous.
-Moral of the story
Firms should strictly enforce risk limits. They exist because they keep firms alive. And being alive is always better than the alternative.
Just ask Lehman Brothers and Bear Stearns