Financial Risk Management: A Practitioner's Guide to Managing Market and Credit Risk, 2nd Edition

CHAPTER 6

Managing Financial Risk

The management of financial risk can be divided into two parts: risk measurement and risk control. In general, the industry agrees more on how risk should be measured than on how it should be controlled.

6.1 RISK MEASUREMENT

6.1.1 General Principles

As stated in Chapter 1, the key characteristic that distinguishes financial risk management from other types of risk management is that financial risk management can take advantage of liquid markets as part of a risk management strategy. In this chapter we examine the structure of financial risk management in more detail, and a good starting point is to consider the hypothetical case in which a market is so liquid that any position can be liquidated instantaneously. While this is obviously an extreme that does not exist in reality, it will still provide an instructive background against which to consider more realistic cases.

With such perfect liquidity, risk management could, in principle, just consist of setting loss limits for each trader and each trading group (the industry jargon for this is a stop-loss limit). As soon as a trader reached the limit for a position, the entire position could be liquidated with no further loss. Or if management decided that its risk tolerance had changed because of changes in their view of the economy or the institutional environment, positions could be liquidated with no further losses. Even in such an extreme case, the following rules would be needed.

• Careful and ...