Risk Management in Trading: Techniques to Drive Profitability of Hedge Funds and Trading Desks

CHAPTER 6 Value-at-Risk

Risk is a way to describe the size of an investment. Trading desks use risk limits to restrict the size of investments that their traders can make on behalf of the firm and the firm’s investors. Limiting the size of investments is one of the primary ways that traders control risk. This is not just a matter of restricting capital since many investments (like futures) only require a small amount of money to initiate a trade. Instead, position limits are commonly based on a volatility-based estimate of size called value-at-risk, abbreviated VAR.

Trading desks typically have several VAR limits. The first limit, a soft limit, indicates the target size of the trading portfolio. The second limit, a hard limit, indicates a size which trading positions are not allowed to exceed. Trading desks use these limits to ensure that traders are following trading rules set by the firm and to ensure that diversification is working properly.

Value-at-risk was originally designed as a way to apply consistent size limits across any type of investment. It has been expanded since that time to estimate the size of large losses and as way for banks to determine the amount of money they need on hand (their regulatory capital requirements). From a decision perspective, the multiple uses of VAR complicate the most common usage for VAR on a trading desk—limiting the size of trading portfolio.

VAR is both a source of risk and a way to control risk. VAR has been expanded over time. ...