In this chapter, we consider the management of a very specific type of risk which is on-going through the life of a trade or group of trades. Even though it is commonly known as risk management, the term is used in the context of market risk actively managed by traders and not in relation to counterparty, operational, reputational, legal and other risks. As explained earlier, trading involves actual and potential flows of assets. The price of assets varies according to market conditions and so trading carries with it market risk. We define risk management as the process of managing this market risk.
We now look at how risk management impinges on different people in the trade lifecycle.
Risk management forms a major part of the daily life of the trader. By trading, a trader is taking on positions that expose him to the risk of market prices changing.
This exposure might be desirable, as in the case where he expects the market to move in a certain direction and wants to take advantage of this move and convert it into profit. For instance, expecting the price of sugar to fall, the commodities trader sells a future in sugar. When the future is due for delivery he can go into the market and purchase the sugar to satisfy the obligations of the future at, hopefully, a lower price than he received for it.
When the trader is uncertain of the direction of a particular market price, he will not want to ...