Risk Budgeting

Return on VAR: Return/ Allocated VAR in the ERM system (through risk budgeting)

Position limit: Place a nominal dollar cap on certain positions

Liquidity Limit: Set dollar position limits

Performance Stopout: Absolute limit of dollar loss

Risk factor limits: limit exposure to some risk factors

Scenario analysis limits: structure the portfolio to limit the scenario impacts

Leverage Limits: limit the leverage

Minimize risk:

1. Limit Exposure
2. Mark to Market: e.g. in FRA, settle periodically and renew with most updated rate
3. Collateral
4. Payment netting
5. Minimum credit standards (but there are SPV and EDPC – Enhanced derivatives products companies
6. Derivative to transfer risk to others
1. Total return swap:
2. Credit spread option
3. Credit spread forward
4. Credit default swap

Risk-adjusted return on invested capital (RAROC): expected return on risk (e.g. VAR)

Return over maximum drawdown (RoMAD) – maximum of drawdown in total period.

Drawdown: peak-to-trough decline during a specific measured period

Sortino ratio = (return – MAR)/downside risk

MAR – minimum acceptable return, downside sigma is reference to MAR

Setting Capital Requirements:

Nominal position limits (notional position limits, monetary position limits) – can be exceeded by using derivatives

VAR-based limits – total VAR may be overestimated

Maximum loss limit

Internal capital requirement and regulatory capital requirement

Behavioral conflicts (manager tends to take more risk when portfolio is losing)