Derivatives in Plain Words by Frederic Lau, with a ... - HKU Libraries

Consideration must be given to the period of time over which the unrealisedloss is to be controlled: too long a period (e.g. a year) may allow largeunrealized losses to build up before management action is triggered. Limitsfor shorter periods may be advisable (e.g. on a monthly basis).49. Limits based on the notional amount or volume of derivatives contractsdo not provide a reasonable proxy for market (or credit) risk and thusshould not generally be acceptable on a stand-alone basis. (A numberof authorized institutions have been relying solely on notional limits.)Volume limits can however have some use in controlling operational risk(i.e. as regards the processing and settling of trades) and also liquidityand concentration risk. Such a risk might arise for example, as it did inthe case of Barings, from having a substantial part of the open interestin exchange-traded derivatives (particularly in less liquid contracts.) TheBarings case also illustrates that for activities such as arbitrage, it isnecessary to set limits on the gross as well as the net positions in orderto control over-trading and limit the amount of funding which is requiredfor margin payments. (A number of authorized institutions have notbeen monitoring the growth of gross positions.)50. It may be appropriate to set limits on particular products or maturities(as well as on portfolios) in order to reduce market and liquidity riskwhich would arise from concentrations in these. (Some institutionshave not been doing this.) Similarly, options risk can be controlled byconcentration limits based on strike price and expiration date. Thisreduces the potential impact on earnings and cash flow of a large amountof options being exercised at the same time.Credit limits51. Institutions should establish both pre-settlement credit limits andsettlement credit limits (not all have been doing this). The formershould be based on the credit-worthiness of the counterparty in muchthe same way as for traditional credit lines. The size of the limits shouldtake into account the sophistication of the risk measurement system: ifSMIGuideline on Risk Management of Derivatives and Other Traded Instruments