Market-risk limits are fundamental controls over the risks inherent in trading activities. Banks need to establish market risk limits related to their risk measures and these limits should be consistent with maximum exposures authorized by their senior management and board. These limits are also allocated to business units and individual traders. The risk management function is responsible for ensuring that exceptions to limits are identified and addressed by management. Some limit systems also include additional features, such as stop-loss limits and trading guidelines.

Financial institutions usually use the following limits:

Limits on net and gross positions: Gross positions, net positions or both can have limits placed on them. The size of a long or short position of an instrument is restricted when limits are placed on gross positions. Net position limits aim to identify natural offsets of long and short positions. Both these limits are useful tools in risk management.

Maximum allowable loss (‘‘stop-loss’’): Each position will be given a maximum allowable loss. When such a limit is crossed it sends up a red flag, and a decision needs to be taken by the management to either liquidate or hedge that position. These limits are more specific to that position rather than broad category limits. Most stop-losses cover losses for a day, a week or month. Limits are set based on historical information over a certain time period.

Value-at-risk limits: Another manner of setting limits is by examining underlying risk factors that affect a portfolio. Limits can be custom set for particular kind of scenario, or for certain kind of scenarios defined at some specified confidence level derived from internal VAR measures. Historical volatilities of risk are used to arrive at measures of sensitivity.

Maturity gap limits: Sometimes rates need to be adjusted to counter the adverse changes that happen to them in the institutions planning horizon. Limits in this case are set so that they can hedge against stated absolute amounts for each time frame. They can also be set to weighted limits that emphasize increasing rate-movement exposure applicable to the relative distance into the future in which the gap appears. The limits need to specify the maximum maturity of the specific instrument or combination of instruments. Maturity gap limits are employed to control risks arising from nonparallel shifts in yield curves and forward curves.

Limits on options positions: It is important that limits be placed on unique limits on options positions to adequately control trading risks. Options limits should include limits which address exposures to small changes in the price of the underlying instrument (delta), rate of change in the price of the underlying instrument (gamma), changes in the volatility of the price of the underlying instrument (vega), changes in the option’s time to expiration (theta), and changes in interest rates (rho).

Limits for volatile or illiquid markets: Volatile or illiquid markets need to have clear limits. In the event that this is not done, its losses could accumulate and management may be forced to take a loss to close a position it cannot offset.