SETTING

LIMITS

By Jawwad Ahmed Farid

S E T T I N G L I M I T S

TABLE OF CONTENTS

SETTING LIMITS ......................................................................................................................................... 5

1.

RISK LIMITS AND CONTROL PROCESS ................................................................................................... 5

a.
b.
c.
d.
e.
f.
g.
h.
2.

Operational (Exception or Management Action) Limits ................................................................ 5

Capital Loss & Stop Loss Limits ...................................................................................................... 5
Inventory Age Limits ...................................................................................................................... 6
Concentration Limits ..................................................................................................................... 6
Transaction Limits ......................................................................................................................... 6
Exposure and Sensitivity Limits ..................................................................................................... 6
Pre Settlement Risk (PSR) and Potential Future Exposure (PFE) Limits ......................................... 6
Hierarchy of Limits ......................................................................................................................... 7
A MORE DETAILED LOOK AT LIMITS .................................................................................................... 8

a.
b.
c.
d.

Capital Loss and Stop Loss Limits .................................................................................................. 8

Value-at-Risk Limits ....................................................................................................................... 11
Regulatory Approach Limits .......................................................................................................... 13
Other Limits ................................................................................................................................... 13
Duration Limits .............................................................................................................................. 13
Convexity Limits ............................................................................................................................ 13
PVBP Limits ................................................................................................................................... 14
e.
Credit Risk Limits ........................................................................................................................... 14
PSR Limits ...................................................................................................................................... 14
Settlement Risk Limits ................................................................................................................... 16
Financial Institution (FI)/ Counterparty Limits .............................................................................. 16
Regulatory Limits .......................................................................................................................... 17
Internal / Concentration Limits ..................................................................................................... 17
f.
Application to Products ................................................................................................................. 18
g.
Setting Limits for Liquidity Risk ..................................................................................................... 18
Cash flow mismatch or gap limits ................................................................................................. 19
Maturity Limits .............................................................................................................................. 19
Target Liquid Reserves .................................................................................................................. 19
Concentration Limits ..................................................................................................................... 19
Contingent liability limit ................................................................................................................ 19
Review ........................................................................................................................................... 19
h.
Setting Limits for Interest Rate Risk .............................................................................................. 20
Repricing limits .............................................................................................................................. 20
i.
Limit Breach, Exception processing, Action Plan for Trigger Zones ............................................... 20
Exception Handling ....................................................................................................................... 20
Example of an Action Plan for Trigger Zones ................................................................................ 20
ANNEXURE - CALCULATING VALUE AT RISK ...................................................................................................... 22

1.

INTRODUCTION .............................................................................................................................. 22

2.

VAR METHODS .............................................................................................................................. 23

a.
b.

Variance Covariance Approach ..................................................................................................... 24

Historical Simulation Method ........................................................................................................ 25

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S E T T I N G L I M I T S

c.
d.
e.
3.

Monte Carlo Simulation ................................................................................................................ 25

Quick Review ................................................................................................................................. 26
Implementing VaR ......................................................................................................................... 26
METHODOLOGY ............................................................................................................................. 26

a.

Setting the Scene ........................................................................................................................... 26

Sample Portfolio ............................................................................................................................ 26
Preliminary steps ........................................................................................................................... 27
VaR Approach Specific Steps ......................................................................................................... 30
Variance-Covariance (VCV) VaR .................................................................................................... 30
Determining Historical Simulation daily VaR ................................................................................ 32
Scaling of the daily VaR ................................................................................................................. 33
CAVEATS, QUALIFICATIONS, LIMITATIONS AND ISSUES ............................................................................ 33

b.
c.

d.
4.

DISCLAIMER .............................................................................................................................................. 35

Please do not photocopy or distribute without permission. All rights reserved Alchemy Software Pvt Limited.
http://FourQuants.com
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