Trading Jenga: Risk Management

Risk Management is the area of trading charged with managing obvious risks and those risks less visible. Risk Managers monitor how and when risks arise and estimate the impact on potential adverse outcomes. These are acknowledged in writing in the internal Risk Management Plan. Risk Procedures and Policies are developed to mitigate future problems before they appear.

Areas of responsibility for risk managers include currency exposure, margin rates, Letters of Credit, monitoring available trading capital associated with Lines of Credit, insurance, status of FINRA licenses, SEC violations, NYMEX violations, compliance, audit, each trade entry and its accuracy, the overall risk of long-term swaps relative to the actual financial health of partners and the actual trade, commodity prices, and the health of their financial institutions such as banks, brokers, and financial clearing houses.

Hacking into trading systems is another problem area for risk managers. Look at the daily reports offered by IT and examine security issues connected with intruders hacking into the router or other key identification issues. A Biometric entry system for the trading area may be the best solution. Fingerprint or iris identification and login are great ways to reduce onsite security violations. Risk management is a key role for any trading company.

Risk managers take actions that will mitigate or hedge these risks. There are many software platforms used to manage this area. International trading houses have several additional areas of risk including currency risk, political risk, local audit and compliance requirements which are different than those for their headquarters and may actually conflict with other compliance demands.

Never allow the top brass to override the risk management plan without a meeting of key executives. This may seem obvious, but it’s an area which affects many trading houses. A key executive prevents a top trader from leaving the firm and trumps the risk manager’s decision to eliminate a trade or a trading partner. Make these decisions wisely and not often.

Risk management quantifies the financial risk involved in individual trades and analyzes the risk for an entire book of business. Many risks hedge each other. Trading houses calculate Value at Risk (VaR) to address adequate capitalization and volatility of the entire trading book to maintain solvency. Do negative returns on long-term investments increase VAR? It seems like this is clearly a key consideration moving forward for risk managers. This also seems to impact currency rates directly. Investors will flock to areas and countries with positive returns.

Will currency rates increases exceed the losses from negative returns? If so, these key considerations will prevail. Examine the Swiss and Japanese models for answers before making long-term decisions.

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