Slide MGT305 Slide13

Risk Management Mistakes to
Avoid
Chapter XXIV

Risk Limits
• It is important that every company define
in a clear and unambiguous way limits to
the financial risks can be taken.
• Procedures should then be set up to ensure
limits are adhered to.
• Ideally, overall risk limits are set at the
board level.

Risk Limits
• It is important that companies monitor
risk carefully when derivatives are used.
• Without close monitoring, it is impossible
to know if a derivative trader has
switched from being an arbitrageur or a
hedger to being a speculator.

Difficult Situation
• It could be a tricky situation when an individual
exceeds risk limits and makes a profit.
• It is tempting to ignore violations of risk limits
when profit results; which in turn leads to a
culture where risks are not taken seriously.
• The penalties for exceeding risk limits should
be equal either when profit or loss results.

Do Not Assume You Can
Outguess the Market

• Some traders may be better than others.
• But no one persists all the time.
• It shows that luck is obvious compared to
skill.
• Thus, there is no reason to increase an
individual’s risk limits as a result of
previous good performance.

Do Not Underestimate the
Benefits of Diversification

• Suppose there are 20 stocks, each of

which has an expected return of 10%
per annum and a standard deviation of
return of 30%.
• The correlation between the returns
from any of two of the stocks is 0.2.