The Trade Lifecycle: Behind the Scenes of the Trading Process, 2nd Edition

Appendix C Control Risks

The two major areas of risk control – market and counterparty – carry their own set of risks.

Market risk control

There is a risk associated with relying too much on the market risk control department to avert risk from market forces. Staff in this department do not prevent disasters from occurring: the expectation is that should something unusual happen, they will be able to provide the necessary data on the risk profile of the organisation at various macro and micro levels so that the extent of the damage can be assessed.

Also, they cannot measure every possible disaster. Nobody can determine how much or in what way the future replicates the past. Market risk control lives in the world of the unknown, but uses probability to give some feel for exposure to risk. Understanding the limitations of market risk controllers is very important in order to assess the credibility of their measurements.

Everything correlated

Market risk allocates risk on an asset-by-asset basis. Interest rate traders are given so much interest rate risk, commodity traders commodity risk and so on. Most of the measurements of risk (with the exception of scenario testing) also consider each risk type separately. This means there is an implicit assumption that one type of market risk is not connected to other types. This assumption is not always correct: we have observed several episodes in the recent and distant past that have caused markets to react in concert across the range ...