Constraints And Capital Allocation Decisions

Constraints imposed to limit risk can be too restrictive, impairing profitability, or not restrictive enough, leading to financial stress, corporate reorganization, or bankruptcy. Imposing restrictions at the business unit level may be too restrictive to the extent diversification benefits or offsetting positions across business units are not taken into account. Risk limits that are often imposed include the following.

Risk budgeting refers to a risk management process that first determines the acceptable total risk for an organization, and then allocates that risk to different activities, strategies, or asset classes as appropriate. An example would be first determining the maximum allowable 5% VaR amount, then allocating that VaR across various business units. A portfolio manager may set a limit for total risk relative to a benchmark and then allocate that risk to deviations from the portfolio’s target asset allocations, deviations from benchmark weights in specific industries, and deviations from benchmark weights for firms within a specific industry.

Position limits are one way to limit risk because they ensure some minimum level of diversification by limiting risk exposures. For example, position limits may be imposed on allocations to individual securities within an asset class, asset classes such as equities or high yield bonds, investments in a single country, securities in a single currency or the differences between long and short positions for a hedge fund manager.

Position limits can be expressed as currency amounts or as percentages of a portfolio’s value. Position limits can also be based on a liquidity measure, such as average daily or weekly trading volume.

Scenario limits are limits on expected loss for a given scenario.

Stop loss limits require that a risk exposure be reduced if losses exceed a specified amount over a certain period of time. An example of a simple stop loss limit is a requirement to reduce the portfolio allocation to a stock or asset class (by a given amount) if it declines in value by more than a specified percentage (or currency amount). A slightly more complex type of stop loss limit is a requirement that a risk exposure be hedged as the value of a security or index falls.

This is referred to as portfolio insurance when the value of a portfolio is hedged by index puts.

Capital allocation decisions refer to how the capital of a firm is used to fund its various business units or activities, analogous to asset allocation for a portfolio manager. The optimal capital allocation, ignoring risk, would be the allocation that maximizes the expected return on the firm’s invested capital. Risk management, however, requires that the risk exposure for each use of firm capital be considered.

One way to introduce risk exposures to various activities into the capital allocation decision is to limit the overall risk of all the activities. By calculating a VaR for each activity or business unit, the maximum acceptable VaR can be allocated across the activities or business units in a process similar to risk budgeting for a portfolio manager. This is but one method of considering risk exposures when determining the optimal allocation of firm capital to various activities.