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Setting up Treasury Limits: Working with Stop Loss Limits

Capital Loss and Stop Loss – Defining risk appetite?

Stop loss limits

Stop loss limits act as a safety valve in case something starts to go wrong. Stop loss limits state that specified action must take place if the loss exceeds a threshold amount. Tight stop loss limits reduce the maximum possible loss and therefore reduce the capital required for the business. However, if the limits are too tight they reduce the trader’s ability to make a profit.

The first step in setting stop loss limits is to determine the appetite of the company regarding its risk tolerance. This translates to specifying the amount of capital that the company can afford to lose.

The following elements would need to be considered when determining the capital loss amount.

  • The expected rate of return that will be earned on the capital will the next twelve month period.
  • The minimum acceptable rate of return that will be required to satisfy shareholders.

In no situation should the capital loss amount eat into eat into principal capital amount or in other words the rate of return required should never be negative.

This is elaborated in the following example:

Capital

USD 1,000,000,000

Rate of return expected

6% p.a.

Expected return

USD 60,000,000

Minimum acceptable rate of return

2% p.a.

Return required

USD 20,000,000

Capital loss amount

USD 40,000,000

 

The next step in this process is to specify a target stop loss limit. The stop loss limits gives us the amount of money that a portfolios’ single-period market loss should not exceed.

This limit together will the capital loss amount will be used in determining the book size of the company. Using the example above the target stop loss limits is set at 10%. This implies that the capital loss amount is equal to 10% of the book size or alternatively the book size is the capital loss amount divided by 10%. This would mean that the book size will be 20,000,000 ÷ 0.10 or 200,000,000. It may be noted that this assumes that the company has perfect ability to liquidate assets at the optimal level if the stop loss limit is activated.

After the target stop loss limit has been defined, and the book size determined, the amount will be allocated to individual investment lines and the stop loss limits will be set at the individual asset level.

These actual stop loss limits implemented at individual levels will have to be lower than the target stop loss limit to account for slippage, i.e. instances when the company would not be able to liquidate the position at a price for which the stop loss limit is exactly met. We recommend actual stop loss limits 1% – 2% less than the target stop loss limit depending on the daily movement in a specific market.

This is illustrated below. We assume that the a book size of 500,000,000 is allocated among 10 lines of investment (positions) equally and that the entire allocated amount is utilized so that the allocated amount is equal to the book value of the investment. While the internal stop loss limit is set at 10%, the actual hard stop loss limit is set at 8% to provide room for 2% of slippage and is supported by 40,000,000 of stop loss capital.

Lines of Investment

Allocated Amount/ Book Value

Purchase Price

Quantity

Stop Loss

Stop Loss Amount

MTM

Market Value

Gain/Loss

Stop Loss decision

1

50,000,000

110

454,545.45

8%

4,000,000

112

50,909,091

909,091

Within Limit

2

50,000,000

201

248,756.22

8%

4,000,000

200

49,751,244

-248,756

Within Limit

3

50,000,000

150

333,333.33

8%

4,000,000

151

50,333,333

333,333

Within Limit

4

50,000,000

95

526,315.79

8%

4,000,000

100

52,631,579

2,631,579

Within Limit

5

50,000,000

35

1,428,571.43

8%

4,000,000

34

48,571,429

-1,428,571

Within Limit

6

50,000,000

348

143,678.16

8%

4,000,000

350

50,287,356

287,356

Within Limit

7

50,000,000

42

1,190,476.19

8%

4,000,000

45

53,571,429

3,571,429

Within Limit

8

50,000,000

549

91,074.68

8%

4,000,000

545

49,635,70
1

-364,299

Within Limit

9

50,000,000

250

200,000.00

8%

4,000,000

265

53,000,000

3,000,000

Within Limit

10

50,000,000

100

500,000.00

8%

4,000,000

150

75,000,000

25,000,000

Within Limit

Expected Capital Loss @ Stop Loss = 40,000,000

Rate of return adjusted for expected capital loss = 6% – (40,000,000÷1,000,000,000) = 2%

Slippage or the reason for having the actual stop loss limit at a level lower than the target is illustrated below. The example assumes that all MTM prices are lower than 10% from those given above. If the actual stop loss limit is breached then the investment can only be liquidated at MTM (revised) = MTM × (1-10%):

%

Lines of Investment

MTM (revised)

Market Value

Gain/Loss

Stop Loss decision

Loss if exceeding Stop Loss

% of BV

Slippage/ Excess Loss

1

100.8

45,818,182

-4,181,818

Liquidate

4,181,818

8.36%

181,818

2

180

44,776,119

-5,223,881

Liquidate

5,223,881

10.45%

1,223,881

3

135.9

45,300,000

-4,700,000

Liquidate

4,700,000

9.40%

700,000

4

90

47,368,421

-2,631,579

Within Limit

5

30.6

43,714,286

-6,285,714

Liquidate

6,285,714

12.57%

2,285,714

6

315

45,258,621

November 2010
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