Affordable Access

Destabilizing properties of a VaR or probability-of-ruin constraint when variances may be infinite



Despite the use of VaR as a means to control risk, regulations that constrain VaR can have an effect opposite of their intent: to increase risk taking by firms that are doing poorly. Hence VaR constraint regulations can have a destabilizing effect on the financial system. A VaR constraint on the probability that future firm equity value will be less than a floor is a constraint on the probability-of-ruin when the floor is zero. The marginal price of risk with this constraint is coherent and also additive. For a wide class of distributions, the firm--when it is doing poorly--may pay a premium for a lottery that will increase the risk of its portfolio and the opposite when the firm is doing well.

There are no comments yet on this publication. Be the first to share your thoughts.


Seen <100 times