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

Larry Eisenberg

Journal of Financial Stability, 2011, vol. 7, issue 1, 10-18

Abstract: 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.

Keywords: Cotendency; Premium; switching; Power; law; Probability-of-ruin; Risk; management; VaR (search for similar items in EconPapers)
Date: 2011
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Persistent link: https://EconPapers.repec.org/RePEc:eee:finsta:v:7:y:2011:i:1:p:10-18

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