Value-at-Risk-Based Risk Management: Optimal Policies and Asset Prices

• DOI: 10.1093/rfs/14.2.371
• Publication Date: 2002-07-26T22:58:17Z
• Authors: Suleyman Basak; Alexander Shapiro
• Keywords: Risk Management; Asset Pricing; 330; Volatility; 0502 economics and business; 05 social sciences; VaR; Portfolio Choice

This article analyzes optimal, dynamic portfolio and wealth/consumption policies of utility maximizing investors who must also manage market-risk exposure using Value-atRisk (VaR). We find that VaR risk managers often optimally choose a larger exposure to risky assets than non-risk managers and consequently incur larger losses when losses occur. We suggest an alternative risk-management model, based on the expectation of a loss, to remedy the shortcomings of VaR. A general-equilibrium analysis reveals that the presence of VaR risk managers amplifies the stock-market volatility at times of down markets and attenuates the volatility at times of up markets. In recent years, we have witnessed an unprecedented surge in the usage of risk management practices, with the Value-at-Risk (VaR)–based risk management emerging as the industry standard by choice or by regulation [Jorion (1997), Dowd (1998), Saunders (1999)]. VaR describes the loss that can occur over a given period, at a given confidence level, due to exposure to market risk. The wide usage of the VaR-based risk management (VaR-RM) by financial as well as nonfinancial firms [Bodnar et al. (1998)] stems from the fact that VaR is an easily interpretable summary measure of risk 1 and also has an appealing rationale, as it allows its users to focus attention on “normal market conditions” in their routine operations. However, evidence abounds that in practice VaR estimates not only serve as summary statistics for decision makers but are also used as a tool to manage and control risk—where economic agents struggle to maintain the VaR of their market