Using Value-at-Risk to Control Risk Taking : How Wrong Can You Be?

Ju, Xiongwei; Pearson, Neil D.

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https://hdl.handle.net/2142/4048

Description

Title

Using Value-at-Risk to Control Risk Taking : How Wrong Can You Be?

Author(s)

Ju, Xiongwei
Pearson, Neil D.

Issue Date

1998-10

Keyword(s)

biases
estimated covariance matrix

Abstract

We study a source of bias in value-at-risk estimates that has not previously been recognized. Because value-at-risk estimates are based on past data, a trader will often have a good understanding of the errors in the value-at-risk estimate, and it will be possible for her to choose portfolios for which she knows that the value-at-risk estimate is less than the “true” value at risk. Thus, the trader will be able to take on more market risk than risk limits based on value-at-risk permit. Biases can also arise if she does not have a good understanding of the errors, but uses the estimated covariance matrix to achieve certain portfolio objectives. We assess the magnitude of these biases for three different assumptions about the motivations and behavior of the trader and find that in all cases, value-at-risk estimates are systematically downward biased. In some circumstances the biases can be very large. Our study of the distributions of the biases also suggests a way to adjust the estimates to “correct” the biases.

Publisher

Office for Futures and Options Research, Department of Agricultural Economics, College of Agricultural, Consumer, and Environmental Sciences at the University of Illinois at Urbana-Champaign

Series/Report Name or Number

OFOR Working Paper Series, no. 98-08

Type of Resource

text

Language

en

Permalink

http://hdl.handle.net/2142/4048

Owning Collections

OFOR Working Paper Series PRIMARY