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The impact of risk regulation on price dynamics

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Listed:
  • Danielsson, Jon
  • Shin, Hyun Song
  • Zigrand, Jean-Pierre

Abstract

Most financial risk regulations assume that asset returns are exogenous, where risk is estimated from historical data. This assumption fails to take into account the feedback effect of trading decisions on prices. We investigate the consequences of risk constrained trading by means of simulations of a general equilibrium model with a value-at-risk constraint and compare the results to the case when risk constraints are not present. Prices are lower on average in the presence of risk regulation, while volatility is higher. Risk regulation may have the perverse effect of exacerbating price fluctuations.

Suggested Citation

  • Danielsson, Jon & Shin, Hyun Song & Zigrand, Jean-Pierre, 2004. "The impact of risk regulation on price dynamics," LSE Research Online Documents on Economics 16628, London School of Economics and Political Science, LSE Library.
  • Handle: RePEc:ehl:lserod:16628
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    File URL: http://eprints.lse.ac.uk/16628/
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    References listed on IDEAS

    as
    1. M.J.B. Hall, 1996. "The amendment to the capital accord to incorporate market risk," Banca Nazionale del Lavoro Quarterly Review, Banca Nazionale del Lavoro, vol. 49(197), pages 271-277.
    2. Gennotte, Gerard & Leland, Hayne, 1990. "Market Liquidity, Hedging, and Crashes," American Economic Review, American Economic Association, vol. 80(5), pages 999-1021, December.
    3. Jean-Pierre Zigrand & Jon Danielsson, 2001. "What Happens When You Regulate Risk? Evidence from a Simple Equilibrium Model," FMG Discussion Papers dp393, Financial Markets Group.
    4. Blum, Jurg, 1999. "Do capital adequacy requirements reduce risks in banking?," Journal of Banking & Finance, Elsevier, vol. 23(5), pages 755-771, May.
    5. Basak, Suleyman & Shapiro, Alexander, 2001. "Value-at-Risk-Based Risk Management: Optimal Policies and Asset Prices," Review of Financial Studies, Society for Financial Studies, vol. 14(2), pages 371-405.
    6. Grossman, Sanford J & Vila, Jean-Luc, 1989. "Portfolio Insurance in Complete Markets: A Note," The Journal of Business, University of Chicago Press, vol. 62(4), pages 473-476, October.
    7. Robert J. Shiller, 1987. "Investor Behavior in the October 1987 Stock Market Crash: Survey Evidence," NBER Working Papers 2446, National Bureau of Economic Research, Inc.
    8. Grossman, Sanford J & Zhou, Zhongquan, 1996. " Equilibrium Analysis of Portfolio Insurance," Journal of Finance, American Finance Association, vol. 51(4), pages 1379-1403, September.
    9. Lucas, Robert Jr, 1976. "Econometric policy evaluation: A critique," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 1(1), pages 19-46, January.
    10. Morris, Stephen & Shin, Hyun Song, 1999. "Risk Management with Interdependent Choice," Oxford Review of Economic Policy, Oxford University Press, vol. 15(3), pages 52-62, Autumn.
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    More about this item

    Keywords

    Value-at-risk; Simulation; Basel II; Regulation;

    JEL classification:

    • C15 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Statistical Simulation Methods: General
    • G1 - Financial Economics - - General Financial Markets
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation

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