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Asset Price Dynamics with Value-at-Risk Constrained Traders

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  • Jean-Pierre Zigrand

    ()

  • Jon Danielsson

    ()

  • Hyun Song Shin

    ()

Abstract

Risk management systems in current use treat the statistical relations governing asset returns as being exogenous, and attempt to estimate risk only by reference to historical data. These systems fail to take into account the feedback effect in which trading decisions impinge on prices. We investigate the consequences for asset price dynamics of the widespread adoption of such techniques. We illustrate through simulations of a general equilibrium model that, as compared to the case when such techniques are not used, prices lower, have time paths with deeper and longer troughs, as well as a greater degree of estimated volatility. The magnitudes can sometimes be considerable. Far from promoting stability, widespread adoption of such techniques may have the perverse effect of exacerbating financial instability.

Suggested Citation

  • Jean-Pierre Zigrand & Jon Danielsson & Hyun Song Shin, 2001. "Asset Price Dynamics with Value-at-Risk Constrained Traders," FMG Discussion Papers dp394, Financial Markets Group.
  • Handle: RePEc:fmg:fmgdps:dp394
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    File URL: http://www.lse.ac.uk/fmg/workingPapers/discussionPapers/fmg_pdfs/dp394.pdf
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    References listed on IDEAS

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    1. 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.
    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. Grossman, Sanford J & Zhou, Zhongquan, 1996. " Equilibrium Analysis of Portfolio Insurance," Journal of Finance, American Finance Association, vol. 51(4), pages 1379-1403, September.
    4. Lucas, Robert Jr, 1976. "Econometric policy evaluation: A critique," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 1(1), pages 19-46, January.
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    Cited by:

    1. Marvin Barth & Eli Remolona & Philip Wooldridge, 2002. "Changes in market functioning and central bank policy: an overview of the issues," BIS Papers chapters,in: Bank for International Settlements (ed.), Market functioning and central bank policy, volume 12, pages 1-24 Bank for International Settlements.
    2. Segoviano, Miguel A., 2006. "Consistent information multivariate density optimizing methodology," LSE Research Online Documents on Economics 24511, London School of Economics and Political Science, LSE Library.
    3. Marco Sorge, 2004. "Stress-testing financial systems: an overview of current methodologies," BIS Working Papers 165, Bank for International Settlements.
    4. Leippold, Markus & Trojani, Fabio & Vanini, Paolo, 2006. "Equilibrium impact of value-at-risk regulation," Journal of Economic Dynamics and Control, Elsevier, vol. 30(8), pages 1277-1313, August.
    5. Sorge, Marco & Virolainen, Kimmo, 2006. "A comparative analysis of macro stress-testing methodologies with application to Finland," Journal of Financial Stability, Elsevier, vol. 2(2), pages 113-151, June.
    6. Miguel Segoviano, 2006. "Conditional Probabilty of Default Methodolgy," FMG Discussion Papers dp558, Financial Markets Group.
    7. Segoviano, Miguel A., 2006. "Conditional probability of default methodology," LSE Research Online Documents on Economics 24512, London School of Economics and Political Science, LSE Library.
    8. Laurent Clerc & Fran├žoise Drumetz & Fran├žois Haas, 2002. "The influence of structural changes on market functioning and its implications for monetary policy: a focus on the euro area," BIS Papers chapters,in: Bank for International Settlements (ed.), Market functioning and central bank policy, volume 12, pages 43-64 Bank for International Settlements.

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