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Diversification and Value-at-Risk

Author

Listed:
  • Christophe Perignon

    (GREGH - Groupement de Recherche et d'Etudes en Gestion à HEC - HEC Paris - Ecole des Hautes Etudes Commerciales - CNRS - Centre National de la Recherche Scientifique)

  • Daniel R. Smith

    (Faculty of Business Administration - SFU.ca - Simon Fraser University = Université Simon Fraser)

Abstract

A pervasive and puzzling feature of banks' Value-at-Risk (VaR) is its abnormally high level, which leads to excessive regulatory capital. A possible explanation for the tendency of commercial banks to overstate their VaR is that they incompletely account for the diversification effect among broad risk categories (e.g., equity, interest rate, commodity, credit spread, and foreign exchange). By underestimating the diversification effect, bank's proprietary VaR models produce overly prudent market risk assessments. In this paper, we examine empirically the validity of this hypothesis using actual VaR data from major US commercial banks. In contrast to the VaR diversification hypothesis, we find that US banks show no sign of systematic underestimation of the diversification effect. In particular, diversification effects used by banks is very close to (and quite often larger than) our empirical diversification estimates. A direct implication of this finding is that individual VaRs for each broad risk category, just like aggregate VaRs, are biased risk assessments.

Suggested Citation

  • Christophe Perignon & Daniel R. Smith, 2010. "Diversification and Value-at-Risk," Post-Print hal-00528390, HAL.
    • Handle: RePEc:hal:journl:hal-00528390
    DOI: 10.1016/j.jbankfin.2009.07.003
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    References listed on IDEAS

    as
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