VAR, Probability-of-Ruin and their Consequences for Normal or Lognormal Risks

32 Pages Posted: 13 Jul 2009

See all articles by Larry Eisenberg

Larry Eisenberg

New Jersey Institute of Technology

Date Written: July 13, 2009

Abstract

Despite the use of VaR as a means to control risk, using VaR can have the opposite effect. VaR is used by bank and insurance regulators more than any other risk measure. A value-at-risk (VaR) constraint on the probability that future firm equity value will be less than a floor, when the floor is zero, is also a constraint on the probability of ruin. A manager who maximizes his firm's expected equity value subject to a VaR constraint, when the firm is in bad financial health, may pay a premium for financial instruments that increase his firm's volatility and does the opposite when the firm is in good financial healths, so it's use may increase banks' volatility in bad economic conditions. Hence the use of VaR may increase the instability of the global banking network when the banking system when it is more vulnerable. This paper examines the cases where risks are multivariate normal or lognormal.

Keywords: Premium switching, Probability of ruin, Risk management, VaR constraint

JEL Classification: G11, G12, G22, G32

Suggested Citation

Eisenberg, Laurence K., VAR, Probability-of-Ruin and their Consequences for Normal or Lognormal Risks (July 13, 2009). Available at SSRN: https://ssrn.com/abstract=1433384 or http://dx.doi.org/10.2139/ssrn.1433384

Laurence K. Eisenberg (Contact Author)

New Jersey Institute of Technology ( email )

School of Management
Newark, NJ 07102-1982
United States
973 642-7263 (Phone)
973 596-3074 (Fax)

HOME PAGE: http://som.njit.edu/people/eisenberg.php

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