An Analysis of Var-Based Capital Requirements

49 Pages Posted: 2 Dec 2003

See all articles by Hong Liu

Hong Liu

Washington University in St. Louis - Olin Business School; Fudan University - China Institute of Economics and Finance

Domenico Cuoco

University of Pennsylvania - Finance Department

Date Written: April 2003

Abstract

We study the dynamic investment and reporting problem of a Financial institution subject to capital requirements based on self-reported VaR estimates, as in the Basel Committee's Internal Models Approach (IMA). We characterize the solution of this problem using martingale duality and parametric quadratic programming techniques. With constant price coefficients, we show that optimal portfolios display a local three-fund separation property. VaR-based capital requirements induce financial institutions to tilt their portfolios towards assets with high expected return (and high systematic risk), but result nevertheless in a decrease of the overall risk of trading portfolios. In general, an institution may optimally under-report or over-report its true VaR, depending on its risk aversion and the stringency of capital requirements. Overall, we find that capital requirements determined on the basis of the IMA can be very effective not only in curbing portfolio risk but also in inducing truthful revelation of this risk.

Keywords: Capital requirements, Basel Capital Accord, Internal Models Approach, Precommitment Approach, VaR, portfolio constraints.

JEL Classification: D91, D92, G11, C61

Suggested Citation

Liu, Hong and Cuoco, Domenico, An Analysis of Var-Based Capital Requirements (April 2003). AFA 2004 San Diego Meetings. Available at SSRN: https://ssrn.com/abstract=470904 or http://dx.doi.org/10.2139/ssrn.470904

Hong Liu

Washington University in St. Louis - Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States
314-935-5883 (Phone)

Fudan University - China Institute of Economics and Finance ( email )

China

Domenico Cuoco (Contact Author)

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States

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