Asset Price Dynamics with Value-at-Risk Constrained Traders

Publication Date
Financial Markets Group Discussion Papers DP 394

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 are 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.