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    The document discusses some key limitations of using Value at Risk (VaR) as the basis for setting minimum equity capital, as Long-Term Capital Management (LTCM) did. Specifically, it notes that LTCM's VaR model assumed asset prices follow a normal distribution and constant volatility, failed to account for liquidity and solvency risks, and used a 10-day horizon that was insufficient for raising additional funds when needed.

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    LTCM Limits of VaR

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    The document discusses some key limitations of using Value at Risk (VaR) as the basis for setting minimum equity capital, as Long-Term Capital Management (LTCM) did. Specifically, it notes that LTCM's VaR model assumed asset prices follow a normal distribution and constant volatility, failed to account for liquidity and solvency risks, and used a 10-day horizon that was insufficient for raising additional funds when needed.

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    Download as PPTX, PDF, TXT or read online from Scribd
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    63 views5 pages

    Limits of VaR

    Uploaded by

    angieend
    The document discusses some key limitations of using Value at Risk (VaR) as the basis for setting minimum equity capital, as Long-Term Capital Management (LTCM) did. Specifically, it notes that LTCM's VaR model assumed asset prices follow a normal distribution and constant volatility, failed to account for liquidity and solvency risks, and used a 10-day horizon that was insufficient for raising additional funds when needed.

    Copyright:

    Attribution Non-Commercial (BY-NC)
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    Limits of VaR

    Definition of Value at Risk


    VaR can be defined as the worst loss that can happen under normal market conditions over a specified horizon at a specified confidence interval level LTCM use VaR, not only to report and compare risk, BUT as the basis to set minimum equity capital

    The parameters must be chosen so that the probability of exceeding VaR is very low

    Limits of VaR
    VaR Assumption: Asset price follows a Normal Distribution
    VaR assumes same normal distribution for all assets types BUT financial assets do not exhibit normal distribution. - Stock markets: left skewed and fat tails

    The event far away from the mean would happen more often than the normal distribution suggests

    Limits of VaR
    LTCM VaR specified horizon same as Commercial Bank
    Specified horizon should correspond to the period required to raise additional funds
    VaRs specified horizon used to set the amount of equity capital was a 10-day horizon same as Commercial banks (closely supervised by regulators) The 10-day horizon was clearly insufficient for LTCM, especially when additional capital will be needed precisely after the fund suffers a large loss.

    Limits of VaR
    LTCM VaR volatility: constant at market risk level
    LTCM the portfolio [is] managed so that its target risk [is] no larger than the risk of an unleveraged position in the S&P 500.
    Beginning of 1998 - Fund Capital $4.8 billion - Daily dollar volatility $45 million $45 $4.8 14.82% 250

    The annual average volatility of S&P500 during 1978-1997 was 15%.

    Limits of VaR
    LTCM VaR volatility: under normal market conditions
    LTCM the portfolio [is] managed so that its target risk [is] no larger than the risk of an unleveraged position in the S&P 500.
    What about liquidity risk? LTCM overlooked the correlation and impact of volatility

    Liquidity risk and solvency risk is not factored into VaR models as they assume that normal market conditions will prevail.
    VaR models have underestimated the probability of severe losses. Traditional VaR methods assume that the fund is a price-taker

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