!

!
!

VaR,!Probability"of"ruin!and!Their
Consequences!for!Normal!Risks
LARRY EISENBERG
New Jersey Institute of Technology, Newark, NJ, USA

Correspondance Address: Larry Eisenberg, School of Management, New Jersey

Institute of Technology, Newark, NJ 07102, USA. Email: larry@riskengineer.com
Electronic copy available at: http://ssrn.com/abstract=1487145

VaR,!Probability"of"ruin!and!Their
Consequences!for!Normal!Risks

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, pays a premium for financial
instruments that increase his firm's volatility and does the opposite when the firm is
in good financial health. Regulations with VaR or probability-of-ruin constraints may
increase banks' or insurers' volatility in bad economic conditions. Hence the use of
VaR may increase the instability of the global financial network when the financial
system is more vulnerable. Basel II regulations, via the Internal Based Ratings
Approach, encourage banks with greater systemic risk, the large banks, to use VaR
constraints thereby encouraging the banks to which the global financial system is
more vulnerable to take on greater risk when it is more vulnerable.
KEY WORDS: Premium switching, Probability of ruin, Risk management, VaR
constraint
JEL CLASSIFICATION: G11, G12, G22, G32

Electronic copy available at: http://ssrn.com/abstract=1487145

1. Introduction
1.1 Why Should Economists Care About Value-at-Risk?
Three times the Goldman traders who made outsized profits during the subprime
meltdown were, according to a Wall Street Journal article (Kelly, 2007) required to
unwind their positions by higher management. Said one commentator (Salmon,
2007) "what fascinates me is the way in which value-at-risk, a very quick-and-dirty
risk measure, seems to have been of paramount importance within the highly
sophisticated investment bank".
The trading desk that made billions of dollars of profits is part of Goldman's
mortgage trading department. More than once the head of the department, according
to (Kelly, 2007), "was summoned to Loyd Blankfein's (Goldman's Chief Executive
Officer) office to cut down on risk...Goldman's top executives understood the
strategy but were uncompromising about the VaR. They demanded that risk be cut
by as much as 50%..."
For regulators and the managers of many financial institutions VaR is a visible
and often reported number. Basel II (Basel Committee on Banking Supervision,
2004) mentions VaR more than any other risk measure. At many financial institutions
the chief risk officer (CRO) gets a daily report on firm-wide VaR as well VaR
disaggregated across the firm's activities. Often the CRO has a direct report to the
board of directors as well as to the chief executive officer (CEO). A special case of
VaR is the probability of ruin: used by insurers and insurance regulators since
Condorcet (1784) introduced it.
Solvency II often known as Basel II for insurers, a proposal for insurance
regulation the European Union plans to have in place by 2012, explicitly uses VaR to
determine insurers' capital requirements (European Union, 2007). Probability of ruin
is an active research topic in the actuarial literature on ruin theory e.g. Gerber and
Shiu (1998).
The defects of VaR as a risk measure are well known in the finance literature.
(For example, it is not subadditive), yet VaR continues to be used by insurers,
sophisticated investment banks like Goldman Sachs and banking and insurance
regulators. Perhaps one defense of VaR is that the marginal price of risk with a VaR
constraint, when the constraint is binding, is coherent (Eisenberg, 2008).

Be it a faulty risk measure used by regulators and practitioners who should know
better or a risk measure to be incorporated into a fundamental theory of decision
making, the consequences of the widespread use of VaR on a firm's risk-taking
behavior and global financial stability bear investigation. A manager who maximizes
firm equity value subject to a VaR constraint, when his firm is in bad financial health,
may pay a premium over the risk-neutral price for instruments that increase the
volatility of firm equity. This is different from the asset substitution problem. With a
VaR constraint the firm will pay a discount for these instruments when prospects are
good.
A risk measure promoted by regulators that may encourage firms in trouble to
take on additional risk may exacerbate the volatility of the global banking system. In
emerging economies with more volatile markets one might expect deeper downturns
and a greater number of banks with periods of dim prospects. The use of VaR may
exacerbate the volatility of these economies. Whether the use of VaR actually does
have a destabilizing effect depends on how firms use VaR to make decisions.
This paper builds on the results of (Eisenberg, 2007) in which a CEO maximizes
his firm's expected equity value subject to a VaR constraint. This constraint is a
constraint on the probability that firm's portfolio value (assets minus liabilities) or
equity will be less than a "floor". With the floor set at zero, this probability is the
probability of ruin. (Eisenberg, 2007) derives a manager's marginal price of risk (a
lottery) when he maximizes his firm's expected equity subject to a VaR or
probability-of-ruin constraint. Here, the risk premium of this price is the focus of our
interest. Unlike standard asset pricing models, this risk premium is dependent on the
state of the firm and its financial health.
In this paper I examine, for lotteries and portfolios that are normal variates, the
properties of the marginal price derived in (Eisenberg, 2007). From these properties
we can infer when a CEO will increase or reduce the risk of his firm. For example,
when risks are normal, a CEO who maximizes his firm's expected equity subject to a
VaR constraint willwhen his firm is in troubleincrease the firm's variance. He
does the opposite when his firm is doing well. He is a "variance switcher".1

1This

claim appears inadvertantly without proof in [12].

Variance switching means that a manager can switch from pricing a financial
instrument at a premium over its risk-neutral price to a discount or vice versa. For
example, if the instrument and the firm's portfolio have a bivariate normal
distribution with positive correlation and expected firm equity value is greater than
the floor, then the manager prices the instrument at a discount to the risk-neutral
price. This is the usual case for a firm in good financial health and we call this case
"good times". However, if firm expected equity value is less than the floor"bad
times"the manager prices the instrument at a premium. This premium switch is
without any change in the instrument's correlation with the firm's value.

The

manager switches from disliking variance to preferring it when the firm goes from
good times to bad times. The opposite happens if the correlation of the instrument
with the firm's portfolio is negative. Whatever the correlation, the manager will
reduce the firm's risk in good times and do the opposite in bad times.
Good and bad, however, are relative to the floor. The manager, for example,
may manage his firm with the goal of getting the firm's credit rating changed from A
to Aa. Suppose credit ratings are based on a floor and a probability: a floor to the
equity value at which a "buffer" between the firm's asset value and the asset value at
which the firm fails and the probability that the firm will maintain this buffer. The
manager seeks to raise his firm's credit rating, but his firm's expected equity is less
than the minimum buffer level required for the higher credit rating. In this case, even
though the firm is A-rated firm the manager will pay a premium for financial
instruments that increase the variance of his firm's portfolio. He will increase the
firm's risk (in terms of variance) because by doing so he increases the probability that
the required buffer for an Aa-rating will be maintained.
For another example of a CEO whose floor may be below the firm's expected
equity value is a CEO who wants to achieve greater growth in the firm's equity than
he expects with his current portfolio. Because, independent of his ambition, in this
setup the CEO always maximizes the firm's expected equity, more ambitious growth
is represented by raising the floor to the VaR (or if you will equity) constraint.
Going forward, firm value and the manager of the firm also stand for portfolio value
and the portfolio manager.
1.2 Results

The main contributions of this paper are:

1. For normal risks (a lottery, the firm's asset-liability portfolio), when the firm is
in bad financial health a higher correlation of a lottery with the firm's portfolio
corresponds to a higher premium to the firm's price for the lottery over the riskneutral lottery price. The opposite holds when the firm is in good financial health.
2. The equation for security market line of the CAPM is a special case of the
marginal price of risk equation derived in Eisenberg (2007).
4. At a critical probability that the firm's value will be less then the floor the firm's
management switches from averting risk, as measured by the variance of the firm's
equity, to preferring risk.
5. When a firm is in bad times, the firm will price its own portfolio at a premium.
Management prefers an increase in scale, that increases risk over leaving the scale
unchanged or reduced. In good times the opposite holds.
6. The firm's forward price for its asset-liability portfolio equals the floor.
7. If regulators respond to a downward shock to the economy by reducing the risk
of markets, they will make it more difficult for firm in bad times that have violated
their VaR constraints to satisfy them without an equity infusion.
8. Extrapolating the results of the static model investigated here with sequence of
myopic static models, given an unchanging multivariate distribution for traded
lotteries, management that maximizes the expected value of the firm's portfolio will
become more risk neutral over time.
Of these results perhaps the first is the most important. Basel II encourages those
firms with the greatest systemic risk, the large banks, to use VaR constraints, and
banks that are subject to VaR constraints are likely take on more risk when they are
in trouble thus placing the banking system at greater risk when it is more vulnerable.
1.3 Systemic Risk, Firm Size and Basel II
Basel II allows banks to choose between the standardized and internal ratings
based (IRB) approaches. The latter requires an extensive investment in information
technology. Due to the cost of implementing the IRB approach large banks are more
likely to choose it (Hakenes and Schnabel, 2006) than small banks. Because default
by firms with greater liabilities pose a greater systemic threat than default by firms
with less liabilities, Basel II encourages those firms that could pose the greatest

systemic threat to the financial system to operate with a VaR constraint; and firm's
that have such a constraint may be taking on more risk when the financial system is
more vulnerable. For a review of the literature through 2006 on the effect of Basel II
on risk-taking of banks by size and on aggregate risk the reader is referred to
Hakenes and Schnabel (2006). Recent papers on the IRB approach include Kwak
and Lee (2007) and Fees et. al. (2008).
In contrast to the partial equilibrium model used here, these papers, for the most
part, use general equilibrium models, so comparing results is problematic. It is
interesting to note, however, that (Hakenes and Schnabel, 2006) conclude that if
regulators were to apply the IRB approach uniformly across banks, then stability is
improved. The results here on the variance switching suggest otherwise. In the
partial-equilibrium static model used here, any firm whose manager maximizes his
firm's expected equity subject to a VaR constraint will increase the variance of his
firm's asset-liability portfolio when his firm is doing poorly. Variance switching may
have exacerbated the financial crisis of 2007-2009.
1.4 Variance Switching and the Financial Crisis of 2007-2009
1.4.1 Variance Switching, Margin Calls and Liquidity Spirals
The potential procyclical effects of capital requirements and margin calls are well
known. Regulations that require firms to reduce their positions in response to adverse
shocks may be responsible for amplifying those shocks through liquidity spirals and
other consequences. There is a substantial literature on determinants of liquidity and
market instability starting perhaps with Allen and Gale (1994). Studies since the
beginning of the 2007-2009 crisis include Brunnermeier (2009), Brunnermeier and
Pedersen (2009), and Huang and Wang (2009). There appear to be few studies, if
any, on the procyclical effects of what I call variance switching. However significant
a role margin calls or liquidity spirals played in this crisis, variance-switching may
have also played a role and bears further investigation.
1.4.2 Problems with VaR: Stuffing the Tails vs. Variance Switching
Variance switching provides some insight to the contribution of VaR regulations to
the financial crisis of 2007-2009. Among the many ways that VaR regulations may
have contributed to the financial crisis, it is commonly conjectured that VaR

regulations helped cause the financial crisis or made the crisis more severe via traders
"stuffing the tails", and that regulations using CVaR rather than VaR would prevent
tail stuffing.
Consider one-year 95% VaR which gives the maximum loss that occurs with a
probability of at least 5% in one year. This VaR is completely insensitive to losses
that occur with a probability of less than 5% in one year, so a constraint on one-year
VaR at the one-sided 95% for the firm's portfolio is unaffected by positions in a
trader's book that have less than a .5% probability of a loss. For example the sale of
an out-of-the-money put option that has less that a 5% chance of expiring in the
money in one year has no effect on one-year 95% VaR. However a drastic enough
drop in the market price of the put's underlying, can cause a loss orders of magnitude
greater than the revenue from the sale of the put.
Increasing variance when portfolio value is normally distributed is quite different
from stuffing the tails. Strictly interpreted, stuffing the tails can be viewed as altering
the functional form of a distribution. However, one can move large losses to the tails
of a normal distribution and still have a normal distribution.
Consider a portfolio of credit default swaps (CDS) that we model as normally
distributed. By underestimating the correlations to the bonds underlying the CDS,
the CDS is estimated as having a low variance. 5% of the area of a standard normal
density lies below approximately -1.65. Let ! denote the value of the CDS portfolio

with non-standard normal parameters !!" " ", then ! # ! $ " % with % & '!(" )".

Suppose the current value of the CDS portfolio is ! and its true " is $100 million.
Suppose also that because the correlations of the underlying bonds to the CDS are
^ is $20 million. Then the estimated 95% VaR is a
underestimated, the estimated "
loss of 1.65 times $20 million or $33 million, but the actual 95% VaR is $165
million. By underestimating " one can stuff the tails. That is we assign large losses
to a high-" move when they are in fact a low-" move. We stuff the tails by
underestimating " .
In contrast to stuffing the tails, variance switching has nothing to do with a biased
under reporting of variance. Variance switchers don't under report variance, they
change the actual variance; and sometimes they make it bigger rather than smaller.
One can sometimes lower the probability of large losses by increasing variance rather

than reducing it, that is by making more risky investments do not have a higher
expected value than less risky investments.
Increasing the variance reduces the probability mass in any finite interval, and as
the variance approaches infinity, the probability mass in any finite interval goes to
zero. When the portfolio value is normally distributed, the probability that the
realized value of the firm's portfolio is between the floor and the mean portfolio value
decreases as the variance increases.

As the variance approaches infinity the

probability that the portfolio will be less than the floor approaches one-half. If the
floor is greater than the mean portfolio value, then increasing the variance reduces
the probability that the portfolio value will be less than the floor. The opposite is the
case if the floor is less than the expected portfolio value. With variance switching,
the firm's preference for or aversion to volatility is evident in the risk premium of its
price for a lottery. The sign of the risk premium of the firm's price for a lottery
depends on the economic prospects of the firm and the correlation of lottery with the
firm's asset-liability portfolio, where the prospects are good if expected portfolio
value is greater than the floor.
Consider a firm "on its VaR constraint". That is the firm has a binding and
feasible VaR constraint. The firm's "constraint price" for a lottery is the cash traded
for the lottery that leaves the firm on its constraint after the trade. In a universe of
normal risks, consider two lotteries ! and * with the same expected payoff but ! has
a positively correlation with the firm's portfolio and * a negative correlation. As
shown here, in bad times, the firm's constraint price for ! will be higher than that for
*. In fact the constraint price for ! will be at a premium to the risk-neutral price for !
and the firm's constraint price for * will be at a discount to the risk-neutral price for
*.
1.5 A Sequence of Myopic Two-Date Model and Long-Term Risk Neutrality
1.51 Assumptions to a Sequence of Myopic Two-Date Models
We gain a key insight into the dynamic effects of VaR regulations by considering a
sequence of the dates where the static model considered here is used myopically.
Given a stationary multivariate distribution for all traded lotteries, firms will become
risk neutral. Because the assumptions are restrictive the conclusion that firms will

become risk neutral is not intended as a prediction. Rather its is cautionary and
provides a benchmark for non-myopic models.
In the static model used here, the firm trades on the first date with the goal of
maximizing the expected value of its asset-liability portfolio on the second date
subject to a VaR constraint. Consider a daily sequence of models where each model
is the two-date model analyzed here. This implies that the firm has: 1) a rolling
horizon equal to the time between the two dates in the static model and trades
myopically; 2) VaR regulations require firms to be in compliance at the close of
business; 3) there are no exogenous changes in the parameters of the multivariate
density.
1.52 Endogenous Changes in Portfolio Variance and Changes in the Firm's Risk
Preferences in a Sequence of Myopic Two-Date Models
Consider how changes in the variance of the firm's portfolio due to trades executed
by the firm affect subsequent trading decisions. In bad times, the firm seeks to
increase portfolio variance, and in good times the firm does the opposite.
Increased portfolio variance in bad times decreases the absolute value of risk
premiums, so increasing portfolio variance moves the firm towards risk-neutral
pricing. In the limit as the firm's variance increases to infinity, the firm's prices
become risk neutral. In bad times one could infer the firm moves towards risk-neutral
pricing but more slowly as it's variance increases. More slowly because the premium
at which the firm it requires to sell a lottery that increases its variance decreases, and
the discount it is willing to buy lotteries that decrease its variance increases.
Once the firm becomes risk neutral if the market rewards higher variance with
higher return, then the firm's variance will increase very fast as it seeks to maximize
expected value without regard to risk. If the market does not reward increased
variance with greater expected return, the evolution of the firm's variance and
expectation once the firm becomes risk neutral is ambiguous.
Decreased portfolio variance in good times, increases the absolute value of risk
premiums, so the firm will reduce its risk at an accelerating rate. There are two
possible medium-term outcomes for the composition of the firm's portfolio and for its
attitude towards risk.

The firm will convert its portfolio to the risk-free asset

completely, or it will do partially because the expected value of the firm's portfolio
value will equal the floor before the portfolio is completely converted.
Which occurs depends on the market price for the firm's portfolio. If the market
price for the portfolio is less than the floor discounted at the risk-free rate, conversion
will be partial, and the firm will be risk-neutral. If the market price for the portfolio
equals the discounted floor, then conversions is complete and the firm is completely
risk neutral. If the market price of the portfolio is greater than the discounted floor,
coversion will be complete and the firm will not be risk neutral.
If the market rewards greater risk with greater expected return, then the firm's
initial portfolio (before conversion) will be priced by the market lower than a
quantity of the risk-free asset with the same expected payoff as the initial portfolio.
Hence conversion will be partial and the firm will become completely risk neutral.
1.6 Exogenous Changes
1.61 Exogenous Changes to the Portfolio Mean
An exogenous downward shock to the portfolio mean may cause the firm to be in
violation of its VaR constraint. Also the constraint may no longer be feasible without
external equity. If the firm does not issue equity, and the current constraint is not
feasible, then floor or the maximum tolerable probability of reaching the floor will
have to be reset. The firm may have to trade to adjust the distribution of its portfolio
to satisfy the new feasible constraint. The model analyzed here says nothing about
how a VaR constraint would be reset.
A VaR constraint may remain feasible after an exogenous downward shock to the
portfolio mean. The firm will have to alter the composition of its portfolio to satisfy
its constraint by raising the portfolio mean or reducing (increasing) the portfolio
variance if the firm is in good (bad) times.
An exogenous upward shock to the portfolio mean will cause the firm to become
more conservative in its risk preferences.
1.62 Exogenous Changes to the Portfolio Variance
Because there are endogenous changes in the portfolio variance, one time shocks to
the variance should not affect portfolio variance over longer periods.

10

1.7 Advice for Regulators

1.7.1 Short and Long-Term Consequences
Regulators need to be aware that firms in trouble may switch from seeking to
reduce risk as measured by the variance of their asset-liability portfolios to increasing
it when the expected payoff of the firm's portfolio is low relative to the floor. Basel
II encourages those firms with the greatest systemic risk, the large banks, to use VaR
constraints, and banks that use VaR constraints are likely take on more risk when
they are in trouble placing the banking system at greater risk when it is more
vulnerable. More generally regulators need to consider the potential procyclical
effects of their regulations of which variance switching is one. Also, there may be
longer-term consequences of VaR regulations.
If firms behave in accordance with a sequence of myopic two-date models, then
given no change in the multivariate distribution of traded lotteries (the weights of the
lotteries in the firm's portfolio can change), firms may eventually move towards riskneutral pricing. While one be must skeptical about modeling financial decision
making with a sequence of myopic two-date models, the implications of such a
sequence are a warning to regulators and can be used as a benchmark prediction for
dynamic models.
1.7.2 CVaR vs. VaR and the Uses of VaR
VaR can be used in basically three ways: passively, defensively or actively (Jorion,
2001). These are: to monitor risk, to set limits or to allocate risk. An allocating of
risk can be viewed as the solution to a constrained optimization problem where the
limits are the constraints. If so, one cannot use VaR actively unless one also uses it
defensively. To use VaR defensively, one must measure VaR; so VaR cannot be
used defensively unless it is used passively.
Regulations could stipulate passive, defensive (hence also passive), or passive,
defensive and active use of VaR or CVaR. CVaR may be superior to VaR for
passive and defensive use. It is not clear that it is superior for active use.
Used to monitor risk CVaR or expected shortfall is commonly viewed as preferable
to VaR because one cannot stuff the tails with CVaR. Because the CVaR of a firm's
portfolio is the expected value of the portfolio up to its floor level, CVaR is sensitive

11

to even highly improbable events. There is another benefit to using CVaR to monitor
risk.
Not all firms are always in compliance with regulations. The variance switching
results in this paper and in Eisenberg (2008b) hold for a firm whose constraint is
binding and feasible and is in compliance with its VaR constraint. For firms that are
not in compliance with their constraint, but accurately report their exposures, there is
good news for CVaR relative to VaR. CVaR provides more information about tail
risk for all firms including those that are non-compliant. The fact that on its VaR or
CVaR constraint a firm is a variance-switcher may be irrelevant to firms outside of
their constraint.
To set limits, there are many way that VaR or CVaR can be used. The limits may
be defined in terms of VaR, deltas and gammas, number of positions or notional
exposure. Limits on VaR are VaR constraints, and VaR constraints have implications
for the allocation of risk, so this defensive use of VaR cannot be separated from using
VaR actively. More generally, the implications of using VaR to trigger limits defined
in terms of some other risk measure depend on the specifics of what the limits are and
how they are set. Used defensively CVaR might be superior for the same reason it
may be superior to monitor risk: CVaR is sensitive to improbable events.
To allocate risk, however, it is not clear the CVaR is superior to VaR. The firm's
constraint price when the firm has a CVaR constraint will usually be very close to the
firm's constraint price with a VaR constraint (Eisenberg, 2008b). With a CVaR
constraint, the price has two terms. The first term is the constraint price when the
firm has a VaR constraint, and the second term, subtracted from the first, has a
magnitude equal to that of the lottery payoff divided by the portfolio floor. In
general any lottery will be of smaller magnitude than the firm's portfolio and its floor,
so the first term dominates; and the risk premium to the constraint price with a CVaR
constraint will be close to that with a VaR constraint. Hence the constraint price risk
premium will be about the same under either constraint.
The bad news about switching to regulations that stipulate the defensive (with
CVaR limits) or active use of CVaR is that, as with a VaR constraint, when the firm
is on its constraint the firm is a variance switcher. The risk allocation decisions of a
firm with a VaR constraint should not differ much from its decisions with a CVaR

12

constraint. For firms that do not violate their constraints, whether the constraint is a
VaR or a CVaR constraint should not matter.
1.7.3 Conservative Strategies
When the management of a firm that has a VaR constraint claims to adopt a more
conservative strategy by seeking a higher credit rating, such a change may imply that
the firm will, counter to intuition, take on more risk as measured by variance with
either constraint. The reason is that if aiming for a higher credit rating implies
aiming for a greater capital buffer and hence a higher floor, then the firm may be
raising the floor to its VaR constraint.
1.8 Advice for Managers
First, astute financial managers already know that monitoring risk using numbers
from VaR reports is no safeguard against stuffing the tails. Those who don't already
know should.

This means that management most impose constraints on the firm's

risk in addition to the VaR constraints currently required by regulators.

Second, managers should be aware that if: 1) they seek to maximize the value of
the firm's asset liability portfolio; 2) they model risks as normal; 3) their VaR
constraints are binding and 4) their trades are consistent with their objective; then
even if they have not been aware of the results in this paper, they will trade as if they
have been explicitly using these results. The implication is that in bad times even if
they have not violated their VaR constraint, they may be increasing their firm's risk.
Third, as mentioned using a CVaR constraint may cause the same risk-taking
behavior as a VaR constraint. However because CVaR is linear it is a much more
convenient measure to use than VaR.2 For this reason, perhaps more than any other,
CVaR may be preferred to VaR.
Fourth, as mentioned above, consider a manager who 1) already is maximizing
expected equity value subject to a VaR constraint; 2) wants to increase the firm's
expected equity as represented by increasing the floor to the firm's VaR constraint; 3)
does not change in the universe of tradable securities (or projects, such as those
newly available due to technological advances). To achieve his objective this
2Properties

of the measure VaR are different from those of the constraint price with a VaR
constraint. The latter is additive, and therefor subadditive. The former is not subadditive.

13

manager must increase the firm's risk as measured by variance. While it may seem
obvious when a manager seeks greater growth he may take on more risk it is less
intuitive that he may take on more risk when he become "more conservative" by
seeking a higher credit rating via raising his floor.
1.9 Structure of the Paper
Section 2 discusses variance-switching behavior, and reviews the literature on this
topic. A manager who is a premium switcher may switch between paying a premium
over the risk-neutral price of a lottery (the residual risk of a hedge, policy, financial
security or contract) and paying a discount without a change in the correlation any
lottery with any other lottery.
Section 3 compares and contrasts variance switching with asset substitution.
Section 4 reviews results from Eisenberg (2007) used here.
Section 5 discusses properties of the risk premium to the firm's constraint price for
a lottery.
Section 6 shows that a firm will seek to increase the size of its portfolio rather than
doing nothing when it is bad times.
Section 7 discusses how a firm that is in violation of a feasible VaR constraint can
change its portfolio to satisfy the constraint.
Section 8 concludes.
Proposition proofs are in the Appendix where ! denotes the end of a proposition
proof. Otherwise it denotes the end of a definition or proposition statement.
2. Variance Switching
Standard asset pricing models such as the Capital Asset Pricing Model (CAPM)
(Litner; 1965a, 1965b; Mossin, 1966; Treynor, 1961) or Arbitrage Pricing Theory
(APT) (Ross, 1976) make no inferences made about the state of a firm and its price
for risk. VaR regulations are, intentionally, are about the state of a firm. Though not
motivated to influence a firm's price for a lottery, VaR regulations have consequences
for how a firm prices risk. The price is a reservation price, and it is specific to the
firm. Given market prices the firm may trade a lottery or it may not.
In standard asset pricing models, the risk premium for a lottery cannot change sign
unless its correlation with the market or with a factor changes sign. However with a

14

VaR constraint the firm's constraint price for a lottery can have a risk premium that
changes sign without any change in the lottery's correlation an underlying factor or
another lottery. A change in the firm's financial health changes the risk premium of
its price for a lottery. A small change in firm's financial health can cause the firm's
price for a lottery to change sign.
When a portfolio has a high probability of beating a benchmark, decreasing the
variance raises the probability of beating the benchmark and increasing the variance
has the opposite effect. However when the portfolio has a low probability of beating
the benchmark, these effects are switched. If the benchmark is the amount owed to
creditors or a level that represents the liquidation drawdown for a hedge fund, then if
the manager does not beat the benchmark the firm goes bankrupt or the fund is
liquidated. Survival of the firm or fund, and perhaps the manager's employment and
future employment opportunities, may depend on beating a benchmark.
A rough analogy with biology is the flight or fight response of a cornered animal.
When successful flight is probable it may be a low-risk strategy, but when it is not,
the strategy to fight, if the outcome is more uncertain - the animal may win, may be
better than an almost certain (and hence low risk) death.
Variance switching, though not so named, is not new to the economics and finance
literature. Basak and Shapiro (2001) embed risk management objectives in a utility
maximization framework to obtain a result similar to one of the results here. Using
CRRA preferences and lognormal prices, they show that portfolio managers with a
VaR constraint tend to have larger losses in unfavorable conditions relative to
managers who do not have a VaR constraint.
Regarding a notion fundamental in microeconomics, profit maximization, Radner
(1995) argues against the hypothesis put forth by Friedman (1953). Radner argues
firms that maximize profits have the greatest chance for survival, and he posits that
the fraction of profit-maximizing firms that survive is negligible. One of his results
is that firm with little wealth will behave as if they are risk lovers, and firms with
great wealth will behave as if they are more risk averse.
More recently Jarrow and Purnanandam (2004), introduce a theory of the firm that
has implications for capital structure, capital budgeting, and liquidity. In their model
there are three states of the world: no default, default, and insolvency. Before a firm
becomes insolvent, it must default. Default occurs when the firm violates some

15

covenants with its debt holders. Such a model implies that the firm is risk-averse as
long as it is not at the default state. Once in default, but not yet insolvent, the firm
switches to risk-preferring from risk averting behavior (Jarrow, 2004). There are also
empirical studies of mutual fund managers this suggest these managers engage in
variance switching.
Some mutual fund tournament studies conclude that losing managers (those with
lower than average returns partway through the year) have more volatile funds and
winning managers the opposite. Brown et. al. (1996) confirm this hypothesis in
examination of monthly data on growth-oriented mutual funds.

Research

consistent with this conclusion includes Bronars (1987), (McLaughlin, 1988) and
Ehrenberg and Bognanno (1990). Chen and Pennacchi (2001) obtain similar results
to Brown et. al. (1996) but for tracking error to a benchmark index rather than
variance.
Variance switching, not surprisingly, is also related to the asset substitution (Black
and Scholes, 1973; Jensen and Meckling, 1976) or risk shifting problem.
3. Variance Switching Compared to the Asset Substitution Problem
Economic intuition suggests that a company in good financial health should be
more conservative than one close to bankruptcy. Shareholders have much more to
lose from bankruptcy if their firm is doing well and their equity is worth a lot than if
the firm is close to failure and their equity is nearly worthless.
Readers familiar with the asset substitution problem will recall that a far-out-ofthe-money option has a much greater percentage increase in value from increasing
volatility than a deep-in-the-money option. In the context of the asset substitution
problem the out-of-the-money option is the equity of a nearly bankrupt firm and the
deep-in-the-money option is the equity of a firm that has little chance of failure.
Hence shareholders benefit more from a more aggressive or risky strategy when the
firm is doing poorly.
With both variance switching and asset substitution, equity holders benefit more
by increasing risk when the firm is in trouble than when it is not. There is however a
key difference between the variance switching and asset substitution. With variance
switching sometimes shareholders benefit from increasing risk and sometimes by
decreasing it because their firm stays in compliance with its VaR constraint. Their

16

firm is not shut down by regulators, nor is their equity diluted due to issuance of new
shares. In the asset substitution problem shareholders always benefit from increasing
risk.
The usual statement of the risk shifting problem describes a conflict between bond
holders and equity holders as justified by put-call parity and the commonly stated
assumptions to the Black-Scholes option pricing model (Black and Scholes, 1973):
complete markets, geometric brownian motion asset returns, and assets with a
lognormal distribution.

The risk shifting problem is can also be stated with

arithmetic brownian asset returns, a modified option pricing model and assets with a
normal distribution.
As described in standard elementary finance textbooks, when the firm has only
zero-coupon bonds outstanding, all with the equal priority and the same maturity
date, then equity can be represented as a call option on the assets of the firm; and by
put-call parity the firm's debt can be represented as default-free debt minus a put
option on the assets of the firm. So if a change in the asset distribution increases the
value of the call without increasing asset value, equity holders benefit at the expense
of the bond holders.
Because a standard option is monotonic increasing in the standard deviation " of
the returns of its underlying, according to the asset substitution problem equity
holders will always benefit by an increase in " . Hence equity holders will always
seek to make the firm more risky.
However the equity holders' gains are at the expense of the bond holders.
Intuitively one can see why a standard option is monotonic increasing in " under the
Black-Scholes assumptions.

Based on these assumptions calls and puts are the

expected payoffs of these options using risk-neutral probabilities (the expectation

using actuarial probabilities and discounted at the risk-free rate).
Increasing " moves probability mass to the tails for a normal variate Because the
value of a call option is the discounted expectation of underlying values greater than
the option's strike price, moving mass to the tails increases the value of the option for
both types of variates by increasing the probabilities of more extreme values. By putcall parity an increase in the call's value due to an increase in " must be matched an
identical increase in the put's value. Increasing " has another effect and this effect is
important for variance switching.

17

For the normal distribution increasing " lowers the probability mass over any
finite interval. Consider the special case of a probability-of-ruin constraint. In the
variance switching problem the probability that the firm's bonds pay their face value
at maturity is the focus rather than the bonds' expected payoff.

In bad times

increasing " lowers this probability and in bad times increasing " has the opposite
effect. In the asset substitution problem independent of the level of the option strike
relative to expected asset value increasing " always reduces debt value.
4. Preliminaries
4.1 VaR Constraint
A VaR constraint, otherwise known as a Telser safety-first constraint (Telser,
1955-56) is given by the inequality
+ ,-./% 0 2 1 # 3 /% ; 2 1 0 + 4

(1)

where % 5 the firm's value (payoff) realized at Date 1, 2 5 the floor to firm's value
at Date 1, and + 4 5 the manager's maximum tolerable probability and 3 is the
cumulative probability distribution function that is absolutely continuous. A special
case of a VaR constraint is a probability-of-ruin constraint where the asset-liability
floor 2 is zero.3
From Eisenberg (2007) a manager's reservation bid or offer for a lottery (a contract
or project) given that the his objective is to maximize the expected value of his firm's
asset-liability portfolio subject to a VaR constraint is an expectation: the
unconditional expectation of the lottery or its conditional expectation given that the
firm or portfolio equals a "floor" level chosen by the manager.
Consider a firm with a binding VaR constraint that trades a lottery forward for cash
(the cash and the lottery are exchanged at Date 1), and is still on its constraint (the
constraint is feasible and binding) after the trade. For example, a firm buys forward #
units of an insurance policy (# 6 () with a non-negative payoff *. % is the payoff to

the firm's risky portfolio prior to the sale of the policy, and 2 !#" 7 " 5 % $ # * $ 7

is the payoff to the portfolio with # units of * added to % plus a cash payment 7 per
3In

the simple case where liabilities due on the second date are not random, as with zerocoupon bonds that all mature on date 1, a VaR constraint with an asset floor equal to the face
value of the zero-coupon bonds is also a probability-of-ruin constraint.

18

# units of the lottery. If the firm is on its VaR constraint prior to trading *, then
+ ,-./% 0 2 1 # + 4 . If the constraint is still feasible and binding at the initial date
with equality after contracting forward to receive on date 1 # units of * and cash 7 ,
7 8 (, then the firm remains on its constraint after the trade

+ ,-./2 !#" 7 " 0 2 1 # + ,-./% $ # * $ 7 0 2 1 # + 4 9

(2)

One can think of # and 7 as control variables that can be adjusted so that
+ ,-./2 !#" 7 " 0 2 1 # + 4 .

The firm is the buyer and has a forward cash outflow or a forward negative cash

flow 7 8 ( . The average forward price per unit of the lottery is :

7
#.

Note that if

instead of buying the policy the firm sells the lottery, then # 8 (. The forward cash
flow per unit of the policy and the forward price do not change, but since #" 7 8 (,
the firm's forward cash flow for selling | # | units of the policy is # 7 6 (.
In contrast to the average forward price,

;7
;#

the marginal forward cash flow per

unit of the lottery * is

;7
# :
;#

<
< # + ,-. /2 !#" 7 "

<
<7 + ,-. /2 !#" 7 "

0 2 1#

##(

0 2 1#

(3)

##(

4.2 Marginal price of risk with a VaR constraint

Suppose the firm trades ; # units of lottery *.

;7
;#

is the marginal forward cash flow

per unit of the lottery * that leaves a firm on its constraint.

;7
;#

equals the negative of

the conditional expectation of the lottery's payoff given the payoff to the firm's total
portfolio equals the floor (floor event). Let *("= denote the spot marginal constraint
price for *
;7
# : C:,$ *("= A *("= # >? * @% # 2 B9
;#
;7
;#

(4)

is the cash flow per unit of the lottery * is opposite in sign to the conditional

expectation because the firm has a cash outflow when it buys a lottery with a positive
payoff. The marginal spot price per unit of * on the constraint is equal to the
forward price on the constraint *("= discounted at the riskless rate DE : *( # DE:) *("= .

19

We need to make a distinction between the firm's constraint price and its bid and
offer prices. When the VaR constraint is binding, the firm's bid price for a portfolio
of lotteries is not, in general, equal to its offer price. The manager's goal is twofold:
(a) to maximize the firm's expected value and (b) to satisfy his VaR constraint.
The manager's first goal implies the firm's forward bid price for a lottery cannot be
greater than the lottery's expectation, and the second goal implies, the firm's forward
bid price cannot be more than the lottery's conditional expectation. Hence the firm's
reservation forward bid price is the minimum of these two expectations. By similar
reasoning, the firm's offer price is the maximum of the expectations:
forward bid # $

>*
FG'H>*" >? * @% # 2 BI

forward offer # $

>*
FJ!H>*" >? * @% # 2 BI

non-binding VaR constraint

(5)
binding VaR constraint
non-binding VaR constraint
binding VaR constraint

Note that if the forward market bid is lower than the firm's forward offer and the
forward market offer is greater than the firm's forward market bid, then the firm does
not trade *. For the rest of the paper, unless explicitly stated otherwise, constraint
price will mean the marginal forward constraint price with the understanding that
when the constraint is binding the bid or offer must equal the constraint price.
An analog to equation (5) holds for the price of a portfolio of lotteries. Let ! K %'
denote the vector of payoffs for all the lotteries that trade. The firm's portfolio prior
to the trade has a payoff at date 1 denoted by % # ! L ! the dot product of the lottery
payoff vector ! with an initial portfolio vector ! K %' .

When the firm trades a

portfolio " ! of lotteries !, it adds ! L " ! to the firm's prior portfolio, % , to end up
with the portfolio ! L " ! $ % . From [0] the forward cash flow ;7 that leaves the
probability of breaching the floor unchanged is
;7 # : !("= L " !A !("= # >? ! @ % # 2 B.

(6)

Again, the signed cash flow is the negative dot product of the lotteries' conditional
expectations given that the portfolio equals the floor event with "!. To determine
the price per unit of this portfolio define # to be a vector of 1's with the same
"!
" !L# , then the forward
with ""!L!# substituted for

dimension as !. Also define 1 unit of the portfolio " ! to be

constraint price for one unit of "! is given by equation (6)

20
"! and the spot constraint price is DE:) !("= L
price as :

;7
;#

"!
" !L# .

Alternatively to write the forward

denote a portfolio of lotteries the firm trades as " 5 !&) " &M " 999" &' "

where " L # # ) and there are ' tradable securities. Then we can also write equation
(6) as
;7
# : !("= L "A !("= L " # >? ! L " @ % # 2 B # >? ! @ % # 2 B L ".
;#

(7)

4.3 Constrained Maximization Problem

From Eisenberg (2007) for distributions that include the multivariate normal given
the assumptions: (a) everywhere differentiable market supply-demand curves that
give the market price of a lottery as a function of the quantity of that lottery the firm
trades and (b) the manager's choice set of portfolios ! is compact, then there is a
global maximum !4 to the manager's constrained optimization problem. The firm's
bid and ask reservation prices for any marginal trade of a lottery or lotteries including
at the optimum !4 must satisfy equation (5) or its analog.
5. Risk Premium with Normal Risks
From the risk premium of the firm's constraint price we can infer the risk
preferences of the firm's management. If the premium is positive for a lottery that
has a positive correlation with the firm's portfolio, zero for a lottery with zero
correlation and negative when the correlation is negative; then the firm's management
values a lottery that will increase the variance of the firm's portfolio more than one
that does not. The main results to this paper are that for normal risks, given the
standard deviation of the firm's portfolio, the lottery and their correlation the risk
premium to the firm's constraint price can switch between negative and positive.
5.1 Vega of the Risk Premium
During usual business conditions, the floor is below the portfolio's expected
value. For lotteries that are positively correlated with firm value the risk premium is
negative. When conditions are less favorable, the premium switches sign. In bad
conditions the manager pays a premium for lotteries that increase firm variance. In
good conditions, he does the opposite. This section discusses the changing sign of

21

the risk premium. First we determine the risk premium to the constraint price with
normal risks by obtaining the constraint price.
5.2 Normal Constraint Price
The following proposition gives the marginal constraint price for a lottery * when

the portfolio 2 !#" 7 " is composed of % the firm's portfolio prior to trading * plus #
units of * plus cash 7 .

Proposition 1 Normal Pricing on the VaR Constraint: If the joint distribution for
the payoff of the portfolio and the lottery N!%" *" is a bivariate normal distribution,
then the firm's marginal reservation price for a lottery with payoff * is given by
*("= #

;7
:
# : C:,$ ? ' $ :
* B # : C:,$ ? ( !*2 !#" 7 ""/2 : 2 !#" 7 "1 $ :
* B. /81
;#

#" M /*1 $ #% " !*% "

:
' 5 ( !*2 !#" 7 ""/2 : 2 !#" 7 "1; ( !*2 !#" 7 "" 5
.
" M /2 !#" 7 " 1
' 5 risk premium
, 5 continuous risk-free interest rate
$ 5 time between date ( and date )
2 5 floor
7 5 forward payment contracted at date 0 and received at date 1
in exchange for payoff of # units of * at date 1

2 !#" 7 " 5 % $ # * $ 7" the portfolio payoff at date 1 forward

payment contracted at date 0 and received at date 1

:
O 5 expected value of O" O # *" %" 2 !#" 7 "

#% % 5 portfolio prior to adding # units of * and cash 7

% 5 portfolio prior to adding # units of * and cash 7 if #% # )

"!*P" 5 covariance of * and P" P # %" 2 !#" 7 "

)!*P" 5 correlation of * and P" P # %" 2 !#" 7 "

"!O" 5 standard deviation of O" O # *" %" 2 !#" 7 "

(!*2 !#" 7 "" 5

" !*2 !#"7 ""

" M !2 !#"7 ""

/91

22

!
5.3 Price of a Small Normal Lottery
Next we obtain the marginal constraint price when the firm trades a "small" lottery.

Whatever definition is used for 1 unit of * and 1 unit of % , #" !*" and #% " !% " are
invariant to them.

Given a definition for one unit of the lottery there is a standard

deviation to that unit " !*". Given #% there is a standard deviation " !% " to the
diversified portfolio prior to the inclusion of the lottery.

Whatever arbitrary

definition for these units is used # " !*" and #% " !% " are invariant to them.
simplify notation let #% # ) Let * 5
is

small

when

* # (.

# " !* "
# % " !% "

Define

To

will say a lottery relative to the portfolio

one

unit

of

*.

Given

" !*",

lim *!#A #% " " !% "" " !*"" # (. Note that when # # ( the cash 7 exchanged for # * is

#Q(

also (. Taking the limit of

;7
;#

from proposition 1 as both # and 7 go to zero we get

the result of the next proposition.

Proposition 2 Small Normal Contract: The spot constraint price for a small lottery
* is
*("= # C:,/= :R1 lim

*Q(

;7
= : C:,/= :R1 ?(!*% "/2 : :
%1$ :
* B9
;#

(10)

!
To get the bid ask price from equation (5) when the VaR constraint is binding
:
C:,$ ( !*% "/2 : 21 $ :
*
%1 8 (
( !*% "/2 : :
bid # $ :,$ :
(11)
C *
%1 S (
( !*% "/2 : :
offer # $

C:,$:
*
%1 0 (
( !*% "/2 : :
:,$
:
:
C ( !*% "/2 : % 1 $ * ( !*% "/2 : :
% 1 6 (9

(12)

The sign of the risk premium depends on the beta of a lottery with the firm's
portfolio and the firm's financial health as in this definition.
Definition 1 Bad, Neutral and Good Times: A firm is in bad (good) times when
the expected value of its asset liability portfolio is less (greater) than the floor9 When

23

they are equal the firm is in neutral times. Note that this definition holds for firms in
violation of their VaR constraints as well as those in compliance.
% 6 ( bad times
:
2 : % & # ( neutral times
' 8 ( good times

(13)

!
Proposition 3 Variance Switching with Normal Risks When the firm is in bad
times it has a preference for risk, and when it is good times it has an aversion to risk
as summarized in table 1.

The firm's economic condition (good, neutral or bad

times) and the sign of the correlation of the lottery with the firm's portfolio determine
the risk premium of the firm's constraint price.

[TABLE 1]
!
5.6 Critical Probability Behavior Switching
Note that

_
%:%
"!% "

is a standard normal variate.

With T :) denoting the inverse

% :%
cumulative distribution function for the standard normal, let + 4 5 T ( :"!
% " ) is the
_

probability that the firm's floor is breached when the firm is on its constraint, then
_
2 :%
T :) !+ 4 " # :
9
(14)
"!% "
Suppose the firm's cash and non-stochastic obligations fix the floor, then the mean of
the firm's portfolio determines the firm's variance switching behavior. One can ask at
what value for the portfolio mean does the firm switch between preferring and
averting risk, i.e. at what value for the mean is the firm risk neutral. Alternatively if
the firm is considering whether to issue equity or debt with non-stochastic payments,
one can ask at what floor, given the portfolio mean, is the firm risk neutral.
Definition 2 Critical Probability $% and Floor &%

24

a) Given the multivariate distribution of the firm's portfolio % and all lotteries, the
constraint price risk premium ' for all lotteries is ( for % # 2U , the critical floor.
That is, using the constraint price from equation (4), for any lottery *, % # 2U solves
' # >? * @% # 2U B : :
* # (.
b) The critical probability +U is the value of the cumulative distribution 3 of the

firm's portfolio evaluated at the critical floor 2U . That is 3 :) !+U " # 2U 9

If 3 is a non-standard cumulative normal, then normalizing to get the standard c.d.f.

3 :) !+U " # 2U becomes T :) !+U " #

:
2U :%
"!% " .

Note that T :) !+ 4 " switches sign at

+ 4 # )M , and the floor equals the mean. As + 4 increases from below to greater than )M ,
the firm switches from being variance averse to preferring variance.
Proposition 4 Critical Values for Good or Bad Times with Normal Risks
a) 2U # :
% and +U # ) .
M

b) On a VaR constraint with parameters + 4 and 2 " + 4 6 +U , V 2 6 2U # :

% V the
firm is in bad times and ' is positive (negative) for lotteries that increase (decrease)
the firm's risk. For + 4 8 +U , the inequalities are reversed.
!
To better understand variance switching, we examine in detail the risk premium to
the firm's constraint price when risks are normal.
5.7 Risk Premium Examples
Because the risk premium to the firm's constraint price is our main interest we
examine the premium for normal risks in more detail.
5.7.1 Sign of the Risk Premium for # W (
Using proposition 1 suppose in (8) that the insurance company has sold insurance
*, and is selling more: #, ; # 8 (. * has a non-negative payoff for the insured. By
selling ; # units of *, the insurer has a liability, a short position in a non-negative
valued asset. The insurer gets positive cash inflow for increasing its short position in
*, ;7 6 (, so the left-hand side is negative.

25

What is the sign of the right-hand side? Under usual conditions, business is sound,
:
and the expected value of the asset-liability portfolio 2 !#" 7 " # :
% $ #:
* $ 7 is
above the floor

:
normal conditions X ( 6 2 : 2 !#" 7 ".

(15)

Next examine #" M !*" $ ) !*% " " !*" " !% ". For a short position in *, #" M !*" 8 (.

Suppose first that * is uncorrelated with any asset, held short or long, in 2 , that

) !*% " # (. In this case ) !*% " " !*" " !% " # (. Multiply (15) by #" M !*" and get a
positive number. Multiply again by : C:,$ and add : C:,$ :
* . The right-hand side
is negative as it should be in this case.
5.7.2 Zero Correlation Risk Premium
5.7.2.1 # # ( and ) !*% " # (

When #, ) !*% " # (, the price of the lottery reduces to the present value of the

expected payoff.

;7
# : C:,$ :
* .
;#

(16)

_
5.4.2.2 2 : 2 !#" 7 " # (

When the expected level of the diversified portfolio is the floor level, then the risk

charge is zero.
5.4.3 Sign of the Risk Premium with )!*% " # (" # W 0

The risk charge is the part of the price that is not due to the expected loss of the
lottery :
* . This charge in the case of ( correlation and before time discounting is

,GYZ U[J,NC # :

:
/2 : 2 !#" 7 "1 #" M !*"
9
" M /2 !#" 7 " 1

Going forward we will use the small contract price.

5.8 SML of the CAPM

(17)

26

When the firm's portfolio is the market portfolio and the floor is the market
portfolio compounded at the risk-free rate the small-contact price equation, equation
(10), expressed in return format is the security-market line (SML) equation of the
CAPM (Litner; 1965a, 1965b; Mossin, 1966; Treynor, 1961). Hence the SML is a
special case of equation (10). This is a claim only about the SML equation. The
CAPM is a general equilibrium model, so it cannot be a special case of a partial
equilibrium model.
Proposition 5 CAPM's SML as a Special Case: Let the firm's floor equal the
market price &F( for the market portfolio, and the firm's portfolio be the market
portfolio times a scale factor &" then the formula for the firm's spot constraint price
for a lottery *, stated as a return is the equation for the SML for the expected return
of *9
!
Figure 1 below graphs the constraint price risk premium as correlation varies from
-1 to 1 and expected equity value (One of the problems with using the normal to
represent equity prices that it allows for negative values.) varies from -100 to 100
with the equity floor equal to 0. Hence the constraint is on the probability of ruin.
Figures 2 and 3 graph the bid and offer risk premiums respectively.
Given the distribution for the firm's portfolio there is a 1-1 correspondence between
the floor and the cumulative probability evaluated at the floor.

[FIGURE 1]
[FIGURE M]
[FIGURE \]
6.4 The Firm's Constraint Price for its own Equity
We can apply the constraint pricing formula not only to some lottery *, but also to
the firm's portfolio.

27

Proposition 6 Portfolio Constraint Price and Return: The forward constraint price
for the firm's portfolio %( equals the floor 2 9
!
6. Homogenous Risk Management
It is easy to show that in bad times, the firm's constraint price for its own portfolio is
at a premium. Because the firm's portfolio has a positive correlation with itself,
adding quantity increases the variance of the firm's portfolio. By contrast, from
proposition 1 the firm's constraint price for a lottery with negative or zero correlation
with the firm's portfolio will be respectively at a discount or risk-neutral. Hence in
bad times, management will prefer increasing risk via a homogeneous expansion of
the portfolio to leaving the portfolio and its risk unchanged. The opposite is true in
good times.
The following proposition says that when the firm is in trouble the firm prefers to
increasing its scale to doing nothing or reducing its scale. By increasing its scale the
firm increases the variance of its portfolio, so it is also increasing its risk. The
opposite holds in good times. The firm prefers contracting to doing nothing or
increasing its scale.
Proposition 7 Homogenous Risk Expansion (Contraction) in Bad (Good) Times:
In bad times the firm's constraint price for its own portfolio is at a premium. Because
the firm's portfolio correlation with itself is positive, the firm pays a premium to
increase risk via homogeneous expansion.
!
7. How to Satisfy a Feasible Constraint that is Violated
Exogenous shocks to the portfolio mean can cause the firm to be in violation of its
VaR constraint. If the constraint is infeasible without diluting shares by issuing more
equity, then the firm must issue new equity or reset the parameters to the VaR
constraint the floor 2 or the maximum tolerable probability of breaching the floor
+ 4 . The model examined here says nothing about how the constraint would be reset.
However if it is not reset, the firm must trade to alter the portfolio mean or variance

28
!!" " ". The following proposition explains how they must changed to satisfy the
constraint.

Curiously if regulators, the treasury of the Fed respond to a downward shock to the
economy by attempting to reduce the risk of assets it will make it more difficult for
firms in trouble (bad times) to satisfy regulatory constraints.
Proposition 8 How to Satisfy a Feasible Constraint that is Violated
(a) When the firm is in violation of a feasible constraint because of a downward shift
in the portfolio mean it can trade to increase the mean or lower (increase) the
portfolio variance in good (bad) times.
(b) Suppose a downward shock to the portfolio mean occurs with an upward shock in
the portfolio variance. If the portfolio mean cannot be increased, then in good times
the portfolio variance will have to be changed more than in bad times.
!
8. Summary
The goal of the paper has been to determine when a firm increases or reduces risk
with a VaR constraint; to provide some insight as to how a firm may use VaR and to
determine the consequences for the volatility of a firm. VaR is the most often risk
measure mentioned in Basel II and Solvency II (known as Basell II for insurers), yet
little is know about how firms use VaR. This study investigates the risk premium of
the marginal price of a lottery (contract, security or residual risk of a hedged
instrument) when a manager maximizes his firm's expected equity value subject to a
VaR constraint.
One result is "variance switching". A manager can "swing for the fences" when
the probability of that the firm's equity value will breach the floor is greater than a
critical level. This is evident when he pays a premium for a lottery that increases the
firm's equity variance when expected equity value is low. How low depends on the
bivariate distribution for a lottery (contract or financial asset) and the firm's portfolio.
Clearly regulations, meant to make the financial system more stable, that may
exacerbate volatility in bad economic conditions deserve greater scrutiny.
Specifically Basell II encourages large banks, via the IRB approach, to use VaR
constraints. Hence regulations meant to make the financial system more stable

29

encourage the banks that present the greatest systemic risk to the financial system to
become more risk when the system is most vulnerable.
This study is at the level of the firm. Embedding the setup used here in network
model such as Eisenberg and Noe (2001) might bear investigation.
Appendix
Proposition 1 Normal Pricing on the VaR Constraint
Proof: For the normal distribution, a change in # affects the two parameters of the
distribution:

;+ ,-./2 !#" 7 " 0 2 1

;#

(18)

:
<+ ,-./2 !#" 7 " 0 2 1 < " M /2 !# "1 <+ ,-./2 !#" 7 " 0 2 1 <2 !#" 7 "
#
$
9
:
< " M /2 !#" 7 "1
<#
<2 !#" 7 "
<#
Adding a small change in the amount of cash ;7 required to offset this change gives
(#

<+ ,-./2 !#" 7 " 0 2 1 < " M /2 !#" 7 "1

;#
< " M /2 !#" 7 "1
<#

:
:
<+ ,-./2 !#" 7 " 0 2 1 <2 !#" 7 "
<2 !#" 7 "
;
#
$
;7 +.
:
* <#
<2 !#" 7 "
<7

(19)

* can be thought of as the cash received by the customer who bought a policy from
the insurance company, so * S (9 The insurance company is short, so # 8 (. If the
insurance company sells an additional amount, ; # 8 (. The marginal price
Going forward we suppress !#" 7 "
;7
# :
;#

# :

,
.

:
<+ ,-./202 1 < " M /21
<+ ,-./202 1 <2
:
< " M /21
<# $
<#
<2
:
<+ ,-./202 1 <2
:
<7
<2

<+ ,-./202 1
< " M /21
<+ ,-./202 1
:
<2

:
: :)
< " M /21
<2 - <2
$
.
<#
< # /* <7 +

;7
;#

6 (.

(20)

(21)

30

The first factor in the first term on the left-hand side of (19) is the partial of a nonstandard cumulative normal with respect to " M /21:
2
<+ ,-./2 0 2 1
<
:
#
'/2A 2" " M /211 ; !!2 "
0
< " M /21
< " M /21 :]

(22)

2
<
)
: M
0 F/2A 2" " /211 ; !!2 "A
< " M /21 1M'" M /21 :]

(23)

:
:
F/2A 2" " M /211 5 1M'" M /21 '/2A 2" " M /2119
Changing variables to standardize, let ( /%1 5
'/( A (" )1 be the standardized normal.

:
2:2
" !2 " .

Let ( # ( /% 1 #

/241
_ :
2:2
" /21

(
<+ ,-./2/= 1 0 2 1
<
)
#
F/( A (" )1 " /21; !!( "
0
< " M /21
< " M /21 1M'" M /21 :]

(
<
'/( A (" )1 ; !!( "9
0
< " M /21 :]

and

(25)
(26)

We get a partial of the cumulative standardized normal. With + 5 " M /21

:
T /( /+ " 211 5 0

(
:]

)
:
:
'/( A (" )1 ; !!( " A ( /+ " 21 # /2 : 21+ : M

(27)
(28)

<T /( " + 1
<T < (
#
9
<+
<( <+
(29)

:
<T
<(
/2 : 21 : \
# '/( A (" )1 A
# :
+ MA
<(
<+
M

(30)

:
<T /( " + 1
/2 : 21 : \
# : '/( A (" )1
+ M"
<+
M

(31)

<T /( " + 1
<T < (
:)
#
:
: # : '/( A (" )1+ M 9
<2
< ( <2

(32)

:
:
: :)
;7
2 :2
< " M /21
<2
<2
.
# : 24 M
$
5
;#
M " /21
<#
< # 32 <7 3

(33)

This gives

and

Get

31

Also:

< " M /21

<
M
M
#
4/# " !*"1 $ M # #% " !*% " $ /#% " !% "1 5
<#
<#
# M4 # " M /*1 $ #% " !*% "59

(34)
(35)

Substituting for " M /21 obtain (4).

!
Proposition 2 Small Normal Contract:
Proof: Let *!#" 5

# " !* "
# % " !% "

consider small * . Substituting for *!#" in equation (16)

get for the forward constraint price

(36)

:
;7
/2 : 21/*!#"" !*"#% " !% " $ #% " !*% " 1
lim
# lim
$:
* .
#,7Q( ; #
#,7Q( ?/# " !% "1M * M !#" $ M! # " !% ""M ) !*% "*!#" $ /#% " !% "1M ]
%
%
Get the spot constraint price discounting at the risk-free rate
# lim : C:,/= :R1 2
#,7Q(

(37)

% $ #:
* $ 7 "1/*!#" $ ) !*% " 1 :
" !*" /2 : !#%:
$ *3 .
M
?* !#" $ M) !*% "*!#" $ ) ]
#% " !% "

If we define 1 unit of the firm's portfolio so #% # 1, then the spot constraint price is
given by equation (10).
!
Proposition 3 Variance Switching with Normal Risks:
Proof: The risk premium for a lottery when risks are normal is
' # (!*% "/2 : :
%1

(38)

by equation (10). ( !*% " 6 ( ^ ) !*% " 6 (, and the lottery if purchased increases the
standard deviation of the firm's portfolio " !% ". Similarly ( !*% " 8 ( ^ ) !*% " 8 (,
and the lottery reduces " !% ". In bad times 2 : :
% 6 (, so ) !*% " 6 ( ^ ' 6 (. Also

in bad times )!*% " 8 ( ^ ' 8 (.

Obtain Table 1.
!

In good times the inequalities are reversed.

32

Proposition 4 Critical Values with Normal Risks:

Proof: a) From equation (38) for any (!*% ", definition 2

' # ( !*% "/2 : :

% 1 # ) !*% " " !*" T :) (+U ) # ( ' T :) (+U ) # (
' +U #

)
and 2U # :
%9
M

(39)
(40)

b) By (a) and that the normal cumulative distribution is monotonic strictly increasing.
!
Proposition 5 CAPM's SML as a Special Case of the Constraint Price Equation:
Proof: Let
$ 5 time between date 1 and date 2
' 5 the number of traded lotteries
FF
( 5 market price of the market portfolio (The superscript denotes the
market's price for the market portfolio in contrast to the firm's
constraint price for the market portfolio.)
(( 5 the market portfolio where (( K %'
)( 5 the firm's portfolio where (( K %'
O( 5 firm's spot constraint price for O; *" F" % (O( in general is not equal to
the market price for O

D !O" 5

O
O(

# gross return on O; O # *" F" %

,!O" 5 net return on O # D !O" : ) # net return on OA O # *" F" %

, 5 continuous risk-free rate

DE 5 gross risk-free rate # C,

"!D !O"" 5 standard deviation of D !O"A O # *" F" %

"!,!O"" 5 standard deviation of ,!O"A O # *" F" %

:
D !O" 5 expectation of D !O"A O # *" F" %
:
, !O" 5 expectation of ,!O"A O # *" F" %

"!D !O"D !P"" # covariance of O and PA O # *" F" %A P # *" F" %

"!,!O",!P"" # covariance of ,!O" and ,!P"A O # *" F" %A P # *" F" %

33

)!D !O"D !P"" #

" !D !O"D !P""

" !D !O"" " !D !P"" A O

# *" F" %A P # *" F" %

Let: 1) FF
( be the market price for the market portfolio (( ; 2) the firm's floor
2 # &D E F F
( where & is a scale factor and 3) the firm's portfolio )( # &(( . Then
the SML of the CAPM for the expected return :
* is true if and only if the constraint
price is true. Hence the SML formula is a special case of the constraint price
formula. Equation (10) is the formula for the firm's spot constraint price. Making
substitutions into this equation we will get the SML equation.
From proposition 6, the firm's spot constraint price for its own portfolio %( equals

the floor 2 discounted at the risk-free rate D !E " X Hence %( # DE:) 2 . Substituting

for 2
%( #

the firm's constraint price for its own portfolio )( # &((

DE:) 2

&F F
( 9

is

That is the firm's constraint price for its portfolio &(( equals

the market price for &(( .

The beta of the prices of * and % in terms of the beta of their net returns is
( !*% " # 4

*(
5( !,!*",!% ""9
%(

(41)

:
Substitute D :) !E " for C:,$ ( %*(( )( "!",M!*!,"!,%!%"""" )for ( !*% ", D !% "%( for :
% and DE %( for 2
into equation (10), the equation for the firm's spot constraint price for the lottery *.
Next substitute &FU( for %( . Divide by &FU( to get
*( # D :) !E " 2*( 4
Divide by *(
) # D :) !E " 24

" !,!*",!% ""

:
* 39
5/D !E " : D !F"1 $ :
" M !,!% ""

(42)

:
" !,!*",!% ""
*
:
/D
!
E
"
:
D
!
%
"
1
$
9
5
M
" !,!% ""
*( 3

:
:
Subtract **( from both sides. Multiply both sides by -1, substitute D !*" for
:
substitute :
, !*" for D !*" : )

" !,!*",!% ""

:
:
, !*" # D :) !E " 24
5/D !F" : D !E "1 39
M
" !,!% ""

(43)
:
*
*(

and

(44)

34
!

Proposition 6 Constraint Price and Return for the Firm's Portfolio:

Proof: Denote the spot constraint price for the firm's portfolio by %( . With The spot
price per share is
%( #

)
>? % @% # % B # DE:) % 9
DE

(45)

!
Proposition 7 Homogenous Risk Expansion (Contraction) in Bad (Good) Times:
Proof: By assumption 2 6 :
%
%( # C:,$ ? ' $ :
% B # C:,$ ? (!%% "/2 : :
%1$ :
%B

(46)

# C:,$ ? /2 : :
%1$ :
% B # C:,$ 2 6 C:,$:
%

(47)

' # C:,$ /2 : :
% 1 6 (.

(48)

!
Proposition 8 How to Satisfy a Feasible Constraint that is Violated
Proof:
(a) Given the parameters to the firm's distribution + 4 and 2 the set of values for the

4
parameters of the portfolio distribution !!" " " is given by T ( 2:%
"!% " ) # + , so !!" " "
:

must satisfy

% $ "!% "T :) !+ 4 ""

2 #:

(49)

)
YGN'4+ 4 : 5 # YGN'6T :) !+ 4 "7 # YGN'!2 : :
% ".
M

(50)

where T :) !+ 4 " is constant. Note that from proposition 4

Hence if the sign is negative, a downward exogenous shift in the portfolio mean
,):
% 8 ( must be compensated for by trading so that
% $ ,M:
% $ ,M "!% " T :) !+ 4 ""
,):

(51)

35

where ,M indicates shifts from trading. If the previous portfolio mean :

% is not
:
:
achieved , % $ , % 8 (, then to satisfy the constraint
)

YGN'!,M " !% "" # YGN'!2 : :

% "9

(52)

Hence in good times the firm reduces portfolio variance, and in bad times it increases
portfolio variance.
(b) By (a).
!
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40

Economic Conditions
2 ::
% 6 ( (bad)
2 ::
% # ( (neutral)
:
2 : % 8 ( (good)

)!*" % " 6 (
$
(
:

)!*" % " # (
(
(
(

)!*" % " 8 (
:
(
$

Table 1: The constraint price premium for a lottery as

determined by the correlation between the lottery and the firm's
portfolio and the floor minus expected portfolio value

41

Normal constraint price risk premia with *!! + !) + #+ $! + $) + & + & ,

. *#+ #//+ #+ 9\" 9)" M(" 0+ & , *#+ - #0#, and *& + - #//+ #//,

Figure 1

42

Normal bid price risk premia with *!! + !) + #+ $! + $) + & + & ,

. *#+ #//+ #+ 9\" 9)" M(" 0+ & , *#+ - #0#, and *& + - #//+ #//,

Figure 2

43

Normal offer price risk premia with *!! + !) + #+ $! + $) + & + & ,

. *#+ #//+ #+ 9\" 9)" M(" 0+ & , *#+ - #0#, and *& + - #//+ #//,

Figure 3