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Diversification and value-at-risk

Perignon, Christophe & Smith, Daniel (2010) Diversification and value-at-risk. Journal of Banking and Finance, 34(1), pp. 55-66.

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Abstract

A pervasive and puzzling feature of banks’ Value-at-Risk (VaR) is its abnormally high level, which leads to excessive regulatory capital. A possible explanation for the tendency of commercial banks to overstate their VaR is that they incompletely account for the diversification effect among broad risk categories (e.g., equity, interest rate, commodity, credit spread, and foreign exchange). By underestimating the diversification effect, bank’s proprietary VaR models produce overly prudent market risk assessments. In this paper, we examine empirically the validity of this hypothesis using actual VaR data from major US commercial banks. In contrast to the VaR diversification hypothesis, we find that US banks show no sign of systematic underestimation of the diversification effect. In particular, diversification effects used by banks is very close to (and quite often larger than) our empirical diversification estimates. A direct implication of this finding is that individual VaRs for each broad risk category, just like aggregate VaRs, are biased risk assessments.

Impact and interest:

15 citations in Scopus
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8 citations in Web of Science®

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ID Code: 43024
Item Type: Journal Article
Keywords: Value-at-risk, Diversification, Copulas, Dynamic conditional correlation
DOI: 10.1016/j.jbankfin.2009.07.003
ISSN: 0378-4266
Subjects: Australian and New Zealand Standard Research Classification > MATHEMATICAL SCIENCES (010000) > APPLIED MATHEMATICS (010200)
Australian and New Zealand Standard Research Classification > ECONOMICS (140000) > APPLIED ECONOMICS (140200) > Financial Economics (140207)
Australian and New Zealand Standard Research Classification > ECONOMICS (140000) > ECONOMETRICS (140300)
Australian and New Zealand Standard Research Classification > COMMERCE MANAGEMENT TOURISM AND SERVICES (150000) > BANKING FINANCE AND INVESTMENT (150200)
Divisions: Current > QUT Faculties and Divisions > QUT Business School
Current > Schools > School of Economics & Finance
Deposited On: 13 Jul 2011 23:08
Last Modified: 03 Dec 2012 12:07

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