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Optimal Dynamic Trading Strategies with Risk Limits

Winner of the 2002 FAME Research Prize

Authors
Domenico CUOCO - The Wharton School, University of Pennsylvania
Hua HE - School of Management, Yale University
Sergei ISSAENKO - The Wharton School, University of Pennsylvania

Date
December 2001

Click here to download a .pdf of this paper (1'975 KB).

Abstract
Value at Risk (VaR) has emerged in recent years as a standard tool to measure and control the risk of trading portfolios. Yet, existing theoretical analyses of the optimal behavior of a trader subject to VaR limits have produced a negative view of VaR as a risk-control tool. In particular, VaR limits have been found to induce increased risk exposure in some states and an increased probability of extreme losses. However,these conclusions are based on models that are either static or dynamically inconsistent. In this paper we formulate a dynamically consistent model of optimal portfolio choice subject to VaR limits and show that the conclusions of earlier papers are incorrect if, consistently with common practice, the portfolio VaR is reevaluated dynamically making use of available conditioning information. In particular,we find that the risk exposure of a trader subject to a VaR limit is always lower than that of an unconstrained trader and that the probability of extreme losses is also lower. We also consider risk limits formulated in terms of Tail Conditional Expectation (TCE), a coherent risk measure often advocated as an alternative to VaR, and show that in our dynamic setting it is always possible to transform a TCE limit into an equivalent VaR limit, and conversely.


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