The efects of VaR position limits on endogenous price formation in financial markets

Abstract

This paper sets out to study the impact that market risk limits have on the price dynamics in securities markets. We start out from a standard model in which trading patterns are determined for utility-maximising investors in non-clearing markets with a particularly simple price formation mechanism. To make trading conditions more realistic, we add borrowing and short-selling constraints and incorporate a stochastic information arrival process into the standard model. We present a VaR position limit formulation that allows us to integrate market risk limit considerations into our model and solve the respective utility maximization problems. Simulation results are then discussed which show an increase in price instability in a scenario of widespread adoption of VaR as a mechanism to limit portfolio risk.