Risk measures and the impact of asset price bubbles

Abstract

This paper analyzes the impact of asset price bubbles on a firm's standard risk measures, including value-at-risk (VaR) and conditional value-at-risk (CVaR). Comparing a bubble and non-bubble economy, it is shown that asset price bubbles cause (i) a firm's VaR and CVaR to decline, but (ii) increase its expected daily and maximum daily losses. This decline in the standard risk measures is due to the increased right skew in a firm value's distribution due to bubble expansion. The increase in the expected daily losses is due to bubble bursting. This implies that the standard risk measures are not adequate for equity capital determination in the present of asset price bubbles, and that scenario analysis which include bursting bubbles are essential for the proper determination of equity capital.