Abstract
Value-at-Risk (VaR) has become the standard criterion for assessing risk in the financial industry. Given the widespread usage of VaR based risk management, it becomes increasingly important to study the effects on the stock market and the option market of these constraints. We therefore introduce a continuous-time asset pricing model, based on Lucas (1978) and Basak and Shapiro (2001), in order to investigate the impact of the VAR risk managers on general equilibrium prices We find that agents with a VAR constraint affect the equilibrium prices remarkably and tend to reduce market volatility, as intended. However, in some cases VAR risk management can undesirably raise the probability of extreme losses. Finally, we demonstrate that option prices in an economy with VAR risk managers display a volatility smile as deserved in practice.
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