Value at risk and inventory control

Abstract

The purposes of this paper are two-fold. On the one hand, we shall provide a decision analysis justification for the Value at Risk (VaR) approach based on ex-post, disappointment decision making arguments. We shall show that the VaR approach is justified by a disappointment criterion. In other words, the asymmetric valuation between ex-ante expected returns above an appropriate target return and the expected returns below that same target level, provide an explanation for the VaR criterion when it is used as a tool for VaR efficiency design. Second, this paper provides applications to inventory management based on VaR risk exposure. Although the mathematical problems arising from an application of the VaR approach, tuned to current practice in financial risk management, are difficult to solve analytically, solutions can be found by application of standard computational and simulation techniques. A number of cases are solved and formulated to demonstrate the paper's applicability.