The effect of var based risk management on asset prices and the volatility smile

Value-at-risk (VaR) has become the standard criterion for assessing risk in the financial industry. Given the widespread usage of VaR, it becomes increasingly important to study the effects of VaR based risk management on the prices of stocks and options. We solve a continuous-time asset pricing model, based on Lucas (1978) and Basak and Shapiro (2001), to investigate these effects. We find that the presence of risk managers tends to reduce market volatility, as intended. However, in some cases VaR risk management undesirably raises the probability of extreme losses. Finally, we demonstrate that option prices in an economy with VaR risk managers display a volatility smile.