Introduction to Value-at-Risk

Gianluca Fusai and Laura Ballotta

INTRODUCTION

Uncertainty about commodity prices, foreign markets, new technologies, government policies, and even weather conditions can affect significantly firm earnings, so that a sound risk management plays an important role in many business decisions. This is important not only for banks, for which quite stringent rules are already at work, but also for corporate firms. Academic finance literature identifies at least three relevant issues associated with unpredicted earnings volatility: (1) higher expected costs of financial distress; (2) higher expected payments to corporate stakeholders (including higher rates of return required by owners of firms); and (3) lower tax payments due to reduction in the fluctuations of taxable income through suitable risk management policies.¹¹For a detailed discussion on these themes, see Stultz (1996). From the management point of view, the decision about which risks to keep and which to hedge requires a comprehensive risk-audit review (Stulz 1996). The aim of this chapter is to present a modern approach to the risk measurement of a financial position through statistical techniques which allow to describe the profit and loss (henceforth P&L)