This study addresses the regulatory request for sustainability-related risk integration into traditional financial risk measures. We propose a new risk metric that combines a traditional market risk measure expressed in terms of Value-at-Risk (VaR) and environmental, social, and governance (ESG) factors. The new metric, VaRESG, considers the orthogonality of the ESG criteria with fundamental variables, applying a perturbative approach and an entropy function of ESG factors. The pilot empirical application relies on a financial portfolio comprising approximately 3,000 equities. The results show the predictive power of VaRESG to reduce unexpected losses (i.e., out-of- VaR). The results were confirmed especially under stress conditions, when the values of losses were higher (in terms of magnitude). To the best of our knowledge, this is the first attempt in the financial literature to effectively integrate ESG risks into the VaR measure to predict the expected losses of an equity portfolio. The measure of VaRESG can be useful to asset managers and institutional investors to reduce unexpected losses, and to supervisors interested in increasing the level of accuracy of VaR estimations.

Integrating ESG Risks into Value-at-Risk / Federica Ielasi. - In: FINANCE RESEARCH LETTERS. - ISSN 1544-6123. - ELETTRONICO. - (2023), pp. 1-20. [10.1016/j.frl.2023.103875]

Integrating ESG Risks into Value-at-Risk

Federica Ielasi
2023

Abstract

This study addresses the regulatory request for sustainability-related risk integration into traditional financial risk measures. We propose a new risk metric that combines a traditional market risk measure expressed in terms of Value-at-Risk (VaR) and environmental, social, and governance (ESG) factors. The new metric, VaRESG, considers the orthogonality of the ESG criteria with fundamental variables, applying a perturbative approach and an entropy function of ESG factors. The pilot empirical application relies on a financial portfolio comprising approximately 3,000 equities. The results show the predictive power of VaRESG to reduce unexpected losses (i.e., out-of- VaR). The results were confirmed especially under stress conditions, when the values of losses were higher (in terms of magnitude). To the best of our knowledge, this is the first attempt in the financial literature to effectively integrate ESG risks into the VaR measure to predict the expected losses of an equity portfolio. The measure of VaRESG can be useful to asset managers and institutional investors to reduce unexpected losses, and to supervisors interested in increasing the level of accuracy of VaR estimations.
2023
1
20
Goal 8: Decent work and economic growth
Goal 9: Industry, Innovation, and Infrastructure
Goal 12: Responsible consumption and production
Federica Ielasi
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Utilizza questo identificatore per citare o creare un link a questa risorsa: https://hdl.handle.net/2158/1305479
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