Economic models used to calculate market risk contain a fundamental flaw that could cause banks to underestimate their capital requirements.

Federal Reserve Bank of Chicago economist Subu Venkataraman finds that almost all risk management models produce a value-at-risk figure, which tells traders how much they are likely to lose. For instance, the model for a $1 million securities portfolio may produce a VAR of $100,000 with a 95% probability. This means that 5% of the time the trader will lose more than $100,000; the rest of the time, he will either lose less or make money.

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