On Setting Day-Ahead Equity Trading Risk Limits: VaR Prediction at Market Close or Open?

This paper investigates the information content of the ex post overnight return for one-day-ahead equity Value-at-Risk (VaR) forecasting. To do so, we deploy a univariate VaR modeling approach that constructs the forecast at market open and, accordingly, exploits the available overnight close-to-open price variation. The benchmark is the bivariate VaR modeling approach proposed by Ahoniemi et al. that constructs the forecast at the market close instead and, accordingly, it models separately the daytime and overnight return processes and their covariance. For a small cap portfolio, the bivariate VaR approach affords superior predictive ability than the ex post overnight VaR approach whereas for a large cap portfolio the results are reversed. The contrast indicates that price discovery at the market open is less efficient for small capitalization, thinly traded stocks.