Rainy Day Funds and Value at Risk

Research Report

Rainy Day Funds and Value at Risk

August 25, 2003

Abstract

The state fiscal challenges created by revenue shortfalls during the most recent economic slowdown have revealed the inadequacy of rainy day funds. The revenue declines in states whose fund creation employs heuristically derived rules-of-thumb have painfully revealed the need for more formal methodology that can prescribe the size of rainy day funds. Well-developed methodologies exist for similar managerial problems encountered in private enterprise. If decisionmakers see rainy day funds as forecaster indemnity insurance policies, then the risk literature provides a rich menu of accepted methodologies that help gauge the size of revenue risks and their commensurate insurance coverage. Subsequent reviews of the value at risk and insurance funding literatures give methodologies applicable for determining the optimal rainy day fund size. These methodologies are finally illustrated using current state fiscal situations.

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