Enhancing gradient capital allocation with orthogonal convexity scenarios

Philipp Aigner and Sebastian Schlütter

No 47/23, ICIR Working Paper Series from Goethe University Frankfurt, International Center for Insurance Regulation (ICIR)

Abstract: Gradient capital allocation, also known as Euler allocation, is a technique used to redistribute diversified capital requirements among different segments of a portfolio. The method is commonly employed to identify dominant risks, assessing the risk-adjusted profitability of segments, and installing limit systems. However, capital allocation can be misleading in all these applications because it only accounts for the current portfolio composition and ignores how diversification effects may change with a portfolio restructuring. This paper proposes enhancing the gradient capital allocation by adding "orthogonal convexity scenarios" (OCS). OCS identify risk concentrations that potentially drive portfolio risk and become relevant after restructuring. OCS have strong ties with principal component analysis (PCA), but they are a more general concept and compatible with common empirical patterns of risk drivers being fat-tailed and increasingly dependent in market downturns. We illustrate possible applications of OCS in terms of risk communication and risk limits.

Keywords: Risk capital allocation; Scenario analysis; Risk communication; Risklimiting; Principal Component Analysis (search for similar items in EconPapers)
JEL-codes: D62 G28 G32 H23 (search for similar items in EconPapers)
Date: 2023
New Economics Papers: this item is included in nep-rmg
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Persistent link: https://EconPapers.repec.org/RePEc:zbw:icirwp:4723

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