Covariance Principle for Capital Allocation: A Time-Varying Approach

Jilber Urbina, Miguel Santolino and Montserrat Guillen
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Miguel Santolino: Department of Econometrics, Riskcenter-IREA, University of Barcelona, 08034 Barcelona, Spain
Montserrat Guillen: Department of Econometrics, Riskcenter-IREA, University of Barcelona, 08034 Barcelona, Spain

Mathematics, 2021, vol. 9, issue 16, 1-13

Abstract: The covariance allocation principle is one of the most widely used capital allocation principles in practice. Risks change over time, so capital risk allocations should be time-dependent. In this paper, we propose a dynamic covariance capital allocation principle based on the variance-covariance of risks that change over time. The conditional correlation of risks is modeled by means of a dynamic conditional correlation (DCC) model. Unlike the static approach, we show that in our dynamic capital allocation setting, the distribution of risk capital allocations can be estimated, and the expected future allocations of capital can be predicted, providing a deeper understanding of the stochastic multivariate behavior of risks. The methodology presented in the paper is illustrated with an example involving the investment risk in a stock portfolio.

Keywords: dynamic allocation; risk management; contribution; diversification (search for similar items in EconPapers)
JEL-codes: C (search for similar items in EconPapers)
Date: 2021
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