The Marginal Cost of Risk, Risk Measures, and Capital Allocation

Daniel Bauer () and George Zanjani ()
Additional contact information
Daniel Bauer: Department of Risk Management and Insurance, Georgia State University, Atlanta, Georgia 30303
George Zanjani: Department of Risk Management and Insurance, Georgia State University, Atlanta, Georgia 30303

Management Science, 2016, vol. 62, issue 5, 1431-1457

Abstract: Financial institutions use risk measures to calculate the marginal capital cost when expanding the exposure to a certain risk within their portfolio. We reverse this approach by calculating the marginal cost based on economic fundamentals for a profit-maximizing firm and then by identifying the risk measure delivering the correct marginal cost. The resulting measure depends on context. Whereas familiar measures can be recovered in some circumstances, other circumstances yield unfamiliar forms. In all cases, the risk preferences of the institution’s claimants determine how the correct risk measure must weight various default states. Our results demonstrate that risk measures used for pricing and performance measurement should be chosen based on economic fundamentals and may not necessarily adhere to the mathematical properties typically imposed in the literature. This paper was accepted by Jerome B. Detemple, finance .

Keywords: capital allocation; risk measure; profit maximization; counterparty risk (search for similar items in EconPapers)
Date: 2016
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (17)

Downloads: (external link)
http://dx.doi.org/10.1287/mnsc.2015.2190 (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:inm:ormnsc:v:62:y:2016:i:5:p:1431-1457

Access Statistics for this article

More articles in Management Science from INFORMS Contact information at EDIRC.
Bibliographic data for series maintained by Chris Asher ().