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Risk Capital Allocation: The Lorenz Set

Jens Hougaard () and Aleksandrs Smilgins ()
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Aleksandrs Smilgins: Department of Food and Resource Economics, University of Copenhagen

No 03_2014, MSAP Working Paper Series from University of Copenhagen, Department of Food and Resource Economics

Abstract: Risk capital allocation problems have been widely discussed in the academic literature. We consider a company with multiple subunits having individual portfolios. Hence, when portfolios of subunits are merged, a diversification benefit arises: the risk of the company as a whole is smaller than the sum of the risks of the individual sub-units. The question is how to allocate the risk capital of the company among the subunits in a fair way. In this paper we propose to use the Lorenz set as an allocation method. We show that the Lorenz set is operational and coherent. Moreover, we propose a set of new axioms related directly to the problem of risk capital allocation and show that the Lorenz set satisfies these new axioms in contrast to other well-known coherent methods. Finally, we discuss how to deal with non-uniqueness of the Lorenz set.

Keywords: Risk capital; Cost allocation; Lorenz undominated elements of the core; Coherent risk allocation; Egalitarian allocation (search for similar items in EconPapers)
Pages: 20 pages
Date: 2014-05
New Economics Papers: this item is included in nep-gth and nep-rmg
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