Distortion measures and homogeneous financial derivatives

This paper extends the evaluation and allocation of distortion risk measures to apply to arbitrary homogeneous operators (“financial derivatives,” e.g. reinsurance recovery) of primitive portfolio elements (e.g. line of business losses). Previous literature argues that the allocation of the portfolio measure to the financial derivative should take the usual special-case form of Aumann–Shapley, being a distortion-weighted “co-measure” expectation. This is taken here as the definition of the “distorted” measure of the derivative “with respect to” the underlying portfolio. Due to homogeneity, the subsequent allocation of the derivative’s value to the primitive elements of the portfolio again follows Aumann–Shapley, in the form of the exposure gradient of the distorted measure. However, the gradient in this case is seen to consist of two terms. The first is the familiar distorted expectation of the gradient of the financial derivative with respect to exposure to the element. The second term involves the conditional covariance of the financial derivative with the element. Sufficient conditions for this second term to vanish are provided. A method for estimating the second term in a simulation framework is proposed. Examples are provided.