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Risk Capital Allocation: The Lorenz Set

Author

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  • Jens Leth Hougaard

    (Department of Food and Resource Economics, University of Copenhagen)

  • Aleksandrs Smilgins

    (Department of Food and Resource Economics, University of Copenhagen)

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.

Suggested Citation

  • Jens Leth Hougaard & Aleksandrs Smilgins, 2014. "Risk Capital Allocation: The Lorenz Set," MSAP Working Paper Series 03_2014, University of Copenhagen, Department of Food and Resource Economics.
    • Handle: RePEc:foi:msapwp:03_2014
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    File URL: http://okonomi.foi.dk/workingpapers/MSAPpdf/MSAP2014/MSAP_WP03_2014.pdf
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    References listed on IDEAS

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    Keywords

    Risk capital; Cost allocation; Lorenz undominated elements of the core; Coherent risk allocation; Egalitarian allocation;
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