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Capital requirements: Are they the best solution?

  • Alejandro Balbas

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    General risk functions are becoming very important in finance and insurance. Many risk functions are interpreted as initial capital requirements that a manager must add and invest in a risk-free security in order to protect his clients wealth. Nevertheless, until now it has not been proved that an alternative investment will be outperformed by the riskless asset. This paper deals with a complete arbitrage free market and a general expectation bounded risk measure and analyzes whether the investment in the riskless asset of the capital requirements is optimal. It is shown that it is not optimal in many important cases. For instance, if the risk measure is the CVaR and we consider the assumptions of the CAPM or the Black and Scholes model. Furthermore, the Black and Scholes model the explicit expression of the optimal strategy is provided, and it is composed of several put options. If the confidence level of the CVaR is close to 100% then the optimal strategy becomes a classical portfolio insurance strategy. This may be a surprising and important finding for both researchers and practitioners. In particular, managers can discover how to reduce the level of initial capital requirements by trading options.

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    File URL: http://e-archivo.uc3m.es/bitstream/10016/3367/1/wb087114.pdf
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    Paper provided by Universidad Carlos III, Departamento de Economía de la Empresa in its series Business Economics Working Papers with number wb087114.

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    Date of creation: Dec 2008
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    Handle: RePEc:cte:wbrepe:wb087114
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    1. Andrzej Ruszczynski & Alexander Shapiro, 2004. "Optimization of Convex Risk Functions," Risk and Insurance 0404001, EconWPA, revised 08 Oct 2005.
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    3. Balbás, Alejandro & Balbás, Beatriz & Heras, Antonio, 2009. "Optimal reinsurance with general risk measures," Insurance: Mathematics and Economics, Elsevier, vol. 44(3), pages 374-384, June.
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    11. W. Ogryczak & A. Ruszczynski, 1997. "From Stochastic Dominance to Mean-Risk Models: Semideviations as Risk Measures," Working Papers ir97027, International Institute for Applied Systems Analysis.
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