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Capital allocation in financial institutions: the Euler method

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  • Dora Balog

    () (Department of Finance Corvinus University of Budapest)

Abstract

Capital allocation is used for many purposes in financial institutions and for this purpose several methods are known. The aim of this paper is to review possible methods (we present six of them) and to help financial companies to choose between the methods. There are some properties that an allocation method should satisfy: full allocation, core compatibility, riskless allocation, symmetry and suitability for performance measurement (compatibility with Return on Risk Adjusted Capital calculation). If we think about practical application we should also consider simplicity of the methods. First we examine the methods from the point of view if they are satisfying core compatibility. We test this with simulation where we add to the existing literature that we test core compatibility with different assumptions on returns: on normal and t-distributed returns and also on returns generated from a copula. We find that if we measure risk by a coherent risk measure, the Expected Shortfall there are two methods satisfying core compatibility: the Euler method (that always fulfills the criteria) and cost gap method (obeys it around in about 99%). As Euler method is very easy to calculate even for many players while cost gap method becomes very complicated as the number of the players increases we examine further the properties of Euler method. We find that it fulfills all the above given criteria but symmetry and as aforementioned it is also very easy to calculate. Therefore we believe that the method might be suggested for practical applications.

Suggested Citation

  • Dora Balog, 2011. "Capital allocation in financial institutions: the Euler method," IEHAS Discussion Papers 1126, Institute of Economics, Centre for Economic and Regional Studies, Hungarian Academy of Sciences.
  • Handle: RePEc:has:discpr:1126
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    File URL: http://econ.core.hu/file/download/mtdp/MTDP1126.pdf
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    References listed on IDEAS

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    1. Homburg, Carsten & Scherpereel, Peter, 2008. "How should the cost of joint risk capital be allocated for performance measurement?," European Journal of Operational Research, Elsevier, vol. 187(1), pages 208-227, May.
    2. Csoka, Peter & Herings, P. Jean-Jacques & Koczy, Laszlo A., 2007. "Coherent measures of risk from a general equilibrium perspective," Journal of Banking & Finance, Elsevier, vol. 31(8), pages 2517-2534, August.
    3. Csóka, Péter & Herings, P. Jean-Jacques & Kóczy, László Á., 2009. "Stable allocations of risk," Games and Economic Behavior, Elsevier, vol. 67(1), pages 266-276, September.
    4. Evert Wipplinger, 2007. "Philippe Jorion: Value at Risk – The New Benchmark for Managing Financial Risk," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 21(3), pages 397-398, September.
    5. Buch, A. & Dorfleitner, G., 2008. "Coherent risk measures, coherent capital allocations and the gradient allocation principle," Insurance: Mathematics and Economics, Elsevier, vol. 42(1), pages 235-242, February.
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    Cited by:

    1. Véronique Maume-Deschamps & Didier Rullière & Khalil Said, 2015. "A risk management approach to capital allocation," Working Papers hal-01163180, HAL.
    2. Véronique Maume-Deschamps & Didier Rullière & Khalil Said, 2016. "On capital allocation by minimizing multivariate risk indicators," Post-Print hal-01082559, HAL.
    3. Véronique Maume-Deschamps & Didier Rullière & Khalil Said, 2014. "On capital allocation by minimizing multivariate risk indicators," Working Papers hal-01082559, HAL.

    More about this item

    Keywords

    Capital Allocation; Coherent Measures of Risk; Core; Simulation;

    JEL classification:

    • C60 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - General
    • C70 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - General
    • G20 - Financial Economics - - Financial Institutions and Services - - - General

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