For portfolios of risks with high degree of clustering – concentration, risk and capital metric (back)allocation is best accomplished by the Covariance Principle. Less well used is the second attribute of this principle, which actually accounts for dispersion - diversification. The critical technical task for application of this principle is to decompose the total Portfolio Covariance into single risk-to-total components, and define the back-allocation ratio – equations (1) and (2) on the datagram. The expression for back-allocation is easy after this – equations (3) and (4). The mechanics are written in context of TVaR, and the same will apply to VaR and SCR. We will show how the Covariance Principle works in context of a notional micro-economy computed case study at workshops and in a paper coming up this spring and summer.
Category: Climate/natural disasters: Disaster risk, Floods/storms, Resilience
Location: Cambridge, MA, United States