The modern risk management of financial institutions increasingly applies methods of active risk controlling that base upon the measurement of market risk. Instruments of active risk controlling are, for example, hedging techniques and risk budgeting procedures. Motivations for active risk controlling were first driven by the increasing magnitude of market risk for the most part and as a result, the Value at-risk concept has become the standard tool to specify risk.
But although academics and practitioners undertook tremendous efforts to adequately measure shortfall risk, the questions of how to control and particularly how to budget this risk attracted surprisingly low interest.
In this paper, we develop a profit & loss-dependent, dynamic risk budgeting approach for financial institutions. Its aim is an optimal adjustment of risk budgets to reduce capital requirements and to reduce the costs of (regulatory) capital. Based on standard modeling of financial market stochastics, we provide a risk budget adjustment method adopting the idea of synthetic portfolio insurance. By varying the strike price of an implicit synthetic put option we are able to keep within budgets accepting a certain default probability.
The paper is organized as follows. Section 2 provides some important preliminary issues and motivates our aim. We analyze the capital requirement decision in Section 3 and characterize our modeling framework in Section 4. The dynamic risk budgeting approach is presented in Section 5 and applied within a simple simulation study in Section 6. Conclusions and practical implications are drawn in Section 7.
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Capital Requirement, Portfolio Risk Insurance, and Dynamic Risk Budgeting
