Capital Requirement, Portfolio Risk Insurance, and Dynamic Risk Budgeting

Abstract:     
Due to risk based capital requirements, financial institutions need to budget their risk-taking to assure their financial survival. This is necessary because the economic capital of the institutions which has to back risky positions is widely assumed to be a short resource. Therefore, financial institutes are advised to pursue a strategy which guarantees that a specified risk budget is never violated. In this paper, we concentrate on the trading portfolios of financial institutions and develop a dynamic risk budgeting approach. We argue that the limitation of risk-taking should depend on actual profit & loss. Based on the standard modeling of financial market stochastics we provide a method of risk budget adjustment 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. Our approach comprises reducing capital requirements and the cost of regulatory capital.

Number of Pages in PDF File: 13

Keywords: Capital requirement, Conditional-value-at-risk, Portfolio insurance, Risk budgeting, Value-at-risk

JEL Classification: G21, G31, C10

Accepted Paper Series