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Optimal Capital Allocation Principles

The final version of this article appeared as: Dhaene J., Tsanakas, A. , Valdez, E. A. , Vanduffel, S. (2012), 'Optimal Capital Allocation Principles', Journal of Risk and Insurance, 79(1), p.1-28.

23 Pages Posted: 26 Jan 2009 Last revised: 3 Jan 2014

Jan Dhaene

Katholieke Universiteit Leuven - Faculty of Economics and Business

Andreas Tsanakas

City University London - Cass Business School

Emiliano A. Valdez

University of Connecticut - Department of Mathematics

Steven Vanduffel

Vrije Universiteit Brussel (VUB)

Multiple version iconThere are 2 versions of this paper

Date Written: January 24, 2009

Abstract

This paper develops a unifying framework for allocating the aggregate capital of a financial firm to its business units. The approach relies on an optimisation argument, requiring that the weighted sum of measures for the deviations of the business unit’s losses from their respective allocated capitals be minimised. The approach is fair insofar as it requires capital to be close to the risk that necessitates holding it. The approach is additionally very flexible in the sense that different forms of the objective function can reflect alternative definitions of corporate risk tolerance. Owing to this flexibility, the general framework reproduces several capital allocation methods that appear in the literature and allows for alternative interpretations and possible extensions.

Keywords: Capital allocation, risk measure, comonotonicity, Euler allocation, default option, Lloyd's of London

Suggested Citation

Dhaene, Jan and Tsanakas, Andreas and Valdez, Emiliano A. and Vanduffel, Steven, Optimal Capital Allocation Principles (January 24, 2009). The final version of this article appeared as: Dhaene J., Tsanakas, A. , Valdez, E. A. , Vanduffel, S. (2012), 'Optimal Capital Allocation Principles', Journal of Risk and Insurance, 79(1), p.1-28.. Available at SSRN: https://ssrn.com/abstract=1332264

Jan Dhaene

Katholieke Universiteit Leuven - Faculty of Economics and Business ( email )

Naamsestraat 69
Leuven, 3000
Belgium

Andreas Tsanakas (Contact Author)

City University London - Cass Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom

Emiliano A. Valdez

University of Connecticut - Department of Mathematics ( email )

341 Mansfield Road U-1009
Storrs, CT 06269-1009
United States

HOME PAGE: http://www.math.uconn.edu/~valdez

Steven Vanduffel

Vrije Universiteit Brussel (VUB) ( email )

Pleinlaan 2
Brussels, Brabant 1050
Belgium

HOME PAGE: http://www.stevenvanduffel.com

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