Insights to Systematic Risk and Diversification Across a Joint Probability Distribution

Abstract

This paper analyses and develops insights to systematic risk and diversification when random, imperfectly dependent, losses are aggregated. Systematic risk and diversification are shown to vary across layers of component losses according to local dependence and volatility structures. Systematic risk is high and diversification is weak overall if high risk layers are heavily dependent on the aggregate loss. This result explains weak diversification observed in financial markets despite weak to moderate correlations overall. A coherent risk setup is assumed in this paper, where risks are measured using distortion and allocated using the Euler principle.

Keywords: Distortion risk, spectral risk, Euler allocation, systematic risk, diversification, layer, Value-at-Risk

JEL Classification: C00