Risk management under weighted limited expected loss

Abstract

We present and solve an optimal asset allocation problem under a weighted limited expected loss (WLEL) constraint. This formulation encompasses the risk management problem with a limited expected loss (LEL) constraint as a specialized instance and offers a pertinent internal risk management instrument for firms. We observe that a WLEL constraint makes the optimizing investor pursue less volatile payoffs than the unconstrained Merton solution. Compared to the LEL-constrained problem with the same weighted default threshold, the WLEL optimal terminal wealth displays a less dispersed distribution with a smaller variance, suggesting a more secure risk management framework. Conducting a comprehensive equilibrium analysis in the presence of a WLEL risk manager, we validate the relatively conservative investment approach undertaken by the WLEL manager. Subsequently, we expand our findings to encompass broader incomplete market settings, wherein the uniqueness of the equivalent local martingale measure is not assured.

Keywords: utility maximization with constraint, risk management, (weighted) expected limited loss, asset allocation

JEL Classification: G11, G12