Mathematics (Aug 2021)

Covariance Principle for Capital Allocation: A Time-Varying Approach

  • Jilber Urbina,
  • Miguel Santolino,
  • Montserrat Guillen

DOI
https://doi.org/10.3390/math9162005
Journal volume & issue
Vol. 9, no. 16
p. 2005

Abstract

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The covariance allocation principle is one of the most widely used capital allocation principles in practice. Risks change over time, so capital risk allocations should be time-dependent. In this paper, we propose a dynamic covariance capital allocation principle based on the variance-covariance of risks that change over time. The conditional correlation of risks is modeled by means of a dynamic conditional correlation (DCC) model. Unlike the static approach, we show that in our dynamic capital allocation setting, the distribution of risk capital allocations can be estimated, and the expected future allocations of capital can be predicted, providing a deeper understanding of the stochastic multivariate behavior of risks. The methodology presented in the paper is illustrated with an example involving the investment risk in a stock portfolio.

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