Fair risk allocation in illiquid markets

Abstract

Let us consider a financially constrained leveraged financial firm having some divisions which have invested into some risky assets. Using c oherent measures of risk the sum of the capital requirements of the divisions is larger tha n the capital requirement of the firm itself, there is some diversification benefit that should b e allocated somehow for proper performance evaluation of the divisions. In this pa per we use cooperative game theory and simulation to assess the possibility to jointly sat isfy three natural fairness requirements for allocating risk capital in illiquid markets: Core C ompatibility, Equal Treatment Property and Strong Monotonicity. Core Compatibility can be viewed as the allocated r isk to each coalition (subset) of divisions should be at least as much as the risk increment th e coalition causes by joining the rest of the divisions. Equal Treatment Property guarantees that if two divisions have the same stand� alone risk and also they contribute the same risk t o all the subsets of divisions not containing them, then the same risk capital should be allocate d to them. Strong Monotonicity requires that if a division weakly reduces its stand�alone r isk and also its risk contribution to all the subsets of the other divisions, then as an incentiv e its allocated risk capital should not increase. Analyzing the simulation results we concl ude that in most of the cases it is not possible to allocate risk in illiquid markets satis fying the three fairness notions at the same time, one has to give up at least one of them