capital allocation using the ruhm-mango-kreps algorithm david l. ruhm, fcas enterprise risk...
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Capital Allocation using the Ruhm-Mango-Kreps Algorithm
David L. Ruhm, FCAS
Enterprise Risk Management Symposium
Session CS-13: Risk-Adjusted Capital Allocation
July 30, 2003
Washington, DC
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The Capital Allocation Problem
• How can total-company capital, and its costs, be allocated to all sources of risk in a way that:– Is internally consistent (summing within parts),– Allocates in proportion to risk contributed,– Attributes diversification benefits to sources,– Can be used with any specified risk measure,– Is consistent with established financial theory.
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The RMK algorithm
RMK meets the above requirements, plus:
• Is simple to use,
• Can be explained,
• Has solid underlying mathematical theory,
• Evaluates all risk in terms of total-company, “top-down” view (instead of evaluating each part as if stand-alone)
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The RMK Algorithm
Central principle
Each component is evaluated, to measure its contribution to total-company risk.
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The RMK Algorithm
• The algorithm, in short:– Simulate possible outcomes, by component and total
company. Calculate unweighted average outcome (expected value) for each.
– Select a risk measure on total company outcomes, expressed as higher weights on adverse outcomes.
– Apply the risk-weights to the individual components, and calculate risk-weighted averages.
– Allocate capital in proportion to risk, as measured by the difference between the risk-weighted average and the unweighted average:
Risk ~ Risk-Weighted Expected Value – Unweighted Expected Value
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Selecting a risk measure
• Any standard risk measure (e.g., value at risk, tail-value at risk, default rate of surplus) can be expressed in the form of weights.
• Simplest: Net loss outcomes > 1 , net gain outcomes = 1.– Measures tail of distribution, all loss outcomes equally weighted.– Risk Measure ~ Frequency of Loss x Average Severity of Loss.– Is a good risk measure, similar to TVaR.– Weights could be refined to distinguish among loss, gain levels.
• In general, risk measure weights are:– Non-negative,– Higher for worse (“riskier”) outcomes,– Lower for better outcomes.
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Some examplesContext Curve Weights Result
Stock Mkt Normal Wang transform
CAPM
Derivatives Lognormal Wang transform
Black-Scholes
Insurance Any TVaR (wtd) Default Rate of Surplus
Insurance Any P(ruin) Myers-Read
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RMK useful properties
• Any additive allocation method can be replicated using the RMK framework.
• Works with user’s choice of risk measure.• Allocates total company risk to parts, down to any
desired level of detail.• Consistent with financial theory, and arbitrage-
free: risk-weighted averages are equivalent to “risk-neutral” valuations.
• Simple, transparent.
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Selected References
• Ruhm / Mango, “A Risk Charge Calculation Based on Conditional Probability,” Bowles Symposium, Atlanta, April 2003 (submitted to NAAJ).
• Kreps, “Riskiness Leverage Ratios,” Instrat working paper
• Ruhm / Mango, “A Method of Implementing Myers-Read Capital Allocation in Simulation,” CAS Spring Meeting, May 2003 (submitted to CAS Forum).