Excess based allocation of risk capital (Q2427804)

This paper introduces a new rule to allocate risk capital to portfolios or divisions with a corporation. The goal is to determine an optimal capital allocation rule so as to minimize the excesses of sets of portfolios in a lexicographical sense. The excess of a set of portfolios is defined as the expected loss of that set of portfolios in excess of the amount of risk capital allocated to them. The rationale behind the method is to select an optimal capital allocation rule so that the largest excess is made as small as possible. The authors translate the optimal capital allocation problem into a series of linear programming problems. They also prove the uniqueness of the optimal capital allocation rule and that the rule satisfies some desirable properties.