MEASURING AND ALLOCATING PORTFOLIO RISK CAPITAL IN THE REAL WORLD: PRACTICAL APPLICATION OF VALUE-AT-RISK AND EXPECTED SHORTFALL

Abstract

Financial risk professionals are constantly interested in the risk capital allocation especially when dealing with management of portfolios under their control. This paper seeks to investigate two major risk measures namely the Value-at-Risk (VaR) and Expected Shortfall (ES) in dealing with the risk capital allocation problem. Data from the London Stock exchange was used for this study. Assuming no dividends payment, the Geometric Brownian motion (Black-Scholes Model) and a fair per-unit capital allocation principle were applied to ascertain the coherence of the two considered risk measures within a two year time horizon. It is evident from the results that stock with high mean rate of log returns and low volatility turns to have a lower fair per unit capital allocation of risk in any selected portfolio. Results of stocks with the least quantified risk (in pence) of all considered portfolios in this paper were Portfolio I (Mining: BLT - 926), Portfolio II (Media: PSON - 175), Portfolio III (Financial services: SDRC - 459), Portfolio IV (Bank: STAN - 739) and Portfolio V (FTSE 100 top 10 Companies: BATS - 1021) respectively.

Keywords:   Coherent Risk Capital Allocation Value-at-Risk Expected Shortfall