Risk Concentration and Diversification: Second-Order Properties

TL;DR

This paper explores how second-order regular variation theory can improve the quantification of risk concentration and diversification benefits in financial risk management, addressing complexities in risk aggregation.

Contribution

It introduces a second-order approximation framework for risk concentration and diversification benefits using advanced regular variation theory.

Findings

Provides second-order approximations for risk concentration

Enhances understanding of diversification benefits

Addresses complexities in risk aggregation

Abstract

The quantification of diversification benefits due to risk aggregation plays a prominent role in the (regulatory) capital management of large firms within the financial industry. However, the complexity of today's risk landscape makes a quantifiable reduction of risk concentration a challenging task. In the present paper we discuss some of the issues that may arise. The theory of second-order regular variation and second-order subexponentiality provides the ideal methodological framework to derive second-order approximations for the risk concentration and the diversification benefit.