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Rethinking Risk Capital Allocation in a RORAC Framework

by Arne Buch of d-fine GmbH,
Gregor Dorfleitner of University of Regensburg, and
Maximilian Wimmer of University of Regensburg

December 3, 2009

Abstract: This paper considers the economic optimization problem of a firm with several subbusinesses striving for its optimal RORAC. An insightful example shows that the implementation of a classical gradient capital allocation can be suboptimal if division managers are allowed to venture into all business whose marginal RORAC exceeds the firm's RORAC. The marginal RORAC requirements are then refined by adding a risk correction term that takes into account the interdependencies of the risks of different lines of business. It is shown that this approach can guarantee that the optimal RORAC will be achieved eventually.

JEL Classification: C61, D81, D82, G21, G22.

Keywords: Risk capital allocation, Gradient allocation principle, Coherent risk measures, Performance measurement, RORAC.

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