Benchmarking the incremental risk charge

Christopher C. Finger

Abstract

ABSTRACT

In this paper, we develop a framework to interpret the constant level of risk portfolio rebalancing under the incremental risk charge. Rebalancing in this context is intended to reward greater liquidity, all other things being equal, and to produce lower capital charges. While there is some consensus on the appropriate algorithm to model rebalancing, there has been little discussion of the actual modeling assumptions that underpin the algorithm, nor of the intuition as to the nature of the impact of the rebalancing. We discuss rebalancing, and identify three distinct mechanisms by which rebalancing influences risk.We then perform a benchmarking exercise, applying our model to a number of representative portfolios in order to assess the impact of each of the rebalancing mechanisms. We show in particular how some of the rebalancing mechanisms offset each other, making the overall effect of rebalancing more robust than might be expected of other modeling assumptions.