Predict the point at which risk begins to magnify using concentration risk
Concentration risk is the potential for a loss in value of an investment portfolio or a financial institution when an individual or group of exposures move together in an unfavorable direction. The implication of concentration risk is that it generates such a significant loss that recovery is unlikely. The portfolio will be liquidated or the institution will face bankruptcy.
In addition, concentration risk can be found in various types of risk exposure such as:
- Market liquidity risk: The difficulties in liquidating, purchasing, or switching investment assets quickly are common problems for a large investment portfolio. Concentration risk is usually calculated by comparing the liquidity of assets to their risk exposure.
- Credit risk: The default of an individual debtor or a group of debtors in the same sector can be ruinous without sufficient diversification.
Generally, concentration risk is managed by concentration risk limits. There are many techniques for quantifying the concentration risk:
- Use concentration indices (e.g., concentration portfolio, Gini coefficient, Herfindahl-Hirschman index, Hannah-Kay index, Hall-Tideman index, and Theil entropy index) to measure the level of concentration in the portfolio
- Use transaction cost analysis to estimate market impact
- Incorporate turnover constraints into portfolio analysis
- Determine the impact from “what if” scenarios
- Stress test the extreme events
For more on tools for concentration risk, see Financial Toolbox™, and Risk Management Toolbox™.
Examples and How To
- Credit Risk Modeling with MATLAB (53:09) - Video
- Using MATLAB to Bridge the Gap Between the Portfolio Construction and Trading (57:28) - Video
- Advanced Risk and Portfolio Management: A (Very) Visual Introduction (39:58) - Video
- Portfolio Optimization with Various Constraints Including Turnover Constraints - Example
- Dynamic Entropy Pooling: Portfolio Management with Views at Multiple Horizons - Example
- Analyze the Sensitivity of Concentration to a Given Exposure - Example
- Credit Portfolio Simulation Using a Credit Migration Matrix - Example
- Concentration Indices - Documentation
- Transaction Cost Analysis - Function
- Counterparty Credit Risk and CVA - Documentation
- A Fully Integrated Liquidity and Market Risk Model - MATLAB Central
- Setup Turnover Constraints for Portfolio Objects - Function
- Wrong Way Risk with Copulas - Documentation
See also: credit risk, liquidity risk, transaction cost analysis, Basel III, value-at-risk, systemic risk, credit scoring model, fraud analytics